Slow Sales, New IRS Rules Prompt Real Estate Exchanges
Real estate investor Paul Williams doesn’t do much buying and selling. Instead, he prefers to trade.
In January, Williams exchanged land in Apple Valley worth $67,000 for the down payment on a $200,000 home in Sherman Oaks. The next month, Williams traded another five acres in Phelan worth $91,000 for the equity stake in a $160,000 Burbank home.
Now, the Westlake Village real estate broker is swapping seven apartments and two parcels of land in Apple Valley and in San Bernardino County for a 154-acre farm in Tulare County, a commercial lot in San Fernando and $50,000 cash.
Williams is president of the San Fernando Valley Exchangors, a group of real estate professionals who get together on the second Monday of every month at the 94th Aero Squadron Restaurant in Van Nuys to swap their real estate holdings. About 20 to 35 people show up for the 9:30 a.m. meetings, Williams said, and they all take turns pitching their properties.
Most of the exchanges are so-called tax-deferred like-kind exchanges provided for in Section 1031 of the Internal Revenue Code. Property owners can defer capital gains on their real estate by swapping instead of selling--as long as they buy something of equal or greater value.
Any property other than a primary residence or vacation home qualifies for a 1031 exchange, as long as participants in the deal meet a long and detailed list of requirements. The benefits can be substantial, however. A seller with property that has gone up in value can defer all the capital gains to some undetermined date. Meanwhile, the seller has continued use of the money that would otherwise have been earmarked for federal income taxes.
Members of the San Fernando Valley Exchangors, such as John Barta of Buyer’s Broker Realty in Tarzana, say real estate exchanges are growing in popularity for two reasons. First is the fact that last year the IRS changed its rules to provide what are known as “safe harbors” for taxpayers. That means that as long as the strict IRS rules are followed, the taxpayer should not have problems with the IRS. Before, most of the rules were nebulous, and few transactions could be assured of passing IRS muster.
Secondly, Barta said, “you have a market where people can’t sell what they’ve got for cash. When people find they can’t sell their property, they turn to people who can do exchanges.”
“The rules are now clearer in terms of the steps you need to take for a delayed exchange,” said David L. Keligian, tax partner at the Encino law firm Grayson, Givner, Booke, Silver & Wolfe. Still, “most small investors are not all that knowledgeable about 1031 exchanges,” he said. Investors should also be aware of the $2,000 to $3,000 in accounting and legal fees usually associated with a property swap.
Barta reported that he does about half a dozen exchanges every year. He charges 3% of the value of the property, or $100 an hour, for his work.
“It’s not a volume kind of business,” he said. “Some people do exchanges just for the sake of bettering their position. The tax consequences may be secondary.”
Homeowners who sell their home can avoid capital gains by buying a new home within two years of selling their old one. This rule is provided for in Section 1034 of the Internal Revenue Code, which also allows sellers 55 or older a onetime profit on their home of up to $125,000.
It would be simpler if a similar set of rules were applied to transactions that now come under Section 1031. But, who says the IRS has to do things the simple way?
But, the 1031 rules are here--at least for now--so it’s worth understanding them.
Investors A and B, for example, don’t need to directly swap their properties. The investors can bring property owner C or D into the picture so that each participant gets just the property that he or she wants.
IRS rules also allow for a bit of a time lag. Investor A can “sell” his or her property to Investor B and place the funds directly in an escrow account or have the money paid to what’s known as an accommodator. A then has 45 days to designate another property that he or she wants to trade into and a total of 180 days to close the deal.
“You see an awful lot of mom-and-pop investors doing exchanges,” said Sherman Oaks resident Philip J. Holthouse, partner at the West Los Angeles accounting firm Holthouse Carlin & Van Trigt. It’s necessary to remember, though, that taxpayers who don’t follow the IRS rules exactly may find themselves with a half-baked plan that doesn’t provide the benefits of tax-deferral.
Keligian advises owners to read up on 1031 exchanges and consult a certified public accountant. Also, because most trades that involve more than two parties involve some sort of time lag, it’s advisable to hire an accommodator. Finding a reputable one can be challenging, but many CPAs and attorneys can make referrals.
Finally, Keligian said, don’t do a trade just because of the tax savings. There may be other reasons that make a taxable sale more worthwhile: For instance, you may really want that piece of property and the seller only wants to do a trade deal.
“Almost anyone who owns investment property can do a 1031,” said Jerry Erskin, first vice president at CB Commercial in Sherman Oaks. “It can be for anybody.”
Erskin is now representing a “seller” who is looking to trade his $1.2-million commercial property in Chatsworth for something else. That seller has already found a “buyer” but now is looking for a property to trade into.
