by J. Robert Taylor, J.D.
Avoiding paying taxes is legal, if you follow the IRS Code. When it comes to real property, doing a 1031 tax-deferred exchange has become a standard tool in the real estate investor's toolbox.
Longterm creation of wealth in real estate can be done without ever paying any capital-gains taxes through utilizing tax-deferred exchange techniques. This section of the code applies to all types of property, including land, homes, apartments, commercial property and even leasehold property.
Investors are generally motivated to exchange for at least one of four reasons. First, they want to change their investment from one type of property to another type, i.e., sell land and exchange it for income-producing property or sell a property in Tahoe and trade into one in Hawaii. Second, they may want to sell a property where there is very little or no loan and trade for a much more expensive property with more leverage so that over time there will be greater appreciation. Third, they may wish to diversify the type of real estate they own, i.e., instead of just rental houses they may want to trade some of their real estate portfolio into office buildings. Fourth, since a married couple can now exclude $10,860,000 from estate taxes, holding on to depreciated real estate until the first spouse dies allows the estate to sell the property using the stepped-up basis you get on death, thus avoiding all capital-gains taxes.
What if I don't exchange?
All of these goals could be fulfilled by just selling the investment property and then taking the proceeds after tax and buying the new investment. Unfortunately, this method may cost you approximately 40 percent in capital-gains taxes on your net gain in the property.
Gain generally equals the selling price minus your original purchase price minus whatever depreciation you have deducted. There may also be additional taxes due on any depreciation you have taken on the property.
One upside is that the new property you purchase will have a new tax basis for depreciation purposes. When you exchange, the old basis is carried over to the new property and thus you will be getting fewer tax benefits from depreciation. However, the benefit of paying no capital-gains tax usually outweighs any benefits that may be obtained by depreciation.
Follow the rules or pay the taxes
1. Both the property you sell and the property you acquire must be held for investment. Personal residences or vacation homes do not qualify for tax-deferred exchanges. You can exchange multiple properties for just one property or vise versa.
2. You must identify your intention to do an exchange when listing the property and on all contract documents.
3. You must perform the exchange simultaneously, meaning sell and buy in the same transaction on the same day OR do a delayed (sometimes referred to as "Starker") exchange.
4. If you elect to do a delayed exchange you must identify the property you will be acquiring within 45 days after the close of escrow of the property you are selling. You can identify up to three properties (more can be identified under special circumstances) and close on all, some or just one of the three you identify. You must close escrow within 180 days after the close of escrow of the property you are selling. Funds from the property you are selling must be held by an intermediary, not the title company, your broker or your attorney. You will pay the intermediary a fee for doing this, which is based on the size and complexity of your transaction.
5. In order to be fully tax deferred you must purchase a property(s) of equal or higher value and you must receive no cash or mortgage relief in the exchange transaction. If you do receive cash or mortgage relief out of the transaction then that portion will be taxable.
6. While you may do a direct exchange with another person, i.e., you buy my condo in Palo Alto and I will buy your apartment building in Redwood City, most exchanges involve three parties: exchanger who wants to exchange, the buyer who purchases the exchanger's property and the seller of the property that is the target of the exchanger. The buyer of the property to be exchanged and the seller of the target property just have to cooperate with the paperwork for the exchanger and are at no legal or tax risk in the transaction.
Timing is everything
Most 1031 exchanges today are done by using the delayed exchange rules, since closing escrows on two or more properties simultaneously can be difficult to arrange. However, the law only gives you 45 days from the sale of your property to identify the property(s) you are going to exchange into, and time goes quickly.
I always encourage clients who need to do an exchange to structure the sale of their property to give them the maximum flexibility so that they can identify the property they want to purchase prior to the close of escrow. That way, if there is some delay, there will be time to recover. If you miss the deadlines, your exchange will be disqualified, and you will owe the tax.
Sometimes clients are reluctant to sell their property because they don't know what to invest in. One solution is to find and purchase the investment property you want before you sell. It is still possible to do a 1031 exchange in that case by doing a "reverse exchange." In other words you acquire the property you want to buy through the intermediary prior to selling your property.
Once your property sells then you do an exchange with the property you have acquired through the intermediary. To do this you have to have the money to purchase the property before you sell the property you own. This is rarely done, but for certain wealthy or resourceful individuals it is possible.
In the Bay Area many homeowners face a large capital-gains tax when they sell their home. One choice is to retain your home as an investment property and rent it out. In the future you can use your property to exchange in other investment property(s) should you choose to do so. This leaves all the money you would have paid in taxes investing in Bay Area real estate. If you can afford to do this, it is a great way to build your estate.
Do I need expert help?
Yes, in most cases you will need a broker who has had considerable experience in navigating the exchange process. I would also encourage most clients to consult with a knowledgeable real estate attorney if there are any questions or concerns. It is also a good idea to consult with an accountant or financial adviser. However, many accountants and financial advisers do not understand real estate exchanges so be prepared to ask lots of questions and make sure the answers deal directly with the tax advantages and disadvantages of doing a tax-deferred exchange.