Understanding The “Tax Free” Exchange

Residential homeowners have a number of tax benefits, the most important of which is the exclusion of up to $500,000 profit made on the sale of the principal residence.

But real estate investors — large and small — still have to pay capital gains tax when they sell their investments. And since most investors depreciated their properties over a number of years, they often have to “recapture” the depreciation, as well as paying a lot of capital gains tax.

There is a way of deferring payment of this tax, and it is known as a Like-Kind Exchange under Section 1031 of the Internal Revenue Code.

Keep in mind the exchange process is not a “tax free” device, although people refer to it as a “tax-free exchange.” It is also called a “Starker exchange” or a “deferred exchange.” It will not relieve you from the ultimate obligation to pay the capital gains tax. It will, however, allow you to defer paying that tax until you sell your last investment property..

The rules are complex, but here is a general overview of the process.

Section 1031 permits a delay (non-recognition) of gain only if the following conditions are met:

First, the property transferred (called “relinquished property”) and the exchange property (“replacement property”) must be “property held for productive use in trade, in business or for

investment.” Neither property in this exchange can be your principal residence, unless you have abandoned it as your personal house.

Second, there must be an exchange; the IRS wants to ensure that a transaction that is called an exchange is not really a sale and a subsequent purchase.

Third, the replacement property must be of “like kind.” The courts have given a very broad definition to this concept. As a general rule, all real estate is considered “like kind” with all other real estate. Thus, a condominium unit can be swapped for an office building, a single family home for raw land, or a farm for commercial or industrial property.

Once you meet these tests, it is important to determine the tax consequences. If you do a like-kind exchange, your profit will be deferred until you sell the replacement property. However, the cost basis of the new property in most cases will be the basis of the old property. Discuss this with your accountant to determine whether the savings by using the like-kind exchange will make up for the lower cost basis on your new property. Also, if you do not do an exchange, how much tax will you have to pay. Sometimes, its better to “bite the bullet” and pay the tax, rather than get involved with another rental, investment property.

The traditional, classic exchange (A and B swap properties) rarely works. Not everyone is able to find replacement property before they sell their own property. In a case involving a man named Mr. Starker, the court held that the exchange does not have to be simultaneous.

Congress did not like this open-ended interpretation, and in 1984, two major limitations were imposed on the Starker (non-simultaneous) exchange.

First, the replacement property must be identified before the 45th day after the day on which the original (relinquished) property is transferred.

Second, the replacement property must be purchased no later than 180 days after the taxpayer transfers his original property, or the due date (with any extension) of the taxpayer’s return of the tax imposed for the year in which the transfer is made. These are very important time limitations, which should be noted on your calendar when you first enter into a 1031 exchange.They are literally carved in stone; they cannot be waived or modified.

In 1989, Congress added two additional technical restrictions. First, property located in the United States cannot be exchanged for property outside the United States.

Second, if property received in a like-kind exchange between related persons is disposed of within two years after the date of the last transfer, the original exchange will not qualify for non-recognition of gain. You must obtain legal advice on this very complex area of “related persons”.

In May of 1991, the Internal Revenue Service adopted final regulations which clarified many of the issues. Here are some of the major highlights:

1. Identification of the replacement property within 45 days. According to the IRS, the taxpayer may identify more than one property as replacement property. However, the maximum number of replacement properties that the taxpayer may identify is either three properties of any fair market value, or any number of properties as long as their aggregate fair market value does not exceed 200% of the aggregate fair market value of all of the relinquished properties.
2. Who is the neutral party? Conceptually, the relinquished property is sold, and the sales proceeds are held in escrow by a neutral party, until the replacement property is obtained. Generally, an intermediary or escrow agent is involved in the transaction. In order to make absolutely sure the taxpayer does not have control or access to these funds during this interim period, the IRS requires that this agent cannot be the taxpayer or a related party. The holder of the escrow account can be an attorney or a broker engaged primarily to facilitate the exchange.
3. Interest on the exchange proceeds. One of the underlying concepts of a successful 1031 exchange is the absolute requirement that not one penny of the sales proceeds be available to the seller of the relinquished property under any circumstances unless the transactions do not take place.

Generally, the sales proceeds are placed in escrow with a neutral third party. Since these proceeds may not be used for the purchase of the replacement property for up to 180 days, the amount of interest earned can be significant. Or it used to be before banks started paying less then pennies on the dollar in interest accounts.

The IRS permits the taxpayer to earn interest — referred to as “growth factor” — on these escrowed funds. Any such interest to the taxpayer has to be reported as earned income. Once the replacement property is obtained by the exchanger, the interest can either be used for the purchase of that property, or paid directly to the exchanger.

The rules are quite complex, and you must seek both legal and tax accounting advice before you enter into any like-kind exchange tra