Anyone who has owned a business or investment property over the booming real estate market of the past several years has likely enjoyed appreciation of at least ten percent per year. This is good news to be sure. There is more good news for those who need to or want to sell the property now and are concerned about paying significant taxes on the gains. With some good advance planning, a business or investment property can be transferred tax free – using a lesser-known regulation of the federal tax code that is gaining in popularity as more investors learn about it.
Like-kind exchanges – also known as 1031 exchanges – which can be used when a seller replaces one property with another, are becoming a hot new real estate trend. Businesses needing to relocate and investors seeking to optimize their portfolios are using like-kind exchanges to, in many cases, completely defer the taxes on these transactions.
Although the code has been on the books for a number of years, use of like-kind exchanges has greatly increased recently. This is not only because of the growing number of people holding real estate leveraged by rapid appreciation, but also because the IRS simplified the rules governing like-kind exchanges when it ruled on what is known as the Starker case. Here are some points to consider in determining whether a tax-deferred exchange is the right option.
There are three key components of like-kind exchanges:
The exchange must be of properties that are of ‘like-kind’. By like-kind, the IRS means real property that is held for business or commercial use. A commercial leasehold qualifies for exchange with a business property held in fee simple title, or a manufacturing facility for a residential apartment complex. But, personal property, stocks and bonds, and partnership interests do not qualify and cannot be exchanged with real estate.
The property must be exchanged, not sold; and the parties must have the prior intention to exchange, which is one reason why planning is critical.
This does not require finding a person with an appropriate property, who happens to want to exchange for the specific property being transferred. A seller can find any buyer he or she wants for a property and select any property he or she would like to own. What makes the transaction an exchange is what happens to the proceeds and in some cases, to the title to the new property, in the interim period between sale and purchase. In a like-kind exchange, the proceeds of the property being relinquished are held by a qualified intermediary until closing on the replacement property. There are intermediaries who specialize in assuming this role in exchanges. Tax or legal professionals can help identify these resources.
The relinquished and replacement properties must be held for business or investment purposes. An exchange cannot be used when selling and buying a personal residence, although there are ways exchanges can come into play if a rental was first used as a residence. An owner may use an exchange to sell residential as well as commercial investment property, or the property where his or her business is located. Long-term leased business properties also qualify, among other types of business properties, including land that could be improved for a business purpose.
It is impossible to stress enough the need for planning when using like-kind exchanges. Certain elements of timing are built into the IRS safe harbor, which, if ignored, can disqualify a transaction. Within 45 days of closing on the relinquished property, the new/replacement property that will be “exchanged” for the sold property must be identified. It is possible to do what is called a reverse exchange, wherein the new or replacement property is identified and purchased first and the title put into escrow with the qualified intermediary, followed by the sale of the relinquished property. Closing on the replacement property must take place in no more than 180 days of the closing date of the relinquished property.
If the replacement property is unimproved commercial land, planning is additionally critical. To meet the 180-day rule in a construction situation, it is required to spend an amount equal to the value of the relinquished property on land and construction within that timeframe. It is that construction be fully completed within 180 days.
In addition to being aware of the rules regarding Like-Kind Exchanges, in using them there are a few caveats:
The basis in the new property carries over from the relinquished property, so in reality, the tax is being deferred, not permanently eliminated.
In the case of properties where the value and equity of the relinquished property is greater than that of the replacement property, the difference is known as ‘boot’ and is taxable. The balance of the gain may still be deferred.
There are fees involved in using qualified intermediaries to hold interim title or proceeds.
In the category of benefits, there is no limit to how many exchanges an owner can do. In addition, there are ways to accomplish personal goals by factoring in exchanges of business properties. For example, a couple nearing retirement may live in Connecticut and own a rental property on the Cape. They could exchange the Cape property for a rental property in Florida, deferring the gain on the Cape property. Assume the couples circumstances change after renting out the Florida property for a year or two and they decide to permanently reside in the Florida house. They could move into the house without voiding the tax benefits of the exchange and then sell the Connecticut house, using the one-time $500,000 exclusion for a couple to minimize taxes on the personal residence.
While they have been simplified, like-kind exchanges are still complex transactions that are best accomplished with the help of professional legal and accounting assistance. They represent an excellent way to keep commercial real estate investments fluid while moving current tax liabilities into a future timeframe.
