The Internal Revenue Code is a labyrinth of hard to decipher rules and regulations intended to minimize tax sheltering alternatives. Consequently, tax planning options are varied and complex. This post will look at and compare a tax deferral strategy most commonly known as a 1031 like-kind exchange and a business tax credit known as the investment tax credit or ITC. In a 1031 like-kind exchange, a seller of property will be able to defer the gain on the sale by purchasing a like-kind property within a defined time period utilizing a qualified intermediary. An investment tax credit by contrast, is earned by investment in certain technologies such as renewable energy, affordable housing, or rehabilitation of historic buildings. In this post, I will be comparing the net result of tax savings v. tax deferral. With that in mind it is important to note that a tax credit is a dollar for dollar offset against taxes owed. In a like-kind exchange the taxes are deferred, rather than offset. Although it is possible to engage in multiple like-kind exchanges with the objective of deferring tax liability beyond death to achieve a stepped up basis, in most cases taxes are deferred until a later time but ultimately the taxes will be due and payable. Refinancing to pull equity out of a property prior to or after completing a like-kind exchange can result in a taxable transaction under the “step transaction doctrine.”
Given that tax credits act as a tax payment while a like-kind exchange is only a deferral of taxes due, a tax credit seems to be a preferable tool, however there may be a larger initial capital outlay in a tax credit transaction, as the generation of the tax credit requires an investment in the renewable energy infrastructure or historic rehabilitation. The best option for you will be case and fact specific, however, the take-away from this post is that a tax credit may be viable where a 1031 like-kind exchange is not an option, or where a party cannot complete a 1031 like-kind exchange.
Comparing the strategies by utilizing an example will help to define the 2 strategies:
1031 Like-Kind Exchange
Sam is selling his building to Paula for $2 million. Sam has owned the building for 10 years and has an adjusted basis in the property of $800,000. Therefore, upon the sale of the building Sam will be faced with a long-term capital gain of $1.2 million. The long-term capital gains tax rate in this situation will most likely be 25%, resulting in a tax bill of $300,000. If Sam identifies a like-kind property within 45 days, keeps his gains on the sale of the building in escrow with a qualified intermediary and closes on the like-kind property within 180 days, the $300,000 tax bill may be deferred.
Utilizing the same set of facts, the sale of the building results in a $300,000 tax bill to Sam. Sam subtracts the $300,000 potential tax liability, leaving him with $900,000 in net gain on the sale. Assuming Sam is a real estate professional (or his ownership of the building was a passive activity) he is exempt from the passive loss rules, and his taxable gains are considered to be derived from passive sources. If Sam invested in a project that completed a qualified rehabilitation of a historic building and generated a tax credit of $300,000, he could utilize that tax credit to offset his $300,000 federal tax bill. To obtain the $300,000 tax credit, assuming current market trends, fees, costs, and expenses, Sam would invest $255,000 and would receive a cash return of approximately $30,000, therefore his net investment (or tax payment) would be $225,000, representing a total return (or tax savings) of $75,000. Sam would therefore have remaining funds of $975,000 after payment of taxes.
With the 1031 like-kind exchange the tax is deferred, but the gains of $1.2 million are rolled over into a new property and are not available to Sam, unless he completes a cash-out refinance that is made for an independent business purpose and not tax avoidance. Also, there will be a costs to Sam for the 1031 exchange, and subsequent exchanges to keep up the deferral, all of which will be an out of pocket cost. Tax credit costs are generally built into the transaction and are not out-of pocket to Sam. The tax credit has resulted in Sam paying a net $225,000 of the $1.2mm gain, or realizing a reduction in his tax rate from 25% to 18.75%.
This post does not suggest that one strategy is optimal or preferable but is intended to point out that if a 1031 exchange is not available, or achievable, or in circumstances where payment of a reduced tax bill is preferable to deferring the ultimate payment of the taxes, a tax credit investment may be a viable tax planning tool.