Buyers & Sellers, Contributor Article, Real Estate & Personal Finance

The pitfalls of property exchanges

Financial, business risks stir concerns

With the number of bargain properties now on the local real estate market, you would think both investors and owner-occupants would be racing to take advantage of attractive deals.

While many potential homeowners — especially first-time buyers attempting to beat the Nov. 30 deadline and take advantage of the $8,000 federal tax credit — have re-entered the market and have made compelling offers to purchase Puget Sound homes, investors have been reluctant to capitalize on reverse tax-free exchanges.

Nine years ago, the federal government enhanced 1031 delayed exchanges that allow taxpayers to defer the capital gains tax on an investment property if they purchase a "replacement" investment property of equal or greater value within specific time frames.

The enhancement, Internal Revenue Procedure 2000-37, permits the title to the "replacement" property to be held by an independent third party (typically a facilitator or attorney) until the "old" property sale closes. In other words, you can buy before you sell and still defer the gain.

"I think the reason why reverse exchanges have not been terribly popular of late is that investors still need the cash to buy the property," said Kelly Yates, an attorney who along with fellow attorney Dennis Helmick operate Exchange Facilitator Corp., which specializes in tax-deferred exchanges.

"Even though something might be an absolute deal and too good to be true, you need money to buy it. It’s difficult finding financing for exchange properties."

This original concept of a 1031 delayed exchange, or Starker exchange, is named after T.J. Starker, an Oregon man who made a deal with Crown Zellerbach in 1967 to exchange some of his forested property for some suitable "like kind" future property. That agreement ended up in court. Starker’s battle was the basis for congressional approval of delayed exchanges.

"What we have been seeing more since the real estate market slowed down more than 18 months ago is conventional tax-free exchanges with a longer closing date," Helmick said. "This gives the seller a longer period to execute the entire exchange."

The clock does not start ticking on a tax-free exchange until the first property closes. Then, the seller has 45 days to identify a replacement "like-kind" property of equal or greater value and 180 days to close that second leg of the exchange.

In real estate, "like kind" can apply to a variety of situations and is quite flexible. A house may be traded for an apartment building, and vacant land traded for an office building, etc. …CONTINUED