Q What is a tax-deferred exchange?
A Tax-deferred exchanges are permitted under §1031 of the Internal Revenue Code. These exchanges are used by people want to defer payment of capital gain taxes when selling and buying investment properties and business properties. Exchange properties may be single family rentals, bare land, commercial, etc. Tax-deferred exchanges are also called “tax free exchanges,” “like-kind exchanges,” and “Starkers.”
Q How would an exchange benefit me?
A When you sell an investment or business Property you owe tax on any capital gain in the Property. On a gain of $30,000 this can mean a tax bill of as much as $10,000, between federal and state capital gain taxes. If you exchange the Property, instead of selling, you don’t have to pay the taxes. Exchanges are a great tool for investors who are trying to grow wealth. You get to keep the $10,000 and use this to leverage into a larger replacement Property.
Because this is only a tax-deferral technique, if at some point in the future you sell the replacement Property (without doing another exchange) the tax will come due at that time.
Q How does an exchange work?
A Most exchanges are simply the sale of a “relinquished” Property and the purchase of a “replacement” Property. Taxpayers need to work with an “accommodator” that will prepare some special paperwork for the sale and the purchase. In Oregon most accommodators are corporations affiliated with title insurance companies. It is the accommodator’s paperwork that creates the exchange. The accommodator is also required to control and hold the cash from the sale.
Q Are there any other requirements?
A Yes. First, you only have 180 days to complete the sale and purchase. This is called the “exchange period.”
Second, there is a requirement that the replacement Property be carefully identified within the first 45 days of the exchange period.
Third, to get a complete deferral of capital gain taxes there are some reinvestment rules. Simply put, it is cash for cash, debt for debt. All cash from the sale must be applied toward the purchase. And if there was a mortgage on the relinquished Property then you need a new mortgage of equal, or greater, amount on the replacement Property.
Q What if my cash for cash, debt for debt adds up to $165,000 but I only buy for $155,000?
A Assuming there is $30,000 of gain in the relinquished Property, you have a tax bill on $10,000 that was not reinvested. You still get a deferral on $20,000 of gain. This is called a partial exchange.
There are also restrictions about how the money from the sale can be spent and when any excess exchange funds can be returned to you. If you are unable to purchase a replacement Property the accommodator may be required to hold your money until after the end of the 180-day exchange period.
Q What happens if I can’t identify a Property within 45 days?
A The exchange fails, the cash held by the accommodator must be returned to you after the 45th day and you have to pay capital gain tax.
Q What if I can’t purchase within the 180 days?
A The exchange fails, the cash held by the accommodator must be returned to you (after the 180th day) and you have to pay the capital gain tax. These deadlines are very rigid and can only be extended in the event of a presidentially-declared emergency.
Q I have a little rental house. Can I exchange it for a second home?
A Although we all believe second homes are an important “investment,” personal-use Property does not qualify for exchange treatment. However, with patience this could work. You might sell the rental house and buy a rental house in an area where you would eventually like to have a second home. After renting the new house for a period of time (consult with your tax advisor) you could begin to use the home personally. Better yet, if you end up retiring into the Property it may qualify for mostly tax-free treatment as a personal residence.
Q I am tired of my three rental houses. Can I exchange them for a nearby commercial Property?
A Yes. You can exchange residential properties for commercial, or any other real Property that you intend to hold for investment or business. Although these are called “like-kind” exchanges, all real Property is “like-kind” with all other real Property, even when the exchange is improved Property for unimproved Property. What is important is that both be held for investment or business purposes.
Q I am tired of my three rental houses and I don’t want any other Property. I just want out! What about buying into a Real Estate Investment Trust (REIT)?
A Unfortunately, because you are selling real estate you must buy real estate. Buying into a REIT is buying stock and is not considered to be an interest in real estate.
An option for you might be purchasing a piece of a Tenancy-in-Common Property (TIC’s). There are companies that market TIC interests, typically office and retail properties. As a smaller investor you may be able to sell your rental houses and buy a percentage interest in one of these properties. You still get an interest in real estate (as required for the exchange) but no longer have to deal with Property management.
Q I am having trouble selling my rental house but there is a condo in Hawaii that I want to buy. Can I buy it before I sell the rental and still qualify for an exchange?
A Buying before you sell is called a “reverse” exchange. While the IRS issued rules for reverse exchanges in 2000 these exchanges are far more complicated than a “forward” exchange. Among other things, you are not permitted to own both properties at the same time. Therefore, you have to “park” one of the properties with an accommodator. Plan to spend some significant time consulting with the accommodator company and your legal and tax advisors to arrange the reverse exchange. The accommodator’s fee for the reverse exchange will be higher than their fee for a forward exchange. You will have other additional expenses – recording fees, closing fees, perhaps higher loan fees, etc.
Q Is there anything else I should be aware of?
A There are a number of technical rules that apply to exchanges. And there are special challenges in exchanges: related parties, new construction, dissolving partnerships, to name a few. Before deciding to do an exchange you should talk to your tax advisor and a knowledgeable accommodator company to review these numerous rules and make sure the exchange will be beneficial to you.
