Understanding Tax-deferred exchanges

By Les Matheney

Les Matheney Real Estate Investments
Citrus Heights, CA
bnecouch@juno.com

Tax-deferred exchanges have been a part of our tax laws since 1921, when Congress passed the law to allow for a "free flow of commerce". The intent of the law was to allow investors and business owners the choice to dispose of and acquire other property in the course of their affairs without paying a portion of their gain as taxes.

These basic guidelines have not changed; however, a tax-deferred exchange is no simple transaction. They can be among the most complex and complicated real estate transactions ever undertaken. Several pitfalls exist which can make them a legal and tax nightmare for those who do not understand the intricacies of such transactions. However, when an exchange is properly structured and executed, it can be a great advantage for property owners. Let's look at some of the basics of tax-deferred exchanges and identify some of the problem areas to avoid.

WHAT QUALIFIES?

Under I.R.C. Section 1031, that part of the code defining tax-deferred exchanges, the property received must be "like kind" to the property given and must be exchanged one for the other. With regards to real estate, "like kind" means property held for business or investment. You can exchange business property for investment property and vice versa.

A primary residence does not qualify for exchanges, but, with the new tax laws governing gain, there's almost no possible tax consequences for selling your home. Real estate developers and builders are classified as dealers and their property as inventory. Dealer property does not qualify for either tax-deferred exchanges nor installment sales.

Unlike property in an exchange is called "Boot". "Boot" usually is cash, trust deeds, stocks, bonds and personal property. One other form of "Boot" that is less obvious is called "Net Debt Relief". "Net Debt Relief" occurs when the total debt on the property transferred is greater than the total debt on the property received. A rule of thumb for a tax-deferred exchange;The new property must be of equal or greater value with equal or greater debt and you receive no unlike property, "Boot".

"Boot" in an exchange creates a taxable event. The taxes will be on the "Boot" or the Gain, whichever is the lesser of the two. That means an owner with a large gain and a small "boot" will have a partial tax-deferred exchange The results are still a tax savings. The code also allows for installment sale treatment of trust deeds carried back in the exchange.

TAX CONSEQUENCES

There are ways to structure an exchange to minimize the tax consequences to both parties. All exchanges have two parties. Three or more parties result in a series of transactions, which include an exchange and a sale, or two exchanges and a sale, or just exchanges. A typical exchange has a buyer, a seller and an exchangor.

There are penalties imposed on exchanges. Owners making an exchange must take their adjusted cost basis with them to the new property. An owner can increase the basis in the new property by taking on more debt on the new property; adding cash to the exchange and expenses incurred in the transaction. Commissions must be capitalized. Owners can reallocate land and improvements on the new property for depreciation purposes. This can be advantageous to an owner exchanging land for an apartment complex. Another penalty to be aware of applies to an owner with a property worth less than the cost. The IRS will not allow a deduction for a loss. An owner with a loss must sell the property, not exchange it, in order to deduct the loss.

Owners exchanging improved property for unimproved property can have tax consequences if they have taken accelerated depreciation. If they have, they must exchange for a property which qualifies for accelerated depreciation. If they do not, they are subject to the recapture provision on the excess depreciation. Straight line depreciation property can be exchanged for land with no recapture.

CHANGES IN THE LAW

While the original law governing tax-deferred exchanges has changed little, many modifications have been made through judicial decisions. The first such decision was in 1929, when the IRS argued there was a gain on an exchange of a commercial property in Pasadena, CA, and a ranch in the Hanford CA area. In 1921 the two properties were exchanged unencumbered of debt. There was no "boot", and each party paid his own expenses and brokerage. Therefore, there should have been no taxes. However, since the two parties had set prices on the properties (both at the same price), the IRS sought to prove that taxes were in fact due, since there was a gain on the Pasadena property. Although the IRS failed to win this case, it still affects today's market and those seeking to exchange property should be aware of the risk if they include a sales price in the final contract. Always remember that the inclusion of a sales price is not necessary in an exchange. Since that 1929 decision, the law has continued to be shaped by judicial actions. A noteworthy case involves the Aldersons, who had a contract and escrow to sell 31 acres in Buena Park, CA When they found out the tax consequences, they changed their minds and wanted an exchange. They found 131 acres in the Salinas, CA area as a replacement property and their buyer, a big corporation, agreed to buy the farm and exchange it for the 31 acres. The escrow instructions were modified from a sale to an exchange . The IRS challenged the Aldersons and it went to court. The court held that a taxpayer could change a sale to an exchange anytime before the close of escrow . This is important to keep in mind should you decide to make an exchange out of a pending sale.

Other important court decisions involved delayed exchanges - most notably Starker I and II. As a result of these important cases, owners retain a Qualified Intermediary to transfer their property and hold the proceeds until a suitable replacement is found. Owners are given 45 days to identify a new property from the time the old property is transferred. This creates some real problems for many owners. Most do not realize how difficult it is to find a replacement property which meets their criteria . If a replacement property is not found within the allotted time, the transaction is taxed as a sale . The closing of escrow on the replacement property must be within six months of close or prior to taxpayer filing the next tax return. That requires planning your date to file your tax returns so you have enough time to close escrow. It may require asking for an automatic filing deferment in April.

CONCLUSION

A tax deferred exchange may be exactly what you need to accomplish your real estate investment or business goals. Be aware of the complexities of such a transaction. Seek out knowledgeable experts to answer your questions and sit down with them to determine if deferring the gain is in your best interest. It always is. Keep your money, you will spend it more wisely than our government.