Now that we understand why tax-deferred exchanges are so advantageous and the motivations for using them, let’s discuss the simple tax-deferred-exchange concept. An important detail to know is that a tax-deferred exchange is viewed as one continuous real estate investment, rather than a taxable sale followed by a reinvestment.
To qualify for a tax-deferred “like kind” exchange of your investment or business real property, you must trade equal or up in both price and equity for another “like kind” property. If you take anything out of the trade, called “boot,” it is taxable because it is “unlike kind” personal property, such as cash or net mortgage relief.
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But there is no limit to the number of investment or business properties you can trade or acquire in a tax-deferred exchange. Also, there is no minimum holding time or frequency rule. Theoretically, you could hold your investment or business property just one day, then trade up, and then trade again the next day, all completely tax-deferred.
EXAMPLE: A few weeks ago, I had lunch with my high school pal, David Woodhead. We go back a long way, first working together one summer at the municipal swimming pool. At lunch, David mentioned he and his charming wife, DeDe, are thinking of trading their two rental houses for one large rental house located in a better area. That’s a perfect tax-deferred exchange of a “like kind” trade up of two properties for one large property. Or, they could trade for a warehouse or office building. All that matters is each “like kind” property involved in the tax-deferred exchange must be held for investment or business use. In other words, “like kind” does not mean “same kind” of property. They need not trade for another rental house. Of course, if they trade down to a property worth less than the total value of the two rental houses, then they will be receiving some taxable “boot,” such as cash or net mortgage relief.
For instance, suppose you own a rental house worth $250,000, subject to a $50,000 mortgage. You want to use your $200,000 equity to trade up to a $600,000 commercial building with a $450,000 mortgage. This is an example of a partially taxable trade up. Although you are trading up in price from $250,000 to $600,000, you are trading down from $200,000 to $150,000 equity in the acquired property. That means you will be receiving $50,000 taxable cash “boot” in the form of net mortgage relief.
Alternatively, suppose you make the same trade from a $250,000 rental house up to a $600,000 commercial building, but you get a new $400,000 mortgage so you will have $200,000 equity in the acquired property. Now you have a fully tax-deferred exchange because you traded equal or up in both price and equity. However, if you need cash, either before or after the exchange you can refinance the mortgage to take out tax-free cash. Just be sure the refinance is not part of the exchange because then the cash you receive becomes taxable boot.
How to calculate your tax-deferred capital gain and basis for the property acquired in the exchange. Presuming a tax-deferred exchange capital gain is attained, the next question usually is, “How much is my tax-deferred capital gain?” The answer: it is the difference between your old property’s net price (called “adjusted sales price” in tax talk) minus your old property’s “adjusted cost basis.”
Net price, or adjusted sales price, is usually the gross sales price minus selling expenses, such as the real estate sales commission, transfer tax and other closing costs you pay.
Adjusted cost basis is usually the old property’s original net purchase price, plus closing costs, which were not tax deductible at that time, minus depreciation deducted during ownership, plus capital improvements added during ownership, minus any casualty loss deductions taken during ownership.
EXAMPLE: To keep our example simple, suppose the buyer of our $250,000 rental house paid all the sales expenses so $250,000 is the net or adjusted sales price. Let’s suppose we paid $150,000 for this rental house, added $10,000 of capital improvements, deducted $50,000 of depreciation during ownership, and there were no casualty loss deductions. Therefore, our deferred capital gain is $250,000, minus the $110,000 ($150,000 + $10,000 – $50,000) adjusted cost basis, or $140,000 capital gain on which we defer tax by exchanging. To determine the new adjusted cost basis of the $600,000 building acquired in the tax-deferred exchange, a simple method is to subtract the deferred capital gain of $140,000 from the $600,000 purchase price for the acquired property, resulting in a $460,000 adjusted cost basis for the $600,000 building. This is a quick way to estimate your new adjusted cost basis for the acquired property.
In the above series of examples, there was a $140,000 tax-deferred capital gain on the sale of the rental house. The tax-deferred exchange tax savings were over $21,000, resulting in being able to use that $21,000 to acquire a larger replacement property rather than paying the $21,000 to Uncle Sam (plus any state tax).
Which property is NOT eligible for a tax-deferred exchange? Before proceeding, it is important to emphasize that virtually any real estate held for investment or use in a trade or business is eligible for a tax-deferred exchange. This is called “like kind” real estate.
Property that is not eligible for a tax-deferred exchange includes:
1. Your principal residence (which is eligible for the far better Internal Revenue Code 121 $250,000 and $500,000 tax exemption if you owned and occupied it at least 24 of the 60 months before its sale);
2. Your vacation or second home (but you can convert it into a rental property, thereby making it eligible for a tax-deferred exchange);
3. Dealer property (such as a home builder’s inventory), and
4. Partnership interests (unless recorded title is held individually in the names of tenant-in-common co-owners).
Report your tax-deferred exchange on IRS Form 8824. Even if no tax is due on your tax-deferred exchange, it must be reported with your personal income-tax returns. This form is not easy to understand so you might want to hire an experienced tax adviser.
If an exchange property is acquired from a related party in an exchange, it must be held at least 24 months; otherwise, the resale profit is taxed back to the original owner of the property. In a related-party tax-deferred exchange, the IRS requires filing Form 8824 in the tax year of the exchange and for two years after that.
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