IRS Clarifies Rules on Tax-Free Exchanges : Shelter: Latest changes in IRS rules that help investors with capital gains are interpreted.

The Internal Revenue Service recently clarified its regulations on so-called tax-free real estate exchanges authorized under Section 1031 of the Internal Revenue Code.

The 1031 exchange is perhaps one of the few remaining legitimate tax shelters available to real estate investors, and final rules issued May 1 by the IRS must be studied by every investor who is interested in selling property but avoiding the high capital-gains tax.

Let us look at how this tax shelter works.

Section 1031 states that “no gain or loss shall be recognized if property held for productive use in trade or business or for investment . . . is exchanged solely for property of a like kind to be held either for productive use and trade or business or for investment.”

A tax-free exchange does not eliminate the tax on the profit made on investment property; it merely defers the tax on the gain. Ultimately, if the investment property is sold--and no further exchanges are made--the taxpayer has to pay gain on the overall profit.

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

First, the property transferred (now referred to as the “relinquished property”) must be “property held for productive use in trade, in business or for investment.”

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

According to the IRS, “a sale of property followed by a purchase of property of a like kind to the property sold does not qualify for non-recognition of gain or loss under Section 1031 regardless of whether the other requirements of Section 1031 are satisfied.”

The form used in obtaining the end result is important, and the IRS will carefully consider the form when it reviews tax-free exchanges.

A third element is that the replacement property must be of “like kind.” The courts have given a wide definition to the term “like kind exchange.” As a general rule, all real estate is considered to be “like kind” with all other real estate. For example, raw land may be exchanged for an apartment building, a farm for an apartment complex or an apartment complex for commercial or industrial property.

Once you meet these tests, you then have to determine the tax consequences.

If you do a traditional like-kind exchange, the profit you will have made on the first property 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 transferred without the recognition of the gain.

You will have to discuss this with your accountant to determine whether the savings to you by using the like-kind exchange will make up for the lower cost basis on your new property.

The traditional like-kind exchange is referred to as a “simultaneous exchange.” A and B both own investment property, and both want to swap. On the day of settlement, A conveys a deed to B, and B conveys a deed to A. This is the classic 1031 exchange.

However, not everyone is able to find replacement property before they sell their relinquished property. In a case involving a man named Starker, the court held that the exchange does not have to be simultaneous.

Under the Starker case, the court held that “simultaneity transfer” is not a requirement for non-recognition of the gain under the tax code. Starker sold property and sometime later purchased property and then successfully argued that this was a “sale and exchange.”

Congress was concerned about the expansion of this like-kind exchange concept. Accordingly, in 1984, it put two major limitations on the Starker (non-simultaneous) exchange.

First, the property to be received by the taxpayer must be identified as such before the 45th day after the date on which the property is transferred.

Second, the new property must be received no later than 180 days after the taxpayer transfers his original property, or the due date with extension of the taxpayer’s return for the year the transfer is made.

In 1989, Congress added two other technical restrictions. First, like-kind exchange would not be applicable where the property in such an exchange between related persons is disposed of prior to two years after the date of the last transfer in the exchange.

Second, real property located in the United States cannot be exchanged for real property outside the United States.

But many questions continued, which perplexed lawyers and accountants, and worried the exchanging taxpayer. The IRS, in its new rules, clarified many of these concerns. Although this column cannot cover the 15 pages of regulations, the following will highlight some of the major issues:

As we discussed, under the Starker-type exchange you have to identify the replacement property within 45 days after you transfer the old property.

What does this mean?

According to the IRS, the taxpayer may identify more than one property as replacement property. However, regardless of the number of relinquished properties transferred by the taxpayer as part of the same deferred exchange, 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 as of the end of the identification period does not exceed 200% of the aggregate fair market value of all of the relinquished properties.

The replacement property or properties must be unambiguously described in the written document or agreement. According to the IRS “real property generally is unambiguously described if it is described by a legal description, street address, or distinguishable name (e.g., the Mayfair Apartment Building).”

One question that has always confused the real estate industry goes to whether the exchanger has the right to earn interest on the sale proceeds that are held in escrow pending the receipt of the replacement property.

One of the major tests to determine the validity of a tax-free exchange goes to the absolute requirement that the sales proceeds are not 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 or in trust with a neutral third party. Keep in mind that these proceeds will not be used for the purchase of the replacement property for as long as 180 days, and the amount of the interest earned can be significant.

According to the new 1031 regulations, the taxpayer does have the right to earn interest--also called growth factor--on these escrowed funds, but the taxpayer will have to report this interest 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.

Ironically, one of the few vocal objections to the IRS rules came from those who had been active in marketing these tax-free exchanges. The so-called “facilitators” are individuals or organizations who act as the escrow agent, and in the past because of the uncertainty of the law dealing with interest have kept the interest for themselves.

Now that the IRS has clarified this issue, the facilitators are upset, because they are going to be losing the use of these funds.

Finally, the IRS clarified the area as to who can be the escrow agent, also known as the “qualified intermediary.” This agent cannot be the taxpayer or a related party. This means the escrow agent cannot be yourself, anyone related to you--for example, immediate family members--or your agent.

Agent is further defined as your employee, your regular attorney or accountant or your regular broker.

However, the holder of the escrow account can be an attorney or a broker engaged primarily to facilitate the exchange, and can also be a financial institution or a title or escrow company. If you did not use your attorney’s services for the past two years, he or she is eligible to act as the “qualified intermediary.”

Seek the advice of tax and legal advisers before signing documents.