Guide to the Basics of Tax-Free Exchange

Let’s say you purchased a rental property several years ago at a cost of $100,000 and that it has been a good investment for you. Not only have you been able to make a few dollars on the income, but until 1986 you were able to take significant paper write-offs through depreciation. The property is now worth $300,000, but your basis for tax purposes, after deducting depreciation, is $60,000.

You believe the property has appreciated to its maximum, and ant to sell it and obtain another investment property. If you were to sell it for $300,000, your profit for tax purposes (eliminating for this discussion any selling expenses) would be $240,000 ($300,000 minus $60,000). The capital gains tax, currently at 28%, would require that you pay $67,200 in federal taxes. This does not take into consideration any state or local taxes.

However, there is a strategy that will enable you to defer paying this tax. It is called a “like-kind exchange,” commonly referred to as a tax-free exchange. It is very similar in nature to the rollover, whereby the tax is deferred--not avoided--until the final property is sold.

The origin of the like-kind exchange is found in Section 1031 of the Internal Revenue Code.

The rules are complex, and you must seek your own tax advisers to address your specific needs. However, here is a general overview of the concept.

Section 1031 permits non-recognition of 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.

Third, the replacement property must be of “like kind.” The courts have applied a broad definition to this concept. As a general rule, all real estate is considered to be “like kind” with all other real estate. Thus, 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 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. 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 exchange works as follows. John owns house “A” and Mary owns house “B.” Each are worth approximately the same amount of money. On a given date, John conveys “A” to Mary, and in exchange, Mary conveys “B” to John. The tax basis of the property remains the same. The basis of the property that John received will be the same as the basis of the property that he conveyed to Mary. This is referred to as the “substituted basis.” When John or Mary ultimately sell the property, they will have to pay tax on this gain, plus any subsequent appreciation. However, in the interim, the money which they otherwise would have paid in tax is going back into the property for further investment purposes.

Unfortunately, the classic exchange rarely works. Not everyone is able to find replacement property before they sell their own 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 obtained replacement 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 replacement property must be identified as such before the 45th day after the day on which the original 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 any extension) of the taxpayer’s return of the tax imposed for the year in which the transfer is made. This is a very important time limitation, which should be marked on your calendar when you first enter into a 1031 exchange.

In 1989, Congress added two additional technical restrictions.

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

Second, if property received in a like-kind exchanged between related persons is disposed of within two years after the date of the last transfer, the original exchange will not quality for non-recognition of gain. This is complex, and you should review with your own tax adviser what constitutes a “related person.”

For a number of years, the complexities and the logistics of transacting a like-kind exchange perplexed lawyers and accountants, and gave no comfort to the exchanging taxpayer. Finally, in May of 1991, the Internal Revenue Service published its 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 topics.

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, 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.

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

2. Interest on the exchange proceeds. One question that had previously confused the real estate industry was whether the exchanger has the right to earn interest on the sales proceeds that are held in escrow or trust pending the receipt of the replacement property. One of the underlying concepts of a successful 1031 exchange is 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 neutral third party. It should be noted that these proceeds may not be used for the purchase of the replacement property for as long as 180 days, and the amount of interest earned can be significant--even in today’s low interest rate climate.

Surprisingly, the IRS permitted the taxpayer to have the right to earn interest--also referred to as growth factor--on these escrow funds. Obviously, 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.

3. Who is the neutral party? Conceptually, the relinquished property is sold, 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 purchase and exchange of the replacement property. To make absolutely sure that the taxpayer does not have control or access to these funds during this interim period, the IRS held that the agent cannot be the taxpayer or a related party. This means that the escrow agent cannot be yourself, anyone related to you or your agent. Agent is further defined as your employee, your regular realty broker, attorney or accountant.

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.”

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