The last great tax loophole - the "1031 Exchange"

In virtually every political election, the issue of taxes is raised. You hear the expression, "let's make the rich pay their fair share" and "let's raise taxes on the upper 1% of wage earners."

All of that sounds good to most hard working taxpaying, law-abiding Americans. However, what most people don't understand or even begin to appreciate is how the top wage earners in this nation use ownership of commercial real estate to offset much, if not all, of their income tax liability. You simply don't even hear wealthy politicians championing the elimination of Section 1031. It's a quiet tool the wealthy in our nation use again and again.

Take this common example. Wealthy client decides to sell his small industrial or office building in Illinois. The sale of that building results in a substantial long-term capital gain in which that client normally would have pay about 25% of that gain to the IRS and Illinois Department of Revenue at the state level.

However, if the client can identify a "replacement property" within 45 days of selling the client's building and the client closes on the acquisition of the replacement property within 180 days of selling the Illinois building, the entire gain is then reinvested into the new property (typically in Florida or Texas), thereby avoiding the gain until the replacement property is then sold, etc. Essentially, the taxpayer can "kick the can down the road" regarding the tax on that gain.

If the client then decides to sell the replacement property, the client typically would have established residency in Florida by then, a state where no capital gains tax exists.

Moreover, with each replacement property purchased, the client may be able to reset the depreciation schedule for that new replacement property even though the prior relinquished property may have been fully depreciated. Depreciation is a common "deduction" on personal income taxes, thereby reducing taxable income. Essentially, depreciation deductions may serve to partially wipe out income tax.

This loophole can even be magnified if the client purchases more expensive replacement property by leveraging debt on the replacement property (i.e., using the proceeds from the sale combined with a bank loan to buy an even more expensive property with more depreciation potential).

As the acquisition price of the property increases with each "flip," so goes the ability to offset income tax liability through higher depreciation deduction potential. And the cycle continues. Moreover, given accelerated depreciation potential under Section 179, the effect can be strong and immediate if the taxpayer is eligible for "accelerated" depreciation following a cost segregation.

All this, while the client sits back and collects rent checks to boot. The income tax liability on those rent check also is offset by the depreciation. Bottom line, 1031 allows a taxpayer to defer the capital gains tax and allows the taxpayer to establish a new basis for depreciation, thereby offsetting income tax. In my humble opinion, it is the most powerful tax loophole in our economy today.

• Vanek, Larson & Kolb, LLC is a full-service business law firm. This article is not intended to be legal advice. You must strictly adhere to all applicable state and federal tax codes and laws which are being modified on a continuous basis. Individual circumstances will vary. Please speak with a qualified tax professional or attorney as this article is not intended to provide tax advice.