If you enjoy paying capital gain taxes when selling an investment or business property, you probably won’t want to learn how to pyramid your real estate wealth by legally avoiding taxes on profitable sales. However, if you prefer to build realty wealth without paying taxes, as millions of other investors and major corporations do, read on.
Or you might enjoy selling your rental property at a profit, perhaps an apartment or commercial building, and using those funds to acquire your ultimate dream home without paying capital gains tax. Read on.
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UNCLE SAM ENCOURAGES TAX-DEFERRED EXCHANGES. Ever since 1921, Internal Revenue Code 1031 has encouraged real estate investors to trade one (or more) “like kind” investment or business property for another property (or more) of equal or greater cost and equity without paying profit tax.
Uncle Sam views a tax-deferred exchange as one continuous investment so no tax is due. However, “like kind” property means all properties in the trade must be held for investment or use in a trade or business.
“Like kind” does not mean “same kind” of property. To illustrate, you can trade your vacant land for a rental house. Or you can trade your apartment building for a shopping center, or a warehouse for an office building. However, your personal residence is not “like kind” so it is not eligible.
Over the years, IRC 1031 has evolved to make tax-deferred realty exchanges easier than ever before. After 1984, when so-called Starker exchanges became legal in IRC 1034(a)(3), direct property trades were no longer necessary.
For example, today you can sell your investment property, have the sales proceeds held by a qualified third-party intermediary beyond your “constructive receipt,” and then use that money to acquire another qualifying replacement property of equal or greater cost and equity without paying any tax.
Even major corporations use Starker exchanges. To illustrate, a few years ago a major oil company avoided capital gains tax by selling its valuable gas station property across from Disneyland in Anaheim, Calif., having the sales proceeds held by a qualified third-party accommodator, and then using those funds to acquire several other qualifying properties.
THE EASY STARKER-EXCHANGE RULES. Starker exchanges have replaced direct property exchanges of one investment property for another. Although direct realty exchanges are still available, Starker exchanges are much easier.
In a Starker exchange, the first qualifying property is sold to a buyer whose cash payment is held by a qualified third-party “accommodator” such as a bank trust department, title company exchange affiliate, or independent exchange firm. The funds must be held beyond the “constructive receipt” of the up-trader.
After the sale of the first property closes, the seller-trader has 45 days to designate to the accommodator up to three suitable properties for acquisition. During the 45 days, those property designations can be changed. But the Starker exchange acquisition(s) must be completed within 180 days after the sale of the old property.
More than one property can be traded on either side of the exchange. To illustrate, I can trade three rental houses for one warehouse. Or I could trade one office building for two rental houses.
However, if the up-trader receives any cash or net mortgage relief out of the trade, that is called taxable “boot” because it is “unlike kind” personal property.
ADVANTAGES OF TAX-DEFERRED EXCHANGES. Whether a direct or a Starker delayed exchange is made, the prime advantage is avoidance of capital gains tax. But there are at least 10 additional advantages, including:
(1) Avoid tax erosion of investment property equity by paying taxes; (2) eliminate or minimize the need for new mortgage financing on the acquired property; (3) replace an undesirable property with a more desirable one; (4) increase depreciable basis for greater depreciation tax deductions; (5) acquire a business or investment property with improved profit potential; (6) make a partially tax-deferred exchange by trading down to a smaller property which is easier to manage; (7) avoid the special 25 percent federal depreciation recapture tax; (8) refinance either property before or after the trade (but not as a direct part of the exchange) to take out tax-free cash; (9) take advantage of an unexpected desirable purchase offer to sell a currently owned property and avoid tax on its sale; and (10) completely avoid any capital gains or depreciation recapture tax by still owning the final property in your pyramid chain of tax-deferred exchanges when you die.
HOW TO TRADE INVESTMENT PROPERTY FOR YOUR DREAM HOME. Although personal residences do not qualify for a tax-deferred exchange, because they are not “like kind” held for investment or use in a trade or business, smart investors and their tax advisers have figured out how to make such a trade.
The simple solution is to trade your investment or business “like kind” property for a “like kind” rental home, which will eventually become your personal residence.
Because all properties in an IRC 1031 “like kind” tax-deferred exchange must be held for investment or business use, that usually means the acquired property must be a rental at the time of its acquisition. Most tax advisers suggest renting it to tenants for at least 12 months after purchase, thus showing rental intent at the time of the trade.
But in 2004 Congress partially plugged this tax-bonanza loophole.
After Oct. 22, 2004, it is no longer possible to quickly combine an IRC 1031 exchange with an Internal Revenue Code 121 principal-residence-sale $250,000 tax exemption (up to $500,000 for a qualified married couple filing a joint tax return) after the owner lives in the acquired property for 24 of the last 60 months before its sale.
Now the acquired property should be rented for at least 12 months before the owner converts it into a personal residence and makes it a principal residence for the required 24 out of last 60 months before selling.
However, the big change was a principal residence acquired in an IRC 1031 trade must now be owned at least 60 months before it can qualify for the IRC 121 tax exemption.
HOW TO AVOID TAX WHEN THE INVESTOR DIES. As mentioned earlier, if you own your investment and/or personal residence at the time of your death, any deferred capital gains and 25 percent depreciation recapture taxes that would be owed if you sold before dying are completely forgiven by Uncle Sam.
For deaths in 2006 and 2007, the net assets in your estate up to $2 million will also be exempt from federal estate tax. In addition, assets left to a surviving spouse, regardless of amount, are fully exempt from federal estate taxes.
Another benefit for your heirs is the inherited assets, whether real or personal property, receive a new “stepped-up basis” to market value on the date of your death. This stepped-up basis is a major advantage when your heirs decide to sell the inherited property. For full details, please consult your tax adviser.
Next week: Tax savings from your home business.
(For more information on Bob Bruss publications, visit his
Real Estate Center).