I have read some recent posts on various websites proclaiming that 1031 exchanges are dead among Baby Boomers.  As Mark Twain wrote from London after reading his own obituary, “The reports of my death are greatly exaggerated.”  In fact, the baby boomers may be the demographic group that uses 1031 exchanges most frequently.  The reasons are fairly obvious.  Wealth is not accumulated overnight, usually.  It takes time.  The older you are, the more time you have had to accumulate wealth.  Plus, those with wealth tend to have better tax and investment advisors who can teach them all the tricks.

But, most importantly, many baby boomers have undertaken extensive and appropriate estate planning and therefore understand the value of 1031 exchanges in an integrated estate plan.  Exchangors can acquire the replacement property or properties and hold them until death.  At this point, their heirs receive a stepped-up basis in the property and the capital gains tax has been completely avoided.

Some promoters are pitching a new product called a deferred sales trust.  Looking beyond whether these types of structures actually achieve the touted tax results, and whether the funds are truly safe, and whether the return on the investment is reasonable, the tax results, especially compared to 1031 exchanges, must be analyzed.  The premise behind the deferred sales trust is that the taxpayer sells the property and effectively receives an installment obligation, thereby allowing the gain to be recognized in future tax years when the payments are received.  Two important tax consequences result from this structure.

First, as gain is recognized in subsequent years, the tax is imposed on these gains based on the tax rates in effect at the time.  Since long-term capital gains rates are at historic lows right now, there is no where to go but up.  So, a present value tax calculation should include the possibility that tax rates will increase.  In Rhode Island, the tax rates on long-term capital gains recently increased from 1.67% to 9.9%, effective beginning in 2010.  For federal tax purposes, President Obama campaigned on a pledge of higher taxes.  As a result, the tax bite on an installment sale will not be insignificant.

Second, payments under installment sale notes are generally treated as income in respect of a decedent when received by the estate of a decedent.  No step-up in basis is allowed.  Thus, the estate or the heirs will pay the income tax.  Not the case with 1031 exchange replacement property.  Replacement property received by an estate or heirs steps-up the basis to its current fair market value.  If the heirs or the estate sells the property at that value, no tax results.  Not the case with installment sale notes.

Another important feature of 1031 exchanges for baby boomers, and other real estate investors, is the ability to exchange into qualifying replacement properties that require little or no active owner involvement.  Many Tenant-In-Common investments are available whereby exchangors can buy a fractional interest in a property and have the property professionally managed for them.  Single-tenant triple-net properties are also available, as are shopping malls with triple-net tenants.  An exchangor should consult with a professional in searching for the various options that are available.  Or, visit the Property Exchange web page sponsored for free by All States 1031 Exchange Facilitator, LLC.

For these reasons, as well as many others, the 1031 exchange often makes more sense than the deferred sales trust.  In any event, consult with a tax attorney, preferably one who is also a CPA and a Certified Exchange Specialist, who can explain the differences and help you decide which option makes the most sense for a particular person and scenario.