1031 Exchanges, Deferrals, and State and Local Taxes

The process of doing 1031 exchanges is always evolving, and if in doubt you can just ask the representatives of KCC Contractor Inc and John Q. Hammons Industries. Both recently had to appear before the Missouri Administrative Hearing Commission. The result of that case was that even a transaction that qualifies for tax deferral under a 1031 exchange federally doesn’t mean the same transaction is necessarily free of use and sales tax.

It’s important to remember that state law gets into the specifics of such transactions, and these individuals were hoping that a Missouri exclusion on use and sales tax for trade-ins would protect them. In this case, the like-kind property was a corporate jet. Their $9.1 million 2004 Learjet was traded for a $10.6 million 2007 Learjet.

Much like other 1031 exchanges, the individuals in this case use a qualified intermediary to conduct the exchange. Ultimately, the Missouri Commission argued that there are other cases where the precedent has been set such that the federal income tax rules regarding exchanges do not reduce use or sales tax.

As you can see from this brief example, 1031 exchanges are not always easy. Used for the purposes of real estate investment especially, they can be powerful for deferring capital gains taxes. These transactions have allowed numerous real estate investors to take the funds from the first sale of a property and apply it to the purchase of another with minimal current tax implications.

In order to do this, a qualified intermediary is used to actually facilitate the transaction. He or she is a third party who actually receives the funds from the first sale on the seller’s behalf and uses them to purchase a second (or more) properties. The added benefit of working with someone who has qualified intermediary experience is that he or she has knowledge about the strict IRS guidelines regarding timeframes for these exchanges.

You should always consult carefully with a tax specialist before initiating one of these exchanges, though, so that you are clear about all the possible implications. As the above case suggests, it pays to be knowledgeable about whether any other tax situations apply even when you’re getting a deferral federally from the proper exchange of one like kind property for another. This way, there are no unpleasant surprises down the road. Do your research before getting started with a 1031 exchange so you know what to expect.