The basic exchange rules haven’t changed – Internal Revenue Code 1031 and
its predecessors have been in the tax code since 1921. But there have been
plenty of exciting new developments since then. Just in the last year or
so, we’ve had important new IRS exchange tax law interpretations and Congress
enacted exchange rule changes as recently as October 22, 2004. Let’s get
started! WHY MAKE TAX-DEFERRED EXCHANGES INSTEAD OF SELLING YOUR PROPERTY?
Some investors seem to enjoy paying taxes on their real estate sale profits.
I don’t. As a smart real estate investor, I hope you don’t either. I still
occasionally get letters from readers who say their real estate broker, their
CPA, or their attorney advised them to sell their investment or business
property and pay the capital gain tax instead of making a tax-deferred
exchange. Those letters shock me (they mostly come from the conservative New England
states where many real estate attorneys and CPAs are not up-to-date on the
benefits and easy rules for Starker delayed tax-deferred exchanges). For some unexplained reason, realty investors and their tax advisers in a
few mostly eastern states have been the last to catch up and understand the
huge benefits of tax-deferred property exchanges. I still remember receiving
a letter, about two years ago, from The tax theory IRC 1031 tax-deferred exchanges is to create one continuous
real estate investment, rather than a taxable sale followed by a purchase of
another property held for investment or business use. Isn’t it better to have
the full amount of your sale profit available for reinvestment rather than
have your profit diminished by a 15% to 25% federal tax (plus any applicable
state tax)? Avoidance of tax erosion is the major reason for tax-deferred
exchanges. EXAMPLE: Suppose you decide to sell your investment or
business property. Your net profit (long term capital gain) will be $200,000.
If it is a depreciable property, such as an apartment building or a rental
house, your capital gain will be taxed at the special 25% federal “recapture
tax rate” on depreciation deducted after May 6, 1997, and at the 15% maximum
capital gains tax rate on the balance of your profit including pre-May 7,
1997 depreciation deducted. Rather than paying more than $30,000 federal
capital gains tax on your $200,000 profit, leaving only $170,000 to reinvest
in another property, wouldn’t it be much better to have the full $200,000
available to acquire a larger investment or business property? Of course! But there are many reasons other than “tax erosion” to make tax-deferred
real estate exchanges, rather than creating a taxable sale followed by
purchase of a replacement property. The “top 10” tax-deferred exchange
reasons are: 1—Avoidance of income tax erosion of property sale profits and avoidance
of depreciation recapture taxes upon the sale; 2—Minimize or eliminate the need for new mortgage financing on the
property being acquired; 3—Get rid of an undesirable property, or one which is difficult to sell,
and acquire one which is either more desirable and/or easier to sell; 4—Increase the investor’s depreciable basis for greater tax shelter by
acquiring a larger depreciable building; 5—Acquire a property which better meets the owner’s needs, such as
providing greater cash flow and/or requiring less management time; 6—Defer part of the capital gain profit tax by “trading down” to a smaller
property which better suits the owner’s needs. An installment sale note will
spread the profit tax over several years while providing the seller with
interest income at a rate higher than is currently available with safety
elsewhere, such as bank CDs and savings accounts (of course, the interest
income received is taxable as ordinary income); 7—Pyramid your wealth into a large estate without paying profit tax along
the way each time you trade up to a larger property. That was the basis of
the late William Nickerson’s wealth pyramid in his famous best-seller classic
book How I Turned $1,000 into $5 Million inReal
Estate in My Spare Time; 8—Refinance either before or after (but NOT as part of) the exchange to
create tax-free mortgage refinance cash to make other investments or use the
cash as you wish (the reason you can’t refinance as part of the exchange is
the cash is then considered taxable “boot” which is “unlike kind” personal
property rather than “like kind” real property); 9—Accept an unexpected cash purchase offer to sell a currently-owned
property at a high price without owing tax on the sale profit; 10—Completely avoid capital gains tax when the investor dies while still
owning the last property in the chain of tax-deferred exchanges. Death is the ultimate tax shelter of all! Although the
net market value of your real estate owned at the time of death will be
included in your estate, no capital gains tax will be due on your realty upon
your demise. However, if you sell your real estate the day before your death,
Uncle Sam will be waiting to claim his capital gain tax! Estates of persons dying in 2004 and 2005 have a $1.5 million federal
estate tax exemption. This exemption increases to $2 million for deaths in
