Tax Free Exchange: A Valuable Alternative To A Home SaleWritten By: Benny L. Kass
Congress is currently talking tax reform. Two very important real estate benefits are on the so-called "chopping block", either to be completely eliminated or significantly curtailed.
It is doubtful that the home owner exclusion of up to 500,000 or 250,000 if you file a single tax return of profit will be impacted; there are too many homeowner voters who will forcefully object. But investors do not have the same strong lobbyist who can make the case for preserving the "like kind" exchange. So if you have an investment property, now might be the time to consider doing an exchange.
Residential homeowners have a number of tax benefits, the most important of which is the exclusion of up to 500,000 or 250,000 if you file a single tax return profit made on the sale of your 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, the capital gains tax can be quite large.
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. In my opinion, these exchange provisions are still an important tool for any real estate investor.
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 >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 by the IRS the ">Second, there must be an exchange; the IRS wants to ensure that a transaction 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 that you determine the tax consequences. If you do a like-kind exchange, your profit will be deferred until you sell the replacement property. However, it must be noted that 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. And discuss also whether you might be better off selling the property, biting the bullet and paying the tax, but not have to be a landlord again.
The traditional, >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 >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 taxpayers 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.
In 1989, Congress added two additional technical restrictions. First, property in the United States cannot be exchanged for property outside the United States.
Second, if property received in a like-kind exchange between >In May of 1991, the Internal Revenue Service adopted final regulations which clarified many of the issues.
This column cannot analyze all of these regulations. The following, however, will highlight some of the major issues:
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 larger number as long as their aggregate fair market value does not exceed 200 of the aggregate fair market value of all of the >Furthermore, the replacement property or properties must be unambiguously described in a written document. According to the IRS, real property must be described by a legal description, street address or distinguishable name e.g., The Camelot Apartment Building."
2. Who is the neutral party? Conceptually, the >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 >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 at least it used to be until banks starting paying pennies on our savings accounts.
Surprisingly, the Internal Revenue Service permitted 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 transaction.
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