(This is Part 5 of a five-part series. Read Part 1, "IRS debunks common tax myths"; Part 2, "Homeowners get good tax news for 2007"; Part 3, "How to deduct mortgage interest, points on taxes"; and Part 4, "Home sellers keep profits, avoid taxes.")
"The difference between death and taxes is death doesn’t get worse every time Congress meets." –Will Rogers
In this series of tax articles, I have discussed the tax benefits for residential properties, such as the exclusion of gain of up to $500,000, or the various tax deductions available to homeowners.
Now we turn to the tax benefits available to real estate investors.
If you own investment property, and sell it, you will have to pay capital gains tax; for 2007, the tax rate is 15 percent.
But investors are required to depreciate a portion of their property. While this may provide a small tax benefit each and every year, when the property is ultimately sold, in many cases this depreciation must be recaptured at the rate of 25 percent.
Enter the like-kind exchange, which is a way of deferring that tax. At the outset of this column, it must be pointed out that contrary to popular opinion, this is not a "tax-free" transaction. The exchange, authorized by section 1031 of the Internal Revenue Code, will only defer — not avoid — the capital gains tax. It will not relieve you from the ultimate obligation to pay the capital gains tax.
Many years ago, a man by the name of T.J. Starker sold property in Oregon, pursuant to a "land exchange agreement," but did not receive any money for the sale. Instead, the seller — a couple of years later — transferred replacement property to Starker. The Internal Revenue Service considered this a taxable sale, but the 9th Circuit Court of Appeals held that this was a deferred exchange permitted under Section 1031 of the Tax Code. In other words, the exchange did not have to take place simultaneously.
The ideal exchange is a direct exchange. I own investment property A and you own property B (also investment). Both are of equal value. On Aug. 1, 2007, you convey B to me and on that same day I convey property A to you. If there is a written agreement between us that this is to be a 1031 exchange, neither of us will have to immediately pay any capital gains tax on any profit we have made.
But it is almost impossible to arrange such a transaction. The logistics of finding the replacement property to be exchanged simultaneously with the relinquished property is very difficult to coordinate.
Accordingly, most 1031 exchanges today are deferred.
There are two kinds of deferred (Starker) exchanges:
- Forward exchange: You sell the relinquished property, and within the time limitations spelled out in Section 1031, obtain the replacement property;
- Reverse exchange: You obtain title to the replacement first, and then sell the relinquished property.
The rules are complex, but here is a general overview of the process. With some important exceptions (discussed below) the rules apply equally whether the exchange is forward or reverse.
Section 1031 permits a delay (non-recognition) of gain only if the following conditions are met:
Must be investment property: The property transferred (called the "relinquished property") and the exchange property ("replacement property") must be "property held for productive use in trade, in business or for investment." Neither property in this exchange can be your principal residence, unless you have abandoned it as your personal house. Your vacation home would also not qualify as investment property, unless you actually start to rent it out more or less full time.
The area of vacation homes is complex and often misunderstood by taxpayers and lawyers alike. The IRS recently promised to provide more information to taxpayers regarding the treatment of these vacation homes.
There must be an exchange: The IRS wants to ensure that a transaction that is called an exchange is not really a sale and a subsequent purchase. Practically, an exchange looks like a sale, but the paperwork involved with the transaction makes it an exchange. It is important that anyone considering a 1031 exchange retain counsel who is familiar with the various rules.
The replacement property must be of "like kind": As a general rule, all real estate is considered "like kind" with all other real estate. Thus, a condominium unit can be swapped for an office building, a single-family home for raw land, or a farm for commercial or industrial property.
Once you meet these tests, it is important that you determine the tax consequences. If you do a like-kind exchange, your profit will be deferred until you sell the replacement property. However, it must be noted that the cost basis of the new property in most cases will be the basis of the old property. Discuss this with your accountant to determine whether the savings by using a like-kind exchange will make up for the lower cost basis on your new property. Many taxpayers are excited about the concept of deferring their gain, but when they analyze their situation, they realize that the tax will only be a few thousand dollars. Additionally, becoming a landlord again may not be that attractive.
There are two important time limitations that are spelled out in the statute and cannot be waived or modified:
1. Identification of the replacement property within 45 days. Congress did not like the fact that Mr. Starker had no time limitations on when the exchange could take place. Accordingly, the law now requires that the taxpayer identify the replacement property no later than 45 days after the relinquished property has been sold. According to the IRS, the taxpayer may identify more than one property as replacement property. However, the maximum number of replacement properties that the taxpayer may identify is either three properties of any fair market value, or any number of properties as long as their aggregate fair market value does not exceed 200 percent of the aggregate fair market value of all of the relinquished properties.