2006, 2007, and 2008. In 2009, for deaths that year the federal estate tax
exemption will be $3,500,000. But 2010 will be the best year to die because
there is NO federal estate tax that year! However, unless Congress changes
the estate tax law, the $1 million federal estate tax exemption returns in
2011, as do the higher pre-2002 federal estate tax rates on assets above the
exempt amount. THE SIMPLE TAX-DEFERRED EXCHANGE CONCEPT. Now that we
understand why tax-deferred exchanges are so advantageous and the motivations
for using them, let’s discuss the simple tax-deferred exchange concept. As
mentioned earlier, a tax-deferred exchange is viewed as one continuous real
estate investment, rather than a taxable sale followed by a reinvestment. To qualify for a tax-deferred “like kind” exchange of your investment or
business real property, you must trade equal or up in both price and equity
for another “like kind” property. If you take anything out of the trade,
called “boot,” it is taxable because it is “unlike kind” personal property
such as cash or net mortgage relief. But there is no limit to the number of investment or business
properties you can trade or acquire in a tax-deferred exchange. Also, there
is no minimum holding time or frequency rule. Theoretically, you could
hold your investment or business property just one day, then trade up, and
then trade again the next day, all completely tax-deferred. EXAMPLE: A few weeks ago, I had lunch with my high school
pal, David Woodhead. We go back a long way, first
working together one summer at the municipal swimming pool. At lunch, David
mentioned he and his charming wife, DeDe, are
thinking of trading their two rental houses for one large rental house
located in a better area. That’s a perfect tax-deferred exchange of a “like
kind” trade up of two properties for one large property. Or, they could trade
for a warehouse or office building. All that matters is each “like kind” property
involved in the tax-deferred exchange must be held for investment or business
use. In other words, “ like kind” does not mean
“same kind” of property. They need not trade for another rental house. Of
course, if they trade down to a property worth less than the total value of
the two rental houses, then they will be receiving some taxable “boot” such
as cash or net mortgage relief. EXAMPLE: Suppose you own a rental house worth $250,000,
subject to a $50,000 mortgage. You want to use your $200,000 equity to trade
up to a $600,000 commercial building with a $450,000 mortgage. This is an
example of a partially-taxable trade up. Although you are trading up in
price from $250,000 to $600,000, you are trading down from $200,000 to
$150,000 equity in the acquired property. That means you will be receiving
$50,000 taxable cash “boot” in the form of net mortgage relief. EXAMPLE: Instead, suppose you make the same trade from a
$250,000 rental house up to a $600,000 commercial building, but you get a new
$400,000 mortgage so you will have $200,000 equity in the acquired property.
Now you have a fully tax-deferred exchange because you traded equal or up in
both price and equity. However, if you need cash, either before or after the
exchange you can refinance the mortgage to take out tax-free cash. Just be
sure the refinance is not part of the exchange because then the cash you
receive becomes taxable boot. How to calculate your tax-deferred capital gain and basis for the
property acquired in the exchange. Presuming a tax-deferred exchange
capital gain is attained, the next question usually is “How much is my
tax-deferred capital gain?” The answer is it is the difference between your
old property’s net price (called “adjusted sales
price” in tax talk) minus your old property’s “adjusted cost basis.” Net price, or adjusted sales price, is usually the gross sales price minus
selling expenses, such as the real estate sales commission, transfer tax, and
other closing costs you pay. Adjusted cost basis is usually the old property’s original net purchase
price, plus closing costs which were not tax deductible at that time, minus
depreciation deducted during ownership, plus capital improvements added
during ownership, minus any casualty loss deductions taken during ownership. EXAMPLE: To keep our example simple, suppose the buyer of
our $250,000 rental house paid all the sales expenses so $250,000 is the net
or adjusted sales price. Let’s suppose you we paid $150,000 for this rental
house, added $10,000 of capital improvements, deducted
$50,000 of depreciation during ownership, and there were no casualty loss
deductions. Therefore, our deferred capital gain is $250,000, minus the
$110,000 ($150,000 + $10,000 - $50,000) adjusted cost basis, or $140,000
capital gain on which we defer tax by exchanging. To determine the new
adjusted cost basis of the $600,000 building acquired in the tax-deferred
exchange, a simple method is to subtract the deferred capital gain of
$140,000 from the $600,000 purchase price for the acquired property,
resulting in a $460,000 adjusted cost basis for the $600,000 building.
