Real Estate Exchanges
Procrastination in our workaday world is generally not a virtue unless taxes on real estate transactions are involved. Rising real estate values have created opportunities for real estate investors to improve their positions by doing tax-free exchanges of investment property.
Property held for investment or business use and sold at a profit is subject to capital gains transaction on the gain over cost basis. Depreciable investment property, held for many years, typically has a lower cost basis, further exacerbating the tax problem.
These taxes can be deferred by doing a tax-free exchange, commonly called a 1031 transaction. In an exchange transaction the seller sells one property and within a specified period buys a second. If done within the rules, any gain on the sale of the first is deferred until the second, or purchased, property is sold.
For this to work, specific rules must be followed. First, the property to be exchanged must be qualified, defined as real estate property held for investment or income-producing purposes or equipment used in a business. Property not qualifying includes personal use real estate, foreign real estate, property held for sale, inventory or stock-in-trade securities and notes.
The IRS has allowed broad definitions of like kind to apply. Grade or quality of property does not matter. Farmland can be exchanged for commercial or residential rental property. Unimproved land can be exchanged for a leasehold property of 30 years or more. Solely owned property can be exchanged for a tenant in common interest in a property.
Next, if the purchased property is of lesser value than the sold property, or the sold property has a mortgage, the seller will get the boot, in this case boot is a term for a taxable gain on the boot portion.
Certain time lines must be followed for a qualified exchange to occur. The seller must identify a replacement property within 45 days of completing the sale of the original property. The seller can identify up to three properties as prospective purchases. The outright purchase must be completed within 180 days of the sale of the first property.
The transaction in a delayed exchange, as outlined above, requires the use of a financial intermediary. The intermediary steps into the sellers shoes and acts as the seller in the closing of the selling transaction. The intermediary will hold the proceeds of the sale while the property to be purchased is identified and subsequently purchased.
The intermediary may not be related to the seller, may not be an employee or may not have acted recently as a professional advisor to the seller. Generally intermediaries are title companies or law firms specializing in that business. They are paid a fee and/or interest on the money they hold in their trust account.
Exchanges may be simultaneous in that the closing of the exchange and the replacement properties take place on the same day. A delayed exchange is the most common, with the target, or replacement, property being acquired after the original property is sold. A reverse exchange is allowed when the target property is purchased in advance of the sale of the original property.
In a more complicated transaction, the taxpayer can arrange to acquire a property and improve the property as part of the transaction. In this case, the intermediary must retain title to the property until the improvements are completed.
Finally, multiple-asset exchanges are allowed between individuals, investors, small businesses and large corporations. For example personal property such as trucks, helicopters, planes, and furniture can be exchanged along with real estate.
Reprinted with permission. The opinions expressed are those of Wendell Cayton, a Registered Investment Advisor in the states of California and Washington, and not those of any company with whom he is associated. He may be contacted at Cayton@ix.netcom.com.