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Why Blending a 1031 Exchange with a Structured Sale Can be a Considered “ A Good Thing”

By Neil Friedman

The basic benefit to a taxpayer associated with both a 1031 Exchange and a Structured Sale is the ability to manage when and how much tax they pay on the sale of an appreciated asset. Each strategy, by itself, has both benefits and limitations. By structuring a transaction to take advantage of the strengths of each strategy, a taxpayer may achieve additional flexibility.

To recap, a 1031 exchange allows a taxpayer to defer gain recognition (and any tax that would have been incurred in that year) on the sale of a qualified appreciated property. In order to get a 100% deferral the taxpayer must reinvest all of their equity and replace debt by acquiring “like-kind” replacement property. Using 1031 rules, gain recognition can be deferred indefinitely.

A Structured Sale also allows a taxpayer to defer gain recognition (and any tax that would be have been incurred in that year) on the sale of qualified appreciated property. Rather than requiring a reinvestment in “like-kind” property, the rules governing a structured sale allow for a “substitute obligor.” The buyer pays the sales proceeds (cash) to an annuity company that then pays the seller out over time. Gain recognition and taxes are calculated on amount of cash received by the seller in any one year.

In either case, the tax due would be calculated on gain. Gain is derived by subtracting the sale price from something called adjusted basis. Think of adjusted basis as an investor’s initial investment. The point is that one’s original investment is not subject to tax. Under 1031 rules every dollar not reinvested is considered gain until all the gain is exhausted. Under a structured sale every dollar received is prorated basis and gain.

What makes all this detail relevant is that by combining a 1031 exchange and a structured sale an investor can bifurcate the sale proceeds to get a return of their principal in just over 2 years without triggering a taxable event. An investor can invest an amount equal to their adjusted basis in a 1031 exchange and the balance of the funds (which is 100% of gain) into a structured sale. After holding the 1031 exchange replacement property for a minimum of two years and a day to earn safe harbor treatment, a taxpayer can sell the property. If the replacement property has not significantly appreciated, then the proceeds are considered a return of basis and no tax is due.

Prior to entering into the structured sale agreement, the taxpayer has the flexibility to design a custom repayment schedule around their particular requirements. They can determine when payments begin, how much cash is paid in any one year and the length of the term of payments. In addition to the many other benefits of a structured sale, the taxpayer has the ability to avoid triggering AMT.

This strategy provides the most benefit for investors who are selling highly appreciated property with little or no debt and who wish to recoup their original investment without incurring a tax bill. As always, any information contained in this article is solely advisory, and should not be considered tax or legal advice. One should always consult their own tax or legal advisor on any and all real estate matters.

Neil Friedman
Founder
Real Estate Consulting Practice
952-223-9422
nlfriedman@gmail.com
www.linkedin.com/in/nlfriedman