This is a quick way to estimate your new adjusted cost basis for the acquired
property. In the above series of examples, there was a $140,000 tax-deferred capital
gain on the sale of the rental house. The tax-deferred exchange tax savings
were over $21,000, resulting in being able to use that $21,000 to acquire a
larger replacement property rather than paying the $21,000 to Uncle Sam (plus
any state tax). Which property is NOT eligible for a tax-deferred exchange?
Before proceeding, it is important to emphasize that virtually any real
estate held for investment or use in a trade or business is eligible for a
tax-deferred exchange. This is called “like kind” real estate. Property which is not eligible for a tax-deferred exchange
includes 1‑‑Your principal residence (which is eligible for the far
better Internal Revenue Code 121 $250,000 and $500,000 tax exemption if you
owned and occupied it at least 24 of the 60 months before its sale); 2‑‑Your vacation or second home (but you can convert it into a
rental property, thereby making it eligible for a tax-deferred exchange); 3‑‑Dealer property (such as a home builder’s inventory), and 4‑‑Partnership interests (unless recorded title is held
individually in the names of tenant in common (TIC) co-owners). Report your tax-deferred exchange on IRS Form 8824. Even
if no tax is due on your tax-deferred exchange, it must be reports with your
personal income tax returns. This form is not easy to understand so you might
want to hire an experienced tax adviser. If an exchange property is acquired from a related party in an
exchange, it must be held at least 24 months otherwise the resale profit is
taxed back to the original owner of the property. In a related party
tax-deferred exchange, the IRS requires filing Form 8824 in the tax year of
the exchange and for two years after that. THE SIMULTANEOUS TAX-DEFERRED EXCHANGE METHOD. As
long-time subscribers know, my first tax-deferred exchange was the trade of a
three-unit building at I shall always be grateful to Walt Lembi, and his dad Frank Lembi (now
in his 80s and still selling real estate!), at Skyline Realty in The first step was to find a cash buyer for my three units. Walt and Frank
took care of that within a few weeks. The second step was to find a property
for the trade up. Finding a qualifying replacement property to complete the trade is
usually the hardest part of a tax-deferred exchange. Clyde Cournale Realty in All went very well. I got my simultaneous tax-deferred trade up, the
seller of the nine units got his taxable cash, and the buyer of my three
units got a good starter investment property. Everybody was happy, even Uncle
Sam who received his capital gain tax on the sale of the nine-unit building. TODAY’S “STARKER EXCHANGES” ARE MUCH EASIER. Although
simultaneous exchanges still occur, if this same tax-deferred exchange
occurred today it would be much easier. The reason is Internal Revenue Code
1031(a)(3), the so-called Starker exchange rules.
Starker exchanges have now become the “standard” type of realty exchange.
