Benny L. Kass - Exchange technique allows real estate investors to put off the tax bill Exchange technique allows real estate investors to put off the tax bill By Benny L. Kass Friday, February 11, 2011; 1:09 PM Q: I bought my house many years ago for $50,000. When my family grew, we bought a larger house where we still live. For years now, we have rented out the original house, which is now worth more than $800,000. We are retired and want to sell that investment property. Our tax adviser has indicated that even with the improvements we made, we may have to pay upward of $200,000 in capital gains tax. Apparently, there is a depreciation recapture tax as well as state and federal capital gains tax involved. Obviously, we don't want to pay that much money. A: You may be a candidate for a like-kind exchange, which is authorized by Section 1031 of the Federal Income Tax Code. That section reads: "No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade of business or for investment." In simple English, you have the right to exchange investment (rental) property, but not your principal residence. How does this work? The rules are somewhat complex and very rigid. But first, you have to make a major decision: Do you want another rental property and to remain a landlord, or do you want to "bite the bullet" and sell the property, paying the tax but walking away with perhaps $500,000 or $600,000 in your pocket? Only you can make that decision. If you want to move forward with the exchange, here's how it works: Your present rental property is known as the "relinquished property," and the new one that you buy (technically you will exchange it) is called the "replacement property." It is important to use those terms in any legal documents that you enter into. The Internal Revenue Service wants to be absolutely sure that your intent was to exchange and not merely sell and buy. Although the statute refers to "like-kind," this includes any kind of real property as long as it is used for investment. For example, you can exchange your single-family rental house for a condominium, a shopping center, a commercial office building or even raw land. The most practical way to start the process is to list your relinquished property with a real estate broker (or try to sell it yourself). When you find a buyer, your real estate contract must reflect that this transaction is part of a 1031 exchange, and that as long as there will be no additional cost or time delay, your buyer will cooperate with you. You must select an independent third party to be a "qualified intermediary" (or QI) for the exchange. That person can be an attorney, as long as he or she has not represented you within a two-year period before the transaction takes place. At the settlement on the relinquished property, all of the net sales proceeds must be held in escrow by the QI. You can, of course, pay closing costs, pay off any existing mortgages on the property, or pay any real estate commission, but you cannot have any access to sales proceeds, even for one minute. Once settlement takes place, you have 45 days in which to identify the replacement property. Identification of the replacement property is not always easy. Accordingly, it is wise to start looking for the new property when you put your relinquished property on the market. You can identify up to three properties of any value, even though you may only buy one of them. However, if you identify more than three properties, the total fair market value of those properties cannot exceed 200 percent of the fair market value of the relinquished property. My experience with clients dealing with a single-family house or a condominium is that they generally will identify only three properties. Incidentally, if you own an investment cooperative, that is considered "real property" and can also be exchanged. You must buy and take title to the replacement property within the earlier of 180 days from the date you sold the relinquished property or the date your next income tax return is due. Since this may shorten the period of time in which you have to buy the new property, most exchangers solve this problem by filing for the automatic extension of their tax return. All of the sales proceeds from the relinquished property must be used to purchase the replacement property. Keep in mind that the new property must be equal to or greater in value than the relinquished property. If it is not, you will have to pay some capital gains tax, called "boot." Now, let's assume there is not enough money in escrow to buy the new property. You can use your own cash, if you have it (and want to use it). Alternatively, you can obtain a mortgage for the difference. Here, too, there is a strict rule, however: That financing must be equal to or greater than the mortgage that was paid off on the relinquished property. These rules are carved in stone and cannot - and will not - be waived by the IRS. A like-kind exchange does not mean you avoid capital gains tax; it only defers your gain until you sell the relinquished property, assuming that you do not do yet another exchange of that property. It is important to understand that the tax basis (your original investment) of the relinquished property becomes the basis of the replacement property. So even if you paid $1 million for that new property, its basis will be your old one. The IRS and the tax code will get you somehow, some day. You can also do a reverse exchange, in which you take title to the replacement property first and then sell your present investment. Those rules are more complicated, and you will need the advice and assistance of your legal and financial advisers. Having read all of this, I suspect you will say, "That doesn't put any money in my pocket, since it all goes into the new property." That's correct, but there is a loophole. Once you own the replacement property, you have the right to pull out some of your equity by getting a new mortgage on the property. Obviously, your lender will want to make sure that you have sufficient assets (or rent) to cover that loan, but this is an option available to you. Check with your lender before you enter into a 1031 exchange to make sure that you will be able to refinance the replacement property. Why is this often called a "Starker" exchange? A Mr. Starker tried to do an exchange whereby the sales proceeds on his investment property were escrowed for a long period of time before it was used to obtain the replacement property. The IRS challenged this. Mr. Starker beat the IRS, although he had to go to court. As a result of that lawsuit, Congress imposed the 45- and 180-day limitations described above but accepted the fact that a 1031 exchange can be deferred. A 1031 exchange is not for everyone. If your capital gains tax is relatively minimal, perhaps its best just to pay the tax and keep the balance of your sales proceeds. Talk with your accountant first to make sure exactly what your tax exposure will be before you sign any legal documents. But if you want to keep all of your money working instead of being siphoned off to pay a large capital gains tax, then give serious consideration to this exchange opportunity.