WHY DO AN INTERNAL REVENUE CODE SECTION 1031 EXCHANGE?

The advantages and disadvantages:

The advantage in doing an exchange is to preserve as working capital the portion of the otherwise taxable gain on the disposition of property that would be paid out in income taxes. You can see this effect from the following example that shows current capital gains tax rates:

Capital Gains Tax For Property Held More Than 12 Months: *Federal Tax 15%  /  California State Tax 9.3%
Property Fair Market Value	$ 500,000
Income Tax Basis	- 300,000
Realized Gain	$ 200,000
Combined Tax Rates Federal and State	x .243
Tax Saved	$ 48,600
Leverage Factor (Assuming 75% Mortgage on Replacement Property)	x 4
Additional Value of Property That Can Be Acquired With Tax Savings from Leverage Factor	$ 194,400
Alternate (More Conservative) Leverage Factor (Assuming 50% mortgage on Replacement Property)	x 2
Additional Value of Property That Can Be Acquired With Tax Savings on Alternate Leverage Factor	$ 97,200

*The Federal Capital Gains Tax Rate is 15% from May 6, 2003 through December 31, 2008. Before and after that time the Federal Capital Gains Tax Rate is 20%. This example does not give effect to the 25% maximum Federal tax rate on all non-recaptured depreciation taken on the property after May 6, 1997 and other depreciation recapture provisions, all of which would increase the tax from the amounts shown, making the increase in working capital even greater than shown.

All tax calculations in the examples assume no impact from the Alternative Minimum Tax that also could increase the tax from the amounts shown, making the increase in working capital even greater than shown.

There are three primary disadvantages in doing a 1031 exchange:

1. To totally avoid all income taxes, all of the equity in the old property must be carried forward into the new property, not allowing any cash to be retained by the Exchanger. This restriction can be mitigated by refinancing the new property after completion of the exchange. There are tracing rules on the interest paid on the amount of funds refinanced that could impact the deductibility of that interest. Deductibility depends upon the use of the refinanced funds and other tax factors.
2. The new (replacement) property does not get a stepped-up income tax basis for the portion of the equity and debt replaced from the old (relinquished) property. The depreciation schedule(s) from the relinquished property(ies) are carried over to the replacement property(ies), and any additional acquisition cost of the replacement property(ies) is placed on a new depreciation schedule using depreciation lives imposed on real property by the 1986 Tax Reform Act, further modified by the 1993 tax act:
   
   Residential Property 27-1/2 years
   Non-residential Property 39 years
3. The Exchanger is required to replace the investment or trade/business property with like-kind property. That is, real property must be replaced with real property and personal property with personal property of the same class. The only limitations on real property are that it cannot be the Exchanger’s personal residence and that U.S. real property cannot be replaced with foreign real property and vice versa.