The Latest Installment

            An installment sale of your business or investment real estate may substantially improve your post-closing cash flow, as compared with a cash sale as the first leg of a 1031 tax-deferred exchange.  Here are some reasons why.

            Reason #1:  Unnecessary debt-service cost:  In a 1031 exchange, the exchangor cannot have less debt on the replacement property than the exchangor had on the relinquished property (or the exchangor will be taxed on the difference).  That means that the exchangor will incur out-of-pocket debt-service cost over future years as the price of using a 1031 exchange, and the interest expense for that debt will be an on-going expense that will cut into the income from a replacement property.  After closing an installment sale, however, the seller is free to purchase a replacement property debt-free.

            Reason #2:  Over-pay for replacement property:  Section 1031 imposes strict time limits on finding and acquiring replacement property.  Because of those time limits, an exchangor is thrown into competition with other exchangors to find and buy suitable property quickly.  That means that the exchangor will almost certainly over-pay for the replacement property, as exchangors generally do.  Many studies have so found[1], and it’s what one would expect if the exchangor must hurry to purchase while the seller can take whatever time the seller wishes.  How effective was tax deferral on the sale of the relinquished property if the exchangor overpays by 10% or thereabouts to buy a replacement property? 

            Reason #3:  Investment distortion:  Complete tax deferral under Section 1031 applies only if the exchangor spends at least as much money to buy replacement property as came from the sale of the relinquished property.  That means that Section 1031 can cause many exchangors to exclude more desirable but less expensive properties which would better serve the exchangors’ business purposes.  What investment sense does that make?

            Reason #4:  Reduced depreciation deductions:  In a 1031 exchange, the exchangor must use a carry-over basis (rather than a stepped-up basis) for purposes of depreciation deductions on the replacement property.  After closing an installment sale, however, the seller may purchase replacement property and start fresh with depreciation deductions.

            Reason #5:  The keep-on-doing-the-same-thing limitation:  In a 1031 exchange, the exchangor’s choice of a replacement investment must be of a “like kind” to the relinquished property, with no allowance for someone who wishes to do something different.  After closing an installment sale, however, the seller is free to choose an entirely different replacement business or investment asset.

            If you are contemplating a cash sale and treating that as the first leg of a 1031 exchange, think carefully about these considerations.—Stan Crow

[1] See, for example, Ken H. Johnson and Jonathan Wiley, "1031 Exchanges and the Sale of Commercial Office Properties", https://www.tandfonline.com/doi/abs/10.1080/10835547.2008.12089809:  “(T)he average price per square foot reveals a significant premium for 1031 exchanges. . . . Using national data on commercial office space provided by CoStar, this work finds a pricing premium of $71.84 per square foot relative to the national market.”  See, also, the other studies there cited.