The timing of income and deductions is of paramount importance in taxation. Just as a dollar today is worth more than a dollar a year from now, so too is a current deduction worth more than a future one, and a deferral of income preferable to an obligation to report income in the current tax year.
Deferral of income accomplishes two objectives: First, it leaves the taxpayer with more money at year-end, thereby increasing the effective yield of investments. Second, since dispositions of property often necessitate new investments, income (and, consequently, tax) deferral has the salient effect of easing cash-flow problems that might otherwise be associated with such a disposition.
Accelerating deductions is also a worthy tax objective. For example, accelerating deductions associated with depreciable property will lower the cost of capital investment by shortening the time period which is required for the taxpayer to recover, tax free, the total cost of a wasting asset. The object of prudent tax planning is therefore to accelerate deductions and at the same time defer recognition of income. Two income- deferral techniques will be explored below; further discussion of accelerating deductions is reserved for a later date.
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Installment sales can be an effective method of dispersing taxable gain associated with the disposition of appreciated property over a period of years. A taxpayer wishing to sell property that is not dealer property or publicly traded property (i.e., stock) may defer reporting gain by structuring the transaction as an installment sale (perhaps requiring a standby letter of credit to insure future payments.)
Assume that the taxpayer owns a piece of realty purchased for $50,000 which is now worth $500,000. A sale for cash would trigger a taxable gain of $450,000, which, taxed at 28% (assuming capital gain) would result in a tax payable of $126,000.
If the transaction were instead structured as an installment sale, with the taxpayer-seller taking $100,000 in cash, and a $400,000 note and mortgage for the balance, with $100,000 being payable in each of the four succeeding years, the tax consequences might be more palatable: The taxpayer would currently be required to report only $90,000 of taxable gain, and would owe only $25,200 in taxes in the current tax year. The same tax treatment would obtain in each of the four succeeding years.
The taxpayer should be aware of certain dangers lurking in this area: Installment sales (1) may not be used to report profit on the sale of depreciable property to a “related person”; and (2) should not be used to when the property being sold has been greatly depreciated. Furthermore, an added measure of caution must be observed when structuring any deferred-payment sale, since even inadvertent compliance with the installment sales provisions will trigger their application, unless the taxpayer affirmatively “elects out” of the statute.
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If property held for productive use in a trade or business is exchanged for other property of a like kind to be used in such trade or business, no gain or loss will be recognized on that exchange, if all statutory requirements are met. Normally an exchange of property will trigger realization and recognition of gain or loss. If its technical requirements (of which there are many) are met, this provision achieves its end by causing a temporary break in the chain of taxation.
Through a series of complex provisions, the statute insures that untaxed gain will only rarely escape future taxation. To illustrate, assume that the taxpayer owned investment property in Manhattan purchased many years ago for $50,000 but was now worth $1,000,000. If the taxpayer acquired in a qualifying like-kind exchange Florida property also worth $1,000,000, the taxpayer’s old basis, $50,000 would “carry over” to the new property, but the taxpayer would recognize no gain currently. A later sale of the Florida property would, however, trigger large taxable gains.
Structuring a like-kind exchange requires careful attention to details in the tax law. The inclusion of cash, the presence of a related party, or the failure to timely designate replacement property are but a few of the many complicating factors which can imperil nonrecognition, or at least cause partial gain recognition. Unlike the installment sales provisions, the like-kind exchange provisions are not elective, and one may not “elect out” of this statute. Inadvertent compliance or, at the other extreme, a failure to comply, despite one’s best efforts to do so, are irrelevant in determining the applicability of the statute. Therefore, a taxpayer wishing to recognize losses should be particularly careful to avoid unintentional statutory compliance.