Even large corporations use Starker exchanges to avoid capital gain tax on
profitable real estate sales and property replacements. For those not familiar with the late T.J. Starker and his very important
contribution to tax-deferred exchange, I’ll give you the short version of his
story. He owned some He deeded his land to C-Z which credited Starker with the sales price,
plus a 6% “growth factor” until he could find suitable qualifying “like kind”
property to acquire with that money for completion of the exchange. After
Starker acquired other property he liked with the funds C-Z was holding for
him, the IRS said he owed tax on his profit because it wasn’t a direct
simultaneous exchange (as I did with my three units for the nine units). Starker paid the disputed tax (to stop the running of interest) and then
sued the IRS in U.S. District Court for a tax refund. He won! But the IRS
appealed to the Ninth Circuit U.S. Court of Appeals. The IRS lost! The happy result for realty investors is we now have IRC 1031(a)(3) which was enacted by Congress in 1984, establishing
the Starker exchange rules. You can read the fascinating case at Starker
v. U.S., 602 Fed.2d 1341. Thanks to T.J. Starker,
today’s tax-deferred “delayed” exchanges are downright easy. The first step is to find a buyer for the investment or business property
you want to sell. When a buyer makes a suitable purchase offer, be sure
the sales proceeds will be held by a qualified third-party intermediary
beyond your constructive receipt. If you receive the sales cash, or have
the right to do so, that ruins your tax-deferred exchange. Leaving the
sales proceeds in escrow means you have a right to receive the cash so the
sale is disqualified as a Starker tax-deferred exchange. The second step, when the sale of your old investment or business property
closes, is to be sure the sales proceeds go directly to a qualified
third-party intermediary, such as a bank trust department which specializes
in Starker tax-deferred exchanges, or to the exchange subsidiary which most
large title companies now can provide. There are also independent exchange facilitator companies. If you select
one of these independents, be sure your funds are well-protected. Some of
these small companies have gone bankrupt, causing loss of tax-deferred
exchanges for their clients (see In re Sale Guaranty Corporation,
220 B.R. 600 for a classic example what can go wrong for exchangers
when the third-party intermediary accommodator goes broke). The third step is to use the cash from your property sale, being held
beyond your constructive receipt by the qualified third-party intermediary or
accommodator, to purchase the suitable replacement property to complete the
tax-deferred exchange. There are several very important rules for designating this replacement
property: 1—The replacement property must be designated in writing to the exchange
accommodator intermediary within 45 days after the sale of your old property
closes; 2—Not more than three possible properties can be designated (however, you
can withdraw one possible property from your list and substitute another
property during the 45 days); 3—As an alternative, you can designate more than three properties if their
total fair market value does not exceed 200% of the fair market value of the
relinquished property; 4—IRC Regulation 1.1031(k-1(e)) allows designating within the 45 days a
replacement property which includes a contract to construct, build, install,
manufacture, develop, or improve property to be acquired. However, a property
already-owned by the exchanger cannot qualify under this Regulation. Within 180 days following the sale of the old property held for investment
or business use, the acquisition must be completed. No time extension is
allowed by the tax statute or regulations. To avoid being under extreme time pressure to meet the 45-day and 180-day
deadlines, one method is to delay the closing date for the sale of your old
investment or business property. A second method is to rent the old property
to the prospective buyer on a lease-option to be exercised on a date to be
designated by the seller after a suitable replacement property is under
purchase contract. MISTAKES TO AVOID. If you are within the 180-day
replacement period, don’t file your income tax return for the tax
year in which you sold your old property. The reason is filing your
income tax return for the prior year automatically stops the running of the
180-day replacement period. EXAMPLE: That happened in the tax case of Christensen,
T.C. Memo 1996-254 where the sale of a large apartment building
closed on December 22, giving Orville and Helen Christensen until June 21 of
the following tax year to close their purchase of a qualifying replacement
property to complete their Starker tax-deferred exchange. The sales proceeds
were held by a qualified intermediary accommodator. However, the Christensens made the costly mistake of filing their
income tax returns on April 15, thus automatically terminating their 180-day
replacement period! Instead, they should have filed for a tax filing
automatic extension and waited to file their tax returns for the prior year
after June 21 when they acquired the replacement property. As a result of
their error, they had to pay $220,039 capital gain tax on their apartment
building sale because they were disqualified from making a tax-deferred
Starker exchange. Wouldn’t you think investors with that much profit could
afford to hire a competent tax adviser? Another mistake to avoid is to correctly designate the qualifying
replacement property within the 45-days after the completed sale of the old
property. EXAMPLE: On August 22, 1989 David and Naomi Dobrich of STARKER “REVERSE EXCHANGES” ARE NOW LEGAL, BUT THEY AREN’T EASY.
