IRS Says §1031 Exchange Will Defer 3.8% Tax On Net Investment Income

There has been some question as to whether taxpayers could use a §1031 exchange to defer the new 3.8% tax on investment income.  The IRS has issued proposed regulations that answer the question with a resounding “Yes”.


The new tax is an additional 3.8% tax on “unearned income” which is generally defined as interest, dividends, rents and capital gains.  The tax is only imposed to the extent the taxpayer’s adjusted gross income is greater than $200,000 for an individual or $250,000 for a married couple.  The tax is not a transfer tax on real estate sales or other similar transactions. 


The proposed regulations provide guidance under §1411 of the Internal Revenue Code (Code), which is effective for taxable years beginning after December 31, 2012.  These regulations are still just proposed, but it is unlikely that there will be significant changes, at least as far as §1031 is concerned.  The IRS is accepting comments on the proposed regulations until March 5, 2013.


In its description of the proposed regulations the IRS stated that, in general, gain that is not recognized under Chapter 1 of the Code for a taxable year “is not recognized for that year for purposes of §1411 (for example, gain deferred or excluded under section 453 (installment method), section 1031 (like-kind exchanges), section 1033 (involuntary conversions), or section 121 (sale of principal residence))”.


The specific §1031 language is found in section 5.C.2.ii:


Except as otherwise expressly provided in the regulations, the income tax gain and loss recognition rules in chapter 1 apply for purposes of determining net gain under section 1411. Thus, for example, to the extent gain from a like-kind exchange is not recognized for income tax purposes under section 1031, it is not recognized for purposes of determining net investment income under section 1411.


The proposed rule is illustrated in Example 7:


(i) In Year 1, A, an unmarried individual who is not a dealer in real estate, purchases Greenacre, a piece of undeveloped land, for $10,000. A intends to hold Greenacre for investment.



(ii) In Year 3, A enters into an exchange in which he transfers Greenacre, now valued at $20,000, and $5,000 cash for Blackacre, another piece of undeveloped land, which has a fair market value of $25,000. The exchange is a transaction for which no gain or loss is recognized under section 1031.



(iii)  In Year 3, for income tax purposes A does not recognize any gain from the exchange of Greenacre for Blackacre. A’s basis in Blackacre is $15,000 ($10,000 substituted basis in Greenacre plus $5,000 additional cost of acquisition). For purposes of section 1411, A’s net investment income for Year 3 does not include any realized gain from the exchange of Greenacre for Blackacre.



(iv) In Year 5, A sells Blackacre to an unrelated party for $35,000 in cash.



(v) In Year 5, for income tax purposes B recognizes capital gain of $20,000 ($35,000 sale price minus $15,000 basis). For purposes of section 1411, A’s net investment income includes the $20,000 gain recognized from the sale of Blackacre.


Thanks to the proposed regulations investors can be confident that a §1031 exchange will not only defer capital gains taxes, but the 3.8% investment tax as well.  Please contact your local First American Exchange office to learn more about this powerful tax-deferral tool.