Swap
Tactic Lets You Defer Capital-Gains Tax
“Like-Kind
Exchange” Applies To Many Real Estate Trade-Ups
Have you ever called your mutual funds
family and exchanged the share in your growth fund for shares in a value fund?
If so, you know that you pay capital gains taxes. A swap like this actually
requires selling those growth fund shares.
Or try bartering your professional
service. Offer, say, your medical services for a friend’s legal services to
avoid income tax. If you’re audited, the IRS will nail you for not reporting
the equivalent of wage income.
But if real estate’s your game, then
swapping is a way of life. One of the sweetest tax breaks ever devised is the
section 1031 exchange, which allows you to swap investment property on a
tax-deferred basis.
Although sometimes known as like-kind
exchanges, these transactions don’t have to involve identical types of
investment property.
You can swap an apartment building for a
shopping center, or a piece of raw land for an office building. You can swap a
second home that you rent out for a parking lot.
It’s a tremendous deal, you can’t do
that with stocks or bonds or personal property.
Originally, Section 1031 transactions
were designed for people who wanted to exchange properties of equal value.
Suppose you own land in Oregon and you trade it for a shopping center in Rhode
Island. If the values are equal, nobody pays taxes even though both properties
may have appreciated since they were originally purchased.
One variation involves properties of
unequal value. Let’s say you have a small piece of property, and you want to
trade up to a bigger one by exchanging it with another party. You can make the
transaction without having to pay capital gains tax on the difference between
the smaller property’s current market value and your lower original cost.
That’s good for you, but your partner
doesn’t make out so well. Presumably, you have to pay cash or assume a
mortgage on the bigger property to make up the difference in value. Known as
“boot” in the tax trade, your partner must pay tax on that part transaction.
Work Through An Agent
To avoid that, you could work through
an intermediary, who is often known as an escrow agent. Instead of a two-way
deal involving a one-for-one swap, your transaction becomes a three-way deal.
Your replacement property may come from a
third party through the escrow agent. Juggling numerous properties in various
combinations, the escrow agent may arrange evenly valued swaps.
Under the right circumstances, you
don’t even need to do an equal exchange.
You can sell a property at a profit, buy a more expensive one, and defer
the tax indefinitely.
You sell a property and have the cash put
into an escrow account. Then the escrow agent buys another property that you
want. He or she gets the title to the deed and transfers the property to you.
But you need to move fast. You must
identify your replacement property within 45 days of selling your estate. Then
you must close on that within 180 days. There is no grace period.
If your closing gets delayed by a storm
or by other unforeseen circumstances, and you cannot close in time, you’re
back to a taxable sale.
Advance Planning Required
Some accountants and lawyers specialize
in Section 1031 exchanges to make sure that you qualify.
Because it’s such a significant tax
benefit, there are all kinds of restrictions and pitfalls that you’ve got to
be careful of. You’ve got to dot all of you i’s and cross all of your t’s.
A Section 1031 transaction takes advance
planning. Find an escrow agent that specializes in the transaction. Contact your
accountant to set up the IRS form ahead of time. Some people just sell their
property, take cash and put it in their bank account. They figure that all they
have to do is find a new property within 45 days and close within 180 days. But
that’s not the case.
As soon as (sellers) have cash in their
hands, or the paperwork isn’t done right, they’ve lost their opportunity to
use this provision of the code.
Section 1031 doesn’t apply to personal
residences. But the IRS lets you sell your principle residence tax-free as long
as the gain is under $250,000 for individuals and under $500,000 if you’re
married.