The Real Estate Exchange
Under Section 1031 of the Internal
Revenue Code
Facilitated by an Exchange
Intermediary
By Richard M. Heller, Esquire,
CCIM, CEC
President, R.E.I. Consultants,
Ltd
"Like-kind" compares the type of
property and is very specific for the most part -- except for real estate.
All real estate, no matter what the use, is treated as like-kind.
Investment property does not include
items held for resale, stock, bonds, notes, other securities or evidence
of indebtedness or interest, partnership interest, certificates of trust
or beneficiary interest and chooses in action. A dealer under the definition
provided by the Internal Revenue Service would not qualify for exchange
treatment.
The exchanger must identify replacement
property within 45 days of transfer of the relinquished property and within
the earlier of 180 days after the transfer of the relinquished property
or the due date (including extensions) of the exchanger's tax return for
the year in which the relinquished property is transferred away (the replacement).
Up to three alternative properties
may be identified as potential replacement property. As an alternative,
any number of properties may be identified during the identification period,
as long as the total value of the properties does not exceed 200% of the
value of the relinquished property. Deferred taxes means just that -- the
amount due is postponed until some future date, similar to the exchange
of a principal residence. The gain reduces the basis of the new property,
which will be recognized when the new property is ultimately sold, or depreciated.
The actual savings are not the taxes, but the time value of money -- the
ability to use the funds today, and pay the taxes at a later date. The
use of the money today affords the exchanger a number of financially beneficial
options including, but not limited to, reducing the mortgage on the replacement
property, increasing a leveraged position with an additional down payment,
reducing the selling price on the relinquished property, or increasing
an offer on the replacement property.
Federal taxes may altogether be
avoided if the taxpayer should die with the heirs inheriting the property
at a stepped-up basis.
Assuming a tax rate of 30%, a 12%
mortgage rate, (which, after taxes would yield a cost of money rate about
8%) or an after tax yield of 8% on investments, and a $100,000.00 gain
on the relinquished property, we can assess the savings of the following
example. If an exchange is successfully completed, $30,000.00 of tax ($100,000.00
@ the 30% rate) that normally would be paid to the taxing authorities,
can be used to reduce the mortgage on the replacement property or can be
invested in some other way. Earning the after tax rate of 8% would, in
the form of savings, double the $30,000.00 in just nine years. An additional
nine year deferral would effectively double the $60,000.00 and so on.
If the property received is depreciable,
the exchanger loses the depreciation on the deferred gain (the gain reduces
the basis of the property) spread over 30 years. Assuming the same $100,000.00
gain, $3,333.00 of depreciation would be lost each year, increasing annual
taxes by $1,000.00. Comparing the present value of $1,000.00 per year additional
cost for 30 years equaling $11,250.00, to the initial tax savings of $30,000.00,
still provides a net benefit of $18,750.00.
It, therefore, makes a great deal
of sense to use this tried and true method of deferring taxes on the gain
acquired on the sale of investment property or that used in a trade or
business thereby allowing you to accumulate wealth.
