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August 2001
Vol. 10, No. 08, pp 45, 47.
Personal Business
Property traders can get a tax break

Also: The benefits of cafeteria plans

If you sell property that you own—for example, a farm—and invest the proceeds in stocks, you owe taxes on any gain you realized on the sale of the farm. However, if you exchange property you own, let’s say a farm again, for similar property such as another farm, you don’t owe any taxes—even if the exchange produces a profit. In tax parlance, this is called a “like-kind exchange” or “Section 1031 exchange”.

In its purest form, a like-kind exchange involves trading one property for another similar property such as a house worth $75,000 for another house worth $75,000. You do not have to pay tax on such a trade or exchange because Section 1031 of the Internal Revenue Code (IRC 1031) permits you to defer taxation when you engage in a like-kind exchange.

Assuming your transaction is correctly structured, this provision permits you to, in effect, sell one property, have the proceeds of the sale held for you, and then use those proceeds to buy a new property. If the transaction is properly structured as a deferred like-kind exchange, you do not pay any tax on it, just as if it were a straight swap of two similar properties.

To do a deferred like-kind exchange, you must “identify” the replacement property within 45 days of when you sell the relinquished property and acquire the replacement property within 180 days of when you sell the relinquished property. “Identification” is a highly technical term and must be done correctly.

IRC 1031 and the IRS regulations concerning exchanges make it possible to defer, and sometimes entirely avoid, paying capital gains tax on a transaction. Given that capital gains are taxed at 20%, like-kind exchanges are important tax deferral devices. But remember: It is not enough for a contract to say something such as “this is a like-kind exchange”; the transaction must be fully structured as an exchange, or it will not pass muster with the IRS and qualify for like-kind exchange treatment.

Insurance and Annuities
The like-kind exchange technique is frequently used in insurance and annuity transactions. If a salesperson offers an annuity product but you already own an annuity, you can exchange the old one for the new one without incurring any tax liability. Ditto for life insurance policies. So long as you’re exchanging one annuity for another, the provisions of Section 1031 apply.

It gets tricky, however, if the products you’re exchanging aren’t identical. Recently, an individual exchanged an annuity for a replacement annuity that had certain insurance features lacking in the original annuity. In a private ruling, the IRS said that swapping one annuity for another that also provides insurance coverage if the owner dies or becomes terminally ill before payouts start is a valid like-kind exchange. The IRS said the transfer didn’t produce a tax liability even though the trade of an annuity contract solely in exchange for a life insurance policy would be a taxable event. The IRS ruling means life insurance and annuity owners have some additional latitude in exchanging what they own for something new. Because an IRS private ruling can’t be relied upon as a precedent, you have to be careful about swapping annuities or life insurance policies.

There is only one potential pitfall associated with the above transaction. The annuity owner will be taxed on the annuity’s earnings if those earnings are used to pay the insurance premiums. But that can be easily avoided: Just write a separate check to cover the premium.

The Benefits of Cafeteria Plans
If you hear the terms “flexible spending plans” or “Section 125 Plans”, they refer to cafeteria plans. A cafeteria plan allows employees to select from several predetermined options and choose where their benefit dollars will be spent. The plan can provide numerous insurance options, including medical, accident, disability, vision, dental, and group term life. It can reimburse actual medical expenses. It can pay children’s day care expenses. And it does these things, through payroll withholding, with pretax dollars. A cafeteria plan allows a small business to offer benefits that would be otherwise unaffordable. Participants also receive significant tax savings.

Each employee must estimate the costs that will be incurred during the plan’s upcoming year and have the estimated amount withheld from wages and paid to the plan. That amount will reduce the employee’s taxable earnings for federal, state, and Social Security purposes. For example, if an employee pays $2000 for day care through a cafeteria plan rather than making the payments personally out of earned income, he or she will see a decrease in take-home pay. This decrease is significantly less than the cost of paying for the same services in after-tax dollars. The $2000 diverted to the cafeteria plan is excluded from taxable income for federal income, Social Security, Medicare, and state tax purposes. As a result, an individual in only the 15% federal tax bracket would save $453 in federal, Social Security, and Medicare taxes in addition to approximately $56 in state taxes, depending on the state in which the person is employed. The reduction in take-home pay would only amount to $1491—much less than the $2000 the employee would have to pay personally.

The total amount employees can save increases if they are in higher income tax brackets. For example, in the above illustration, an employee in the 28% tax bracket would save an additional $260, so the employee’s out-of-pocket cost for the $2000 worth of day care would be only $1231.

The savings from a cafeteria plan are enhanced when you consider the logistics of deducting medical expenses on an individual’s tax return. Individuals can only deduct medical expenses that exceed 7.5% of their gross income. Thus, for example, employees with a gross income of $50,000 ordinarily can only deduct medical expenses in excess of $3750. Employees who participate in a cafeteria plan, however, can contribute pretax dollars to an account that is earmarked for medical expenses, and these moneys can be used immediately without regard for the 7.5% threshold. The only caveat is that money earmarked for medical expenses must be used for expenses that would otherwise be tax-deductible on their income tax return.

For example, you can use money earmarked for medical expenses for the cost of a weight-loss program undertaken at a physician’s direction to treat an existing disease (such as heart disease). But you cannot include the cost of a weight-loss program if the purpose of the weight control is to maintain your general good health and is not ordered by a doctor to treat a specific disease. Last year, the IRS said smoking cessation programs treat nicotine addiction and thus are deductible.

Potential Negatives
One slight negative of redirecting wages that would be otherwise taxable for Social Security purposes is that it may ultimately result in slightly lower Social Security benefits at retirement. Another potential negative is that payments made from a cafeteria plan for dependent care are not eligible for the childcare credit computation on an individual’s federal tax return. In addition, once employees elect to shift a portion of their salaries into the plan, the decision can’t be revoked until the end of the plan year, except under specific circumstances such as a change in marital status, number of dependents, or spouse’s employment. Therefore, any funds that are unused by the end of the cafeteria plan year are not refundable and are forfeited by the employee. What you don’t use, you lose. So you must make sure you accurately estimate the actual expenses that will be paid during the year. Naturally, the difficulty of making such estimates varies, depending on the benefits offered in the plan. Insurance premiums can be easily predicted, as can child care. Medical expenses are a different story.

Employers also benefit from cafeteria plans. First, there is the matter of goodwill: Employees appreciate being able to use pretax dollars for a variety of needs. There are also monetary savings for employers. Just as the taxable wages of employees for Social Security and Medicare purposes are reduced, so are the related taxes, which must be paid by the employer. These taxes decrease by $765 for every $10,000 of benefits paid through the plan on behalf of individuals who have total earnings less than the Social Security threshold.

Milton Zall is a freelance writer who specializes in taxes, investments, and business issues. Send your comments or questions regarding this article to tcaw@acs.org or the Editorial Office 1155 16th St N.W., Washington, DC 20036.

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