The real estate market has certainly improved and with it profits for investors. Many investors like to turn over their money, which means they buy property, hold it until it can be sold at a reasonable profit (usually at favorable long term capital gains tax rates) and reinvest the proceeds in other property they believe positioned for future gain. Sometimes, the investor is simply looking to pocket a profit, with no plan to purchase another property.
The IRS welcomes the good fortune of a successful real estate investment. Short term gains can be taxed as much as 37%. The typical real estate investment is owned for at least one year, which qualifies profit for more favorable long term capital gains tax treatment. Even then, the tax on most investors is 15% or 20%, depending on the investor’s tax bracket.
The investor does not feel the tax pain immediately, as he or she does not have to write a check to Uncle Sam until filing a tax return. For that reason, many overlook an opportunity to avoid paying that tax. A properly structured plan to acquire a replacement property with proceeds of sale can defer taxes indefinitely, until property is ultimately sold for cash and no reinvestment.
The devil is in the details. These transactions must be properly structured. The 1031 exchange, also known as a like-kind exchange, is a trade of one property held for business or investment for another. 1031 refers to Internal Revenue Code Section 1031. If properly done, no taxes are paid in connection with the transfer and there is no limit on how many times the taxpayer can continue exchanging. That means, the investor can continue rolling forward profit, without paying tax, indefinitely.
A like-kind exchange is only available for property held for business or investment purposes. It cannot be used for personal use property, such as a primary residence. But, there is tremendous flexibility within the business or investment property definition. A vacant lot can be traded for an apartment building. A rental house can be traded for a gas station. The only requirement is that it be business or investment real property involved on both sides of the trade.
A direct swap is the simplest and cleanest like-kind exchange available. It could be difficult to find someone willing to trade for property if they want to sell. A like-kind exchange can also involve use of proceeds from sale to acquire title to replacement property, by placing the proceeds with an intermediary. That is a deferred exchange, also known as a Starker exchange, for the Starker family.
The Starkers were trailblazers in the deferred like-kind exchange arena. The Starkers conveyed timberland in exchange for a promise that their buyers would provide acceptable replacement property within five years. The arrangement included a 6% annual growth factor as incentive for the buyer to promptly find acceptable replacement property. Starkers arranged for the sale proceeds to be held in trust until the replacement property could be acquired with those funds. The 1970s saw the IRS challenge the Starkers and lose in a number of court decisions. Realizing that they were beat, the IRS accepted the deferred exchange but adopted regulations limiting the time period for them.
Under the current law, a seller wishing to take advantage of a deferred like-kind exchange must not only arrange for the sale proceeds of the relinquished property to be held by a third party, but must also identify replacement property within 45 days from closing on sale of the relinquished property and ultimately acquire title to the replacement property within 180 days. The taxpayer can identify and unidentify numerous properties during the 45 day identification period, but is stuck with whatever is identified on the 45th day. If title is not acquired within the 180 day window, the exchange falls apart and the taxpayer must pay taxes on all of the gain from his or her sale. The taxpayer has a little flexibility, as the taxpayer may identify up to three properties or, if the taxpayer wants to identify more than three properties, the total of the identified properties cannot exceed 200% of the fair market value of the relinquished property.
It is required that all of these arrangements be documented and parties related to the taxpayer cannot generally hold the funds from the taxpayer’s sale that will be used to acquire the replacement property. All of the documentation must be in place by the time the taxpayer closes on sale of the relinquished property. One cannot create a likekind exchange after the fact.
A like-kind exchange avoids the tax, but it is only deferred. It defers tax until the taxpayer ultimately sells replacement property with no replacement.
The rules require that replacement property be held for business or investment purposes. How long does replacement property have to held you might ask? Experts agreed two years is safe, but the real issue is intent to hold. What if the taxpayer is approached by a buyer who offers a significant profit in less than two years? If the taxpayer held the property for less than 12 months, he or she has a problem. Between 12 months and two years is more of a gray area.
If the taxpayer ultimately sells replacement property without another like-kind exchange, tax will be due. Tax is due on all of the profit from the initial relinquished property sale through the last sale without replacement property. But, there are other ways to even beat the IRS then.
One of the most attractive is for a taxpayer planning to retire, but who is not quite ready. That taxpayer could sell investment property and buy a rental home in the geographical area of planned retirement. After renting it, the taxpayer ultimately moves in the home, makes it his or her primary residence and later sells the property sheltering up to $500,000 of gain under special IRS tax treatment given to sale of a taxpayer’s primary residence.
The key in this scenario is to be able to prove that the property was initially purchased with intent to be held for business or investment. The IRS has a safe harbor for such transaction, requiring the replacement property be owned for at least 24 months. In each of the two 12 month periods in that time frame the tax payer must rent the replacement property to another person at fair rental for at least 14 days and the tax payer’s personal use of the replacement property must not exceed the greater of 14 days or 10% of the number of days rented during each of the 12 month periods. The taxpayer must occupy the home for at least two of the five years prior to its sale. Special rules for 1031 property also require the home be owned at least five years before it is sold. The amount of the exclusion will be prorated between the period of time it was a principal residence and the time it was business or investment property, the government will also tax depreciation taken by the taxpayer.
Deferring tax is the primary reason for most like-kind exchanges. But, there can be many other reasons for a taxpayer to consider such “trades.”
The taxpayer may want to trade for a more attractive investment. A taxpayer may want income and not capital appreciation and may want to replace non-income producing property with income producing property. Exchanging a lot for a rental home would be good example. Other taxpayers may want to acquire a property with greater opportunity for depreciation. The taxpayer may have fully depreciated property currently owned and want to exchange for a more expensive property that can have additional depreciation.
Some may even want to diversify. A taxpayer can exchange one large expensive property for multiple smaller properties.
Other requirements for a successful like-kind exchange includes all of the sale proceeds from the relinquished property be used to acquire replacement property, which means the replacement property must be of equal or greater value to the relinquished property. Anything left over is taxed, dollar for dollar, until all of the profit from sale of the relinquished property is taxed. There are special rules for netting mortgages on sold property and replacement property, but if structured properly, even mortgaged property can be part of a like-kind exchange.
Believe it or not, reverse exchanges are even possible. For years, there was question about whether the IRS would allow a reverse exchange under which a replacement property is acquired before sale of the relinquished property. The IRS ultimately agreed that a reverse like-kind exchange is permissible and published regulations with safe harbors in 2003. The most important requirement is that sale of the relinquished property must close within 180 days after closing on the purchase of the replacement property. Reverse exchanges are more difficult, particularly if financing is involved, but can be done.
Like-kind exchanges are a real opportunity to beat the IRS if properly structured. The key is proper structuring documentation. They should not be done without professional advice.
William G. Morris is the principal of William G. Morris, P.A. William G. Morris and his firm have represented clients in Collier County for over 30 years. His practice includes litigation and divorce, business law, estate planning, associations and real estate. The information in this column is general in nature and not intended as legal advice.