Exchanges Are a Way to Defer Taxes
Would you like to become a real-estate millionaire without paying taxes on your wealth?
Buy a fixer-upper rental house, improve it to increase its market value and make a tax-deferred exchange for another fix-up property. Then do it all over again until you pyramid your way to realty wealth without owing any profit tax.
Pyramiding your real-estate wealth without owing profit taxes along the way requires an understanding of tax-deferred exchanges. Since 1921, Internal Revenue Code 1031 has allowed tax-deferred exchanges of real estate held for investment or use in a trade or business. Tax-deferred exchanges are based on the idea that disposing of one investment (or business) property and acquiring a “like kind” replacement of equal or greater cost and equity is really a continuous investment, so it shouldn’t be taxed.
Tax-deferred realty exchanges, however, cannot involve your personal residence. All exchanged properties must be held for investment or used in your business. But you can make your personal residence eligible by renting it to tenants before disposing of it in a tax-deferred exchange. Or you can trade a business or investment property for a rental house, which, a year or so later, you convert to your personal residence.
To illustrate how a tax-deferred exchange works, let me describe my first tax-deferred exchange. I acquired a rundown three-unit apartment building with a 10% down payment and a 90% mortgage, fixed it up to increase its market value and then wanted to trade up to a potentially more profitable rental property.
With the help of two sharp realty agents, I exchanged my three units for a rundown nine-unit apartment building. Since the seller of the apartment building didn’t want to keep my little three-unit building, one of the realty agents arranged for a “standby” buyer to immediately purchase my three units after my trade up was recorded. It was a tax-deferred exchange for me. For the seller of the nine-unit apartment building, it was a taxable “down trade.” He received cash from the “cash-out” buyer.
But the down-trader wanted to get out of apartment management and expected to pay a capital-gains tax on his sale profit. Everyone walked away happy, except perhaps Uncle Sam, who didn’t receive tax on my tax-deferred exchange up to a larger rental property.
The primary reason for exchanging investment or business property is to avoid profit tax. Eight reasons for exchanging, besides avoiding capital gains tax, include:
* To minimize the need for mortgage financing on the acquired property.
* To dispose of an undesirable property, or one that is hard to sell, by exchanging for one that is more desirable and easier to sell.
* To increase the investor’s depreciable basis by trading for a larger depreciable building.
* To acquire a property that better meets the investor’s needs and is easier to manage.
* To defer part of the profit tax by trading down and carrying back an installment sale mortgage.
* To pyramid your wealth into a large estate without paying profit taxes along the way.
* To receive tax-free refinance cash either before or after the exchange (but not as part of the actual exchange).
* To accept an unsolicited purchase offer to sell an investment property and avoid tax by reinvesting in another qualified property.
There are three basic types of tax-deferred exchanges: a direct exchange of one property for another (very rare today), a simultaneous three-way exchange of a direct trade followed by an immediate “cash-out” sale to a pre- arranged buyer (such as my exchange explained above) and a Starker “delayed” tax-deferred exchange, as authorized by Internal Revenue Code 1031(a)(3).
Starker exchanges are, by far, the easiest and most popular today. They are named after T.J. Starker, who sold his timberland in 1979 to Crown-Zellerbach Corp. and who later used the sales proceeds to acquire other timberland. The key to a successful Starker tax-deferred exchange is having the sales proceeds held by a qualified third-party intermediary, such as a bank trust department or title insurance subsidiary, beyond the constructive receipt of the exchanger. To defer the profit tax, the trader must designate the qualified replacement property within 45 days after the sale of the old property, and must complete its title acquisition within 180 days.
To make Starker exchanges even easier, on Oct. 2, 2000, the IRS issued Revenue Procedure 2000-37 in Internal Revenue Bulletin 2000-40, which approves “reverse exchanges.” That means an investor can now first locate the suitable replacement property and have a third-party accommodator temporarily take title to it before the old “like kind” property is sold.
The big problem for many exchangers has been finding a suitable replacement property within the short 45-day replacement period. Now, by following the new IRS “reverse exchange” rules, Starker exchangers can acquire the replacement property before selling the old property.
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Robert J. Bruss is a syndicated columnist as well as a real estate investor, lawyer, broker and educator in the Bay Area.
