"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 friendís legal services to avoid income tax. If
youíre audited, the IRS will nail you for not reporting the equivalent of wage
But if real estateís 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 donít 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.
Itís 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. Letís
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 propertyís
current market value and your lower original cost.
Thatís good for you, but your partner doesnít 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 donít 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, youíre back to a taxable
Advance Planning Required
Some accountants and lawyers specialize in Section 1031
exchanges to make sure that you qualify.
Because itís such a significant tax benefit, there are all
kinds of restrictions and pitfalls that youíve got to be careful of. Youíve got
to dot all of you iís and cross all of your tís.
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 thatís not the case.
As soon as (sellers) have cash in their hands, or the
paperwork isnít done right, theyíve lost their opportunity to use this provision
of the code.
Section 1031 doesnít 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 youíre married.