TAX DEFERRED EXCHANGES
by Craig E. Buck and Teri Anderson Buck, Attorneys at Law
Copyright (c)2011, Craig E. Buck and Teri Anderson Buck All Rights Reserved. No part of this material may be reproduced, transmitted or stored in any manner, in any form or by any means without the express written permission of the author. Permission is granted to reproduce and distribute this text in its entirety and, if electronically, only if you include a link to our homepage at www.VirginiaClosings.com
ABOUT THE AUTHORS: Craig E. Buck and Teri L. Anderson are partners in The Buck Law Firm, P.C., specializing in real estate, and real estate closings with offices at:
6800 Backlick Rd. Suite 205 Springfield, Va. 22150 (703) 451-5203
1109 Heatherstone Dr. Fredericksburg, Va. 22407 (540) 785-6575
Craig E. Buck was Chairman of the Northern Virginia Association of REALTORS Standard Forms Committee and is author of The Real Estate Contracts Handbook. Click here to order the Contracts Handbook.
HOW TO AVOID TAX ON THE SALE OF INVESTMENT PROPERTY
You must pay tax when you sell property for a profit. There is a real advantage if you can pay the tax years in the future. Liberal rules allow a rollover or exclusion of gain when you sell a personal residence. Different, more restrictive, rules apply to investment property.
WHY DEFERRAL IS IMPORTANT
There is an obvious advantage to postponing payment of taxes. The time value of money and inflation means a bill paid in the future does not cost as much as a bill paid today. If you retire and sell the property, you will be in a lower tax bracket. If you die, the property passes to your heirs at the market value at the time of your death. An entire lifetime of gain goes untaxed (but, watch out for the Federal Death Tax).
A less obvious, but equally compelling, advantage is the effect of leverage. Consider the sale of a property having a taxable profit of $100,000. Combined state and federal taxes of 38% would leave only $62,000 available to re-invest. If that $62,000 were a 20% down payment, you could purchase new property worth $340,000. If you had the entire $100,000 to put down, you could buy $500,000 of new property. If the property appreciates 5% a year, you earn $17,000 per year on one bought after paying taxes and $25,000 on the other.
An investor may want to defer tax because he will not realize sufficient cash from the sale transaction. The investor may have refinanced and not have enough equity to pay the tax owed.
In addition, investors take tax write-offs in the form of depreciation. Depreciation saves money on today's taxes but reduces the owner's basis in the property. Basis is the term used to describe where you start to calculate taxable profit. The seller owes tax on the difference between the reduced basis and the sale price. Using a tax deferred exchange allows the investor to postpone paying.
With an exchange, tax is not forgiven, only deferred. The basis in property sold transfers to the new property. If you buy a property for $100,000 and sell it for $150,000, replacing it with one costing $150,000, the new property has a $100,000 basis. When you sell it later for $250,000, the taxable profit is $150,000.
If you buy a new property adding money, those additional funds add to the basis. So, if you sold for $150,000 and bought a new property for $170,000, the additional $20,000 would raise your basis to $120,000. When you sell later for $250,000, the taxable profit is $130,000. If you had depreciated the old property $10,000, your basis in the old property would be $90,000. Your gain on the first sale would be $60,000.
If exchanged, there would be no tax owed on this profit but the basis in the second property would be $90,000. Following the example a step further, the final sale at $250,000 would generate a $160,000 taxable profit.
SALE OF INVESTMENT PROPERTY
To defer gain on the sale of investment property, there must be an exchange, swapping one property for another.
Section 1031 of the Internal Revenue Code provides, in part, "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 a like-kind which is to be held either for productive use in a trade or business or for investment." If anything of value, other than like-kind property, is thrown in "to boot" you pay tax on the amount of the "boot."
Originally, the exchange requirement meant you had to find an investor who owned a property you wanted or who would buy one you wanted and swap with him in a simultaneous exchange. Mr. Starker stretched this rule by selling his property and putting the funds in escrow. He bought new property with the escrowed funds, in a delayed rather than direct and simultaneous exchange. The IRS objected but the Courts held for Mr. Starker giving rise to the so-called Starker or delayed exchange. After years of fighting the issue, the IRS has issued regulations for a delayed exchange.
With a delayed exchange, the investor may close on the sale of his property before he has settled on, or even identified the target or replacement property. Reverse exchanges, buying before the sale, are not recognized by the IRS. It is possible to accomplish a reverse exchange by "parking" the property - that is selling it to third party and renting it back until a buyer is found. Reverse exchanges are complicated and require special attention beyond the scope of this article.
The investor must identify the new replacement property, in writing, within 45 days of the first closing. Our firm will supply the designation letter as part of our document package.
The investor may designate up to three potential replacement properties. He can even designate more than three but the total value may not exceed 200% of the sale price of the old property. If he exceeds both the three-property and the 200% rules, the exchange is valid only if he acquires property that is at least 95% of the fair market value of all the property identified. If the investor violates these rules, the IRS will treat the transaction as if no property was identified and disallow the exchange entirely.
If the investor designates a property and changes his mind, he can revoke the designation and select other property if he is still within the 45 days. Slip up and miss the date, or designate too much property and he loses the tax deferred exchange.
The investor must consummate the exchange by closing on the new property no later than 180 days after the first closing or before his tax return for the year is filed. The investor cannot have access to the money during the 45/180 day time frame. An independent escrow agent, known as a qualified intermediary, holds the funds and uses them to buy the replacement property for him. Our intermediary firm will place the funds in a separate escrow account identified for the transaction. The account is separately insured by the FDIC and funds are not co-mingled with other escrow funds.