A major problem with Starker exchanges is the replacement property is often
found before the old property is sold. For years, real estate and tax
attorneys debated whether or not Starker “reverse exchanges” could qualify
for tax deferral. The solution was to “tie up” the property to be acquired,
such as with a purchase option, a lease-option, or a long-term purchase
contract with a delayed closing date. These are still excellent methods to
use. But in October 2000, Internal Revenue Bulletin 2000-40, modified by
Revenue Procedure 2000-37 (26 CFR 1.1031 (a)-1), available at the IRS website
www.irs.govexplained the new IRS “safe
harbor” rules when a qualifying replacement property is located before the
old property in a Starker exchange is sold. Title to the property to be acquired to complete the exchange may now be
taken and held by a third-party accommodator who temporarily holds title to
the replacement property (called “parking” by the IRS) if that entity is
considered its owner “for federal income tax purposes.” That means, for example, if a toxic waste dump is discovered on the
property, the third-party title holder will be responsible for its cleanup.
But the exchanger can agree to indemnify the third-party exchange
accommodator against liability while holding title. The maximum “parking”
time limit for either the old or new property is 180 days. During that time,
the exchanger can lease but not hold title to the parked property. Two approved methods for Starker reverse exchange tax deferral.
The IRS has approved at least two reverse exchange methods: 1—The old property can be “relinquished” to the third-party accommodator
in trade for the already-acquired reverse exchange replacement property; then
the old relinquished property can be transferred by the accommodator to its
waiting buyer, or 2—The third-party accommodator can transfer title to the already-acquired
replacement property to the exchanger who then transfers title to the old
property to the exchange accommodator to hold the title until that property
is sold. But the IRS Bulletin adds “Further, the Service (IRS) recognizes that
‘parking’ transactions can be accomplished outside of the safe harbor
provided in this revenue procedure...the Service (IRS) will not challenge the
qualification of either the ‘replacement property’ or ‘relinquished property’
for purposes of IRC 1031.” That statement might become important if the IRS
contests a reverse exchange. The IRS recently issued Revenue Procedure 2004-51 which says
the safe harbor rules do not apply after July 20, 2004 to property held by an
exchange accommodator if that property was previously owned by the exchanger.
To illustrate, a reverse exchange cannot be used to avoid the barrier to
re-acquiring your own property after making improvements, such as new construction.
In other words, you can’t exchange with yourself. Written reverse exchange agreement is required within five days.
The IRS rules require the taxpayer and the exchange accommodator title holder
to enter into a written contract within five days after the transfer of title
for either the old or replacement property to the third-party accommodator.