The replacement property or properties must be unambiguously described in a written document. According to the IRS, real property must be described by a legal description, street address or distinguishable name (e.g., The Nathan Apartment Building).
2. A neutral party is essential. If the taxpayer has any control of even one penny of the relinquished property’s sales proceeds — even for one minute — the exchange will fail. All such proceeds must be held in escrow by a neutral party until the taxpayer is ready to close on the replacement property. At that time, the funds must go directly into that purchase. Generally, an intermediary or escrow agent is involved in the transaction. In order to make absolutely sure that the taxpayer does not have control or access to these funds during this interim period, the IRS requires that this agent cannot be the taxpayer or a related party. The holder of the escrow account can be a broker or an attorney, unless the attorney had within the past two years represented the taxpayer. In such cases, the IRS takes the position that the client controls the attorney and the funds would be constructively in the hands of the taxpayer.
3. Take title within 180 days: Title to the replacement property must be obtained no later than the earlier of 180 days after the relinquished property is transferred or the due date of the taxpayer’s income tax return for the year in which the transfer is made. If, for example, you transferred the relinquished property on Dec. 1, 2007, your tax return is due on April 15, 2008, which is only 136 days. You either have to obtain the replacement property by that date or get extensions from the IRS so that you can extend out to the full 180 days. Nowadays, getting an extension is automatic. If by the due date, you file Form 4868, you will get an extension for six months. Please note, however, that while this allows you to late file your tax return, you still have to pay the tax by April 15, 2008.
4. Interest on the exchange proceeds.
What happens to the interest earned while the sales proceeds are held in escrow? The IRS calls this the "growth factor," and any such interest to the taxpayer has to be reported as earned income. Once the replacement property is obtained by the exchanger, the interest can either be used for the purchase of that property or paid directly to the exchanger.
Reverse exchanges: It is often difficult to meet the 45/180-day requirements. You have found the replacement property, but do not yet have a buyer for your relinquished property. And the owner of the new property is not prepared to wait until you are able to go to closing on your current property.
The reverse Starker — if done properly — can solve this dilemma. Here are some of the important rules:
1. The taxpayer must arrange for the replacement property to be held in a "qualified exchange accommodation arrangement." In government language, this is called "QEAA."
2. Qualified indicia of ownership of the property by the QEAA is required. This means that the QEAA must either have legal title to the replacement property or some other arrangement that is acceptable to the IRS to demonstrate ownership. For example, a land sales contract (also called "contract for deed") may suffice. Under this latter arrangement, the QEAA will not have actual legal title, but will have contractual obligations. This may — depending on state or local law — avoid having to pay a double recordation-transfer tax. Otherwise, this tax must be paid when the property is first transferred to the QEAA and then again when it is transferred to the ultimate taxpayer.
3. No later than five business days after the property is transferred to the QEAA, the taxpayer and the exchange accommodation titleholder (called the QEAT) must enter into a written agreement that states that the latter is holding the property for the benefit of the taxpayer in order to facilitate an exchange under section 1031. Generally, this can be accomplished by a lease of the property from the QEAT to the taxpayer.
4. Both the taxpayer and the exchange accommodation titleholder (the QEAA) must file separate federal income tax returns, so as to advise the IRS of any income and expense incurred while the QEAT had ownership of the property.
5. No later than 45 days after the replacement property is transferred, the taxpayer must identify the relinquished property. The IRS allows the taxpayer to identify alternative and multiple properties, and if the taxpayer owns several investment properties, this provides some flexibility as to which property will be sold.
6. No later than 180 days after the replacement property is transferred to the QEAT, it must be conveyed to the taxpayer.
7. Perhaps the most important aspect of a reverse Starker is the requirement that the taxpayer have a legitimate desire to engage in a 1031 exchange. According to the IRS regulations:
At the time the qualified indicia of ownership of the property is transferred to the exchange accommodation titleholder, it is the taxpayer’s bona fide intent that the property held by the exchange accommodation titleholder represents … replacement property … in an exchange that is intended to qualify for non-recognition of gain (in whole or in part) or loss under §1031.
In other words, you cannot buy the replacement property and then — as an afterthought — decide to treat the transaction as a 1031 exchange.
The rules are extremely complex. You must seek both legal and tax accounting advice before you enter into any like-kind exchange transaction — whether forward or reverse.
Benny L. Kass is a practicing attorney in Washington, D.C., and Maryland. No legal relationship is created by this column. Questions for this column can be submitted to [email protected].
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