Both investment and personal residence property will pass to your heirs at the market value at the time of your death. Thus an entire lifetime of gain goes untaxed (except for estate taxes).
Exchanged property must be like-kind. Fortunately, regulations define the term liberally. Any real estate, whether or not it is improved, qualifies as like-kind. You can exchange a house in Florida for a farm in Virginia or a condominium in Hawaii.
You can sell one property and buy two or more.
You can sell two properties and buy one. However, you must be careful. If you need the money from both sales to fund the purchase and one of the sales falls through, you won't be able to complete the exchange.
You cannot sell a business and buy real estate, unless you price the real estate and business separately. Any property that is not like-kind is treated as boot and you must pay tax on the boot. The most common form of boot is cash. If you swap property and end up with cash left over, you have received boot and pay tax on the cash. If you receive property with a loan lower than the loan you gave up, you have received boot in the form of mortgage relief - but you can add cash from outside the transaction to offset the mortgage relief and negate boot. The replacement property should have mortgage debt or new cash added, equal to or greater than the mortgage debt of the old property.
A simple rule is: buy up - get a more expensive property, borrow up - with at least as big a loan, and use up - use all of the equity so you have no cash left over. If necessary, pay down the loan on the new property.
THE QUALIFIED INTERMEDIARY
Delayed exchanges are much more common than simultaneous. After the first sale closes, a qualified intermediary holds the sale proceeds in escrow. The intermediary is sometimes called an accommodator or facilitator and must be independent of the parties. (Don't use your brother - in - law).
Our firm can supply you with the qualified intermediary. The intermediary establishes the escrow account and acts for the purchaser and seller/exchanger arranging for the transfer of funds and deeding the property. Obviously you will want to check out the intermediary carefully. Are they bonded or insured? (We are) Be sure your funds are held in a separately identified trust account (ours are).
The intermediary also receives the 45 day notice designating the replacement property. The seller has no access to the funds during the 45/180 day period except to purchase the exchange property. He may direct the intermediary to use funds for the deposit, but not for improvements. If the investor expects to make improvements using the exchange funds, write them into the contract so they are the seller's obligation and raise the sales price accordingly.
OUR SERVICES AND FEES
Our law firm has acted as counsel for hundreds of tax deferred exchanges. We can prepare the necessary tax deferred exchange documents, both for closings we conduct and for closings conducted elsewhere.
Our document package is comprehensive and provides all the information needed to complete the exchange. If we are not handling the sale or purchase closing, we coordinate with the other closers to provide them a complete set of instructions. We also provide intermediary services to hold the exchange funds in a separate designated escrow account with interest accruing to the investor.
The law firm fee for preparing the exchange document package is $750. The escrow agent fee for the intermediary services is $750. An additional $100 may be charged when we are not acting as settlement agent for the sale transaction. We find it necessary to charge additional fees to compensate for additional time expended to coordinate with another settlement agent. These fees are paid during the sale transaction and there are no additional fees on the purchase transaction (except perhaps bank wire transfer charges). The quoted fees do not include our regular settlement fees should we be doing the closing also.
IRS Publication 544 "Sales and Other Dispositions of Assets" has a section covering tax deferred exchanges. Form 8824 is used to report the exchange and is included in the publication. You can obtain a copy from the IRS website at http://www.irs.ustreas.gov or call 1-800-TAX-FORM (1-800-829-3676).
You should recognize the need for a tax deferred exchange if the seller: has investment property, intends to buy new investment property and will be subject to tax liability on the sale.
The tax aspects of a deferred exchange are complicated. Speak with a tax expert. The expert can assist with issues such as adjusted basis and the appropriate price and financing for the replacement or target property.
HOW DO YOU DO IT?
CONTRACT LANGUAGE There should be language in the listing and in the sale and purchase contracts to make it obvious the investor intends to accomplish a tax deferred exchange. Here are the three suggested paragraphs to include:
TAX DEFERRED EXCHANGE LISTING
The owner intends to accomplish a tax deferred exchange. Any contract should provide for Purchaser cooperation. Contact lister for details.
TAX DEFERRED EXCHANGE SALES CONTRACT
This transaction will be a Section 1031 Tax Deferred Exchange at no additional expense or liability to the Purchaser. The intention of the Parties is for the Seller/Exchanger to use Section 1031 of the Internal Revenue Code to postpone taxes by exchanging this Property for other property (insert description or "to be designated later and acquired through a trust established at settlement").
The Purchaser and Seller/Exchanger will execute necessary documents to complete the exchange, including any assignments or trust agreements. The Seller will pay all expenses associated with the tax deferred exchange and hold the Purchaser harmless from any liability in connection therewith. All references to "Seller" in the Contract shall mean Seller/Exchanger.
TAX DEFERRED EXCHANGE PURCHASE CONTRACT
This transaction will be a Section 1031 Tax Deferred Exchange at no additional expense or liability to the Seller. The intention of the parties is for the Purchaser/Exchanger to use Section 1031 of the Internal Revenue Code to postpone taxes by receiving this Property through a delayed exchange for other property. Purchaser/Exchanger will place funds in escrow to complete the exchange.
The Seller and Purchaser/Exchanger will execute necessary documents to complete the exchange including any assignments or trust agreements. The Purchaser will pay all expenses associated with the tax deferred exchange and hold the Seller harmless from any liability in connection therewith. All references to "Purchaser" in the Contract shall mean Purchaser/Exchanger.
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