Consider a Tax-Deferred Exchange

Consider a Tax-Deferred Exchange

Most real estate investors are generally aware of the tax-deferred exchange provisions contained in Sec. 1031 of the Internal Revenue Code. These provisions allow you to exchange one piece of investment real estate (or other property held for productive use in a trade of business or for investment) for another without either the current payment of income taxes or realization of gain.

Three-Way Deferred Exchange. The words “tax-deferred exchange” connote a direct trade of properties between two parties, each of which trades the property he owns for the property of the other. It seldom happens that way. It is difficult to find someone who wants to acquire your property and who also has property you want to acquire. Fortunately, the Internal Revenue Code authorizes what is known as a deferred three-way exchange. Under this arrangement, you sell your property and have the money held by a qualified intermediary. When you find the property you want to buy, you have the intermediary use this money to buy the property for you “in exchange” for the property you gave up. Even though the procedure bears little resemblance to and actual trade of two properties between two parties, the end result is the same and you are allowed to treat it as an exchange for tax purposes.

Basic Requirements. The basic requirements of a deferred three-way exchange are as follows:

  • First, the properties must be of “like kind”. Fortunately, almost any kind of real estate is considered to be like kind with any other, so long as they are both held for investment or for business purposes. Land may be exchanged for income property, or an office may be exchanged for a factory. However, real estate may not be exchanged for stocks, bonds, or personal property. Also, a partnership interest (even in a land partnership) may not be exchanged for real estate, although there are sometimes ways around the latter if property structured.
  • Second, the replacement property (the property you are acquiring) must be “identified” in writing within 45 days of the closing of the sale of the property you are selling. You can designate more than one property, and don’t always have to actually purchase each and every property you designate, but there are limits. You can always designate up to three properties (the “three property rule”); or you can designate more than three if their total value does not exceed 200% of the value of the property you sold (the “200% rule”). If you designate too many properties and break both of these rules, you will lose your tax-free exchange treatment unless you close on and receive 95% of the properties which you designated (that is virtually impossible to do so).
  • Third, you must close the purchases of your replacement property within 180 days of the closing of the sale of the property you are selling.
  • Fourth, you cannot receive or have access to the money held by the qualified intermediary until after the 180 day period elapses.

Partial Trade. What happens if your accommodator (another name for the qualified intermediary) has some money left over? If you don’t spend all of the money you received from the sale of your property by acquiring replacement property, the qualified intermediary sends you the balance of your account and you will have to pay tax on your gain up to the amount of “boot” you receive. For example, if you receive $10,000 cash out of the exchange, you may have to pay tax on your gain up to $10,000.

Mortgages. If the property you sell is subject to a mortgage which the buyer assumed or took subject to, this is treated the same as additional cash or “boot” and is subject to tax. However, you may offset this “boot” by the amount of any mortgages you assume or take subject to on the property you acquire. Therefore, it is a good idea to try to purchase a property with a mortgage on it that is at least as large as the mortgage on the property you are selling. In some cases the seller of that property you are acquiring can be persuaded to refinance his property with a larger mortgage in order to help you achieve that objective. That way the seller gets his cash out and you avoid income taxes.

Conclusion. All exchanges are tricky. The consequences of an exchange not following the rules are dire. Call us for help regarding exchanges and all of your real estate needs.