Section 1031 of the Internal Revenue Code allows a taxpayer to defer the income tax applicable to gain otherwise recognizable when you "exchange’’ property used in a trade or business (your practice) or hold for investment, (i.e., rental real estate ) for property of a "like kind." "Exchange" and "like kind property" are the two critical limitations. Like kind exchange treatment is not available for many kinds of property including property held for personal use, vacation homes, stocks, bonds, partnership interests and the like. Many readers have probably been the beneficiary of the deferral provisions of A71031 without knowing it. If you’ve ever "traded in" a phone system, x-ray machine or other item of personal property used in your medical practice and received a credit against the purchase price of a replacement item that was greater than your basis for income tax depreciation on the old item, A71031 allowed you to defer the gain on the sale of the old item to the seller of your replacement property.

Another key limitation is that you can’t receive cash or non-qualified property as part of the exchange, it is taxable to the full amount of the gain that is otherwise deferred. The basis for the tax deferral is that Congress doesn’t want to tax theoretical gains on exchanges of one kind of business property for another and getting cash from the deal is inconsistent with that purpose. Mortgage financing can be used, but care must be taken.

This article will try to explain in simple terms how A71031 can benefit medical professionals in their practice and investment activities. The focus will be on real property as opposed to personal property (equipment) since it has broader application.

What does A71031 mean in the context of a real estate transaction? Let’s assume that you constructed a medical office building in 1993 for $400,000 that has a current fair market value of $1.2 million and has $100,000 basis for income tax purposes and want to replace it with a larger new facility. To sell the building for $1.2 million you will realize a gain on the sale of $1.1 million ($1.2 million - $100,000). This gain is likely to be largely capital gain and taxable at a 15 percent rate for federal purposes. In some situations some of the gain be ordinary income due to the depreciation recapture rules which is taxable at up to a 35 percent rate. Even assuming all of the gain is taxable at the capital gain rate of 15 percent, the tax is still $165,000. If instead of selling the property and investing the proceeds in a larger facility, a A71031 Exchange were utilized, the $165,000 in federal income tax would not be payable and would be available to pay for part of the new facility.

There has to be a catch, you say, and there is. The price for income tax basis in the new property is determined in part with reference to your income tax basis in the property that you sold. Thus, instead of receiving an income tax basis of $1.2 million, the full purchase price reinvested, your "carry over" basis would be $100,000, the income tax basis in the old property plus whatever additional cash ( and mortgage debt) is invested in the new facility. Given that the depreciation of real property is now 39 years and land is not depreciable at all, it takes a long time to recoup the $165,000 in tax paid from the depreciation deductions on the higher tax basis in the new facility a straight reinvestment would provide. As you can see, a like kind exchange is most beneficial when the proceeds of highly appreciated property are reinvested in land, since the tax basis in land, whatever it is, is not recoverable until such time as the property is sold.

Now that you understand the benefit, you may ask "how in the world will I find someone who wants to trade with me for the property I want when it is time to sell the medical office building that my practice has outgrown?" Actually two-party exchanges are fairly rare, although they are what A71031 contemplated when it was first enacted. Over the years, the rules with respect to like-kind exchanges have evolved to make them more practical to use. Three and four party exchanges are possible and have become the way most A71031 exchanges are done. A three party exchange would be as follows: You have the medical office building you want to sell and in turn want to invest in an apartment building. You list your property for sale and when a buyer, "B" approaches you tell him that you do not want to receive cash, but you want to receive an apartment building owned by "C" in exchange. Your agreement of sale with B can require him to acquire the designated property for your benefit and the two transactions would be closed simultaneously with B never taking title to C’s property, but rather having it conveyed to you in exchange for title to your office building. These kinds of three-party transactions can prove to be cumbersome and unnerving for unsophisticated participants. Timing can also be a problem.

The good news is that the A71031 rules allow for deferred exchanges utilizing "Qualified Intermediaries." This allows a seller to negotiate the sale of his property, including in Agreement of Sale a clause requiring the purchaser to possibly participate in a A71031 Exchange. The Qualified Intermediary is the entity that will receive the proceeds from the sale of your property (the Relinquished Property) and hold it for your benefit while you identify and secure the property you want to exchange for it (the Replacement Property). The IRS has published extensive regulations that describe how deferred exchanges are to be handled and provide "safe harbor rules" that if followed, provide absolute protection for the tax deferral being sought.

The agreement between you and the Qualified Intermediary essentially must prohibit you from receiving cash until the time limit for obtaining Replacement Property has expired. Sellers have 45 days from the sale of the Relinquished Property to identify possible replacement properties. You can identify the three properties of any value or more than three properties as long as they do not exceed 200 percent of the value of the Relinquished Property. Thus, you are not relying on the Qualified Intermediary to find you replacement property. You go out and find the property, negotiate the sales agreement and again, include an assignment provision in it which allows the rights under the contract to be assigned to the Qualified Intermediary since the QI has control of the proceeds of the sale of the Relinquished Property.

One of the most limiting factors of like kind exchanges is that you only have 180 days to acquire Replacement Property if you want the protection of the safe harbor rules. This makes it difficult to acquire property constructed to your specifications. In situations where there is a big difference between the value of the Relinquished Property and the value of the Replacement Property, it may be possible to have enough of the construction completed during the 180 day period to transfer title at that point and still qualify. Larger build to suit exchanges can be done outside the safe harbor rules, but require more involved relations with an Accommodation Title Holder. The exchange costs of the transaction will be higher, but are worthwhile to defer the tax on large gains

Don’t worry about finding a Qualified Intermediary, all the national title companies and most regional title companies have separate business entities designed solely to handle the services of Qualified Intermediaries in like kind exchanges. Their fees depend on the complexity of the transaction but are surprisingly reasonable.