The contract must state title is held for the benefit of the exchanger to
facilitate a tax-deferred IRC 1031 reverse exchange under Revenue Procedure 2000-37
which requires reporting the transaction to the IRS. The exchanger has 45 days after the third-party accommodator acquires
title to the replacement property to identify which currently-owned property
the exchanger will be relinquishing. Up to 180 days is then allowed after the
accommodator acquires title to the replacement property for the exchanger to
sell the old relinquished property. Obviously, being an accommodator in a reverse exchange is not a job
for amateurs – be sure to select a firm which specializes in Starker delayed
exchanges. Incidentally, your attorney, CPA, real estate agent, or any
other entity with which you have done business within the last two years is not
eligible to be your qualified third-party intermediary accommodator. NEW RULE FOR CONVERTING PROPERTY ACQUIRED IN A TAX-DEFERRED
EXCHANGE TO YOUR PERSONAL RESIDENCE. Effective October 22, 2004,
President Bush signed the American Jobs Creation Act of 2004. It amended
Internal Revenue Code 121(d)(10) – the principal residence sale tax exemption
rule – to read: PROPERTY ACQUIRED IN LIKE-KIND EXCHANGE. If a taxpayer acquired
property in an exchange to which IRC 1031 applied, subsection (a) shall not
apply to the sale or exchange of such property if it occurs during the 5-year
period beginning with the date of the acquisition of such property. In plain English, that means after October 22, 2004, taxpayers who acquire
an investment or business property in an IRC 1031 “like kind” tax-deferred
exchange, such as a rental house, must own it at least five years before they
can sell it and claim the IRC 121 principal residence sale exemption up to
$250,000 (up to $500,000 for a qualified married couple if both spouses meet
the 24 out of 60 month principal residence occupancy test). Of course, at the time of acquisition the residence must be a rental
property to qualify for the IRC 1031 tax-deferred exchange. Most tax advisers
suggest renting the property at least six to 12 months to show rental intent
at the time of the exchange. The IRS has no official position on minimum
rental time after the exchange. This is still a great method for “freeing” what would otherwise be a
taxable capital gain upon the sale of an investment or business property. The
only change made by new IRC 121(d)(10) is the property must be held at least
five years before its sale can qualify for the IRC 121 principal residence
sale exemptions (after at least 24 months of the owner’s principal
residence occupancy during the 60 months before sale). EXAMPLE: Suppose you own an investment or business
property in which you would have a $400,000 capital gain if you sell it. But
you don’t want to pyramid your estate by trading up to a more valuable
investment property. You would like to eventually liquidate your profit
without paying a huge capital gain tax. Virtually the only way to do that is
to make a Starker tax-deferred exchange for a residence rental property where
you would like to move in for at least 24 of the 60 months before selling it
and claiming the $250,000 IRC 121 principal residence sale exemption (up to
$500,000 for a qualified married couple filing jointly). The new tax law
change simply says you must hold title to the acquired residence at least
five years before qualifying for IRC 121 (but you only need live in it two of
those five years as your principal residence). Another method can be used by homeowners who have more than a $250,000 or
$500,000 capital gain who want to sell their current principal residence and
acquire investment or business property. EXAMPLE: Your principal residence where you have lived
many years has greatly appreciated in market value. If you sell it, your net
profit (capital gain) will be $600,000. That is not an unusual situation in
many communities. If you are single, you can claim a $250,000 exemption by
using IRC 121 (or up to $500,000 if you are married and your spouse also
meets the two out of last five years principal residence occupancy test). But
the excess capital gain exceeding your IRC 121 exemption will be taxed.
However, if you want to escape the capital gain tax completely, you can
convert your home into a rental property before selling it, and then make a
Starker tax-deferred exchange for another qualifying investment or business
property of equal or greater cost and equity. To answer your obvious question
how long must your home be rented to tenants before qualifying for a
tax-deferred exchange, the official IRS answer is “Nobody knows for sure.”
Most tax advisers suggest renting your former principal residence at least
six to 12 months to show rental intent before exchanging it for a qualifying
“like kind” investment or business property to defer tax on 100% of your
profit. I.R.S. APPROVES TAX-DEFERRED EXCHANGES INTO TENANCY IN COMMON
(TIC) INVESTMENT PROPERTIES. That brings us to another method of
avoiding tax when disposing of a property held for investment or use in a
trade or business. It involves making a Starker exchange of your current
rental or investment property for a tenant in common (TIC) share in a
commercial property. EXAMPLE: Several years ago my friends, Andy and Dory,
sold their The IRS approved this technique in Revenue Procedure 2002-22. As a general
rule, there cannot be more than 35 TIC co-owners. They must agree unanimously
on major sale, lease, and finance decisions. TIC shares can be sold or
transferred. However, investors are cautioned of possible pitfalls, such as
acquiring an interest in an over-priced commercial property being sold by
inexperienced marketers to seek quick profits in a new real estate investment
area. At the recent 2004 National Association of Realtors convention in |
