(This is Part 6 of an eight-part series. See Part 1: Recent changes to the $250,000 home-sale tax exemption; Part 2: Personal-use time determines vacation-home tax break; Part 3: Moving costs beef up real estate tax deductions; Part 4: Homeowners take refuge in casualty loss assistance; Part 5: Real estate investing generates big tax benefits; Part 7: Home-business expenses add up to tax savings and Part 8: 10 most often overlooked real estate tax deductions.)
If you own (or want to own) an investment property, it can become the basis for increasing your real estate wealth by making periodic trades up for larger properties.
For example, my first tax-deferred exchange was a trade of my little three-unit apartment building for a larger nine-unit apartment building that offered fix-up profit potential. If I had not made that tax-deferred exchange, as authorized by Internal Revenue Code 1031, the profit on the sale of my three units would have been eroded by capital gain taxes.
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Many real estate fortunes have been earned as a result of repeated tax-deferred trades for larger and larger properties. The best-selling classic real estate book, “How I Turned $1,000 into $5 Million in My Spare Time,” by William Nickerson, is based on the author’s tax-deferred exchanges to pyramid his way to wealth.
WHAT IS A TAX-DEFERRED EXCHANGE? To qualify for tax-deferral when selling a property, an investment realty owner must trade “equal or up” in both price and equity for one or more qualifying “like kind” properties without taking out any taxable “boot” such as cash or net mortgage relief. If the owner receives any cash or net mortgage relief in the trade, that amount is taxable.
However, “like kind” does not mean “same kind” of property. To illustrate, you can trade your rental house for a tenant-in-common share in a management-free commercial building. Or you could trade your equity for an apartment building, shopping center, office building, or warehouse.
But all properties in a tax-deferred exchange must be held for investment or use in your trade or business. Ineligible properties include your personal residence, vacation homes (unless rented to tenants), partnership interests unless held as tenants in common, and dealer property (such as a home builder’s inventory of new homes).
WHY EXCHANGE INSTEAD OF SELLING? The simple answer is tax avoidance. Since 1921, Internal Revenue Code 1031 has sanctioned tax-deferred exchanges of investment and business properties. A qualified tax-deferred trade up is viewed, taxwise, as one continuous investment.
There are at least 10 reasons for exchanging realty: (1) pyramid your investment equity without tax erosion of your sale profit; (2) minimize or eliminate the need for new mortgage financing on the property acquired; (3) get rid of an undesirable property that is difficult to sell and acquire a better property; (4) increase the investor’s depreciable basis; (5) acquire a property which better meets the investor’s needs, such as more cash flow or easier management; (6) partially defer profit tax by trading down to a smaller property that suits the owner’s needs; (7) avoidance of depreciation recapture tax when selling a property; (8) refinance either before or after the trade to take out tax-free cash; (9) accept an unexpected purchase offer to sell a currently-owned property without owing tax; and (10) completely avoid capital gains tax by still owning the last property in a chain of tax-deferred trades when you die.
STARKER EXCHANGES MAKE TRADES EASIER. In 1984, Internal Revenue Code 1031(a)(3) was added to make tax-deferred exchanges even easier. Rather than having to make direct, simultaneous trades as I did in my first exchange, now investors can sell their property, have the sales proceeds held by a qualified intermediary or accommodator, and then use that money to acquire the qualifying replacement property of equal or greater cost and equity.
These exchanges, called “Starker exchanges,” now are the most popular type of trades.
Although not found in the tax code, the term “Starker exchange” originated in 1979 when the late T.J. Starker received a purchase offer for his Oregon timberland from the Crown-Zellerbach Corp. He agreed to sell if C-Z would hold his sales proceeds until he could find suitable other property to acquire with the money. C-Z agreed to pay Starker a 6 percent “growth factor.” Later, Starker found suitable property and he directed C-Z to use his money to buy that property to complete his tax-deferred exchange.
However, when the IRS learned of this transaction, Starker was told it was not a tax-deferred exchange. He paid the disputed capital gain tax and then sued for a tax refund. Fortunately for investors, Starker won. Congress later codified the result.
STARKER EXCHANGES HAVE TIME LIMITS. The tax code now includes time limits that must be met to qualify for a Starker tax-deferred exchange. After the first property is sold, the sales proceeds must be held by a qualified third-party intermediary or accommodator beyond the up-trader’s “constructive receipt.”
While the sales proceeds are held by the third-party, the investor has only 45 days to designate to the accommodator the qualifying replacement property to be bought with the sales proceeds being held.
Up to three possible property acquisitions can be named. Then the exchanger has up to 180 days from the sale date to complete the tax-deferred acquisition. More than one property can be involved on either side of the trade.
REVERSE EXCHANGES HAVE BEEN APPROVED. In late 2000, the IRS issued Revenue Procedure 2000-37, which authorized “reverse exchanges.” That means the replacement property is acquired by the third-party accommodator before the old investment or business property is sold.
Although the short 45-day replacement period problem is thereby resolved, title to the replacement property must be taken in the name of the accommodator, thus creating possible financing problems.
NEW 2004 RULE FOR TRADING INTO YOUR DREAM HOME. Rather than pyramiding their estates, as William Nickerson did in his famous book, by use of tax-deferred exchanges, many investors want to liquidate their investment property profits without paying huge capital gains tax.
Their solution is to trade into either a dream home for personal occupancy, or to trade into a principal residence to eventually sell and claim the $250,000 or $500,000 tax exemption of Internal Revenue Code 121.
To illustrate, suppose you own a commercial property in which you have a $400,000 capital gain. But rather than trade up for another investment property, you want to exchange for a “dream home” where you and your spouse can enjoy the good life. This can be done with careful planning and a Starker exchange.
The first step is to sell your investment property and have the sales proceeds held by a qualified third-party accommodator. The second step is to use those sales proceeds to acquire your ultimate dream home.
But that property must be a rental at the time of acquisition. Most tax advisers suggest renting it for at least six to 12 months after purchase to show rental intent. Then you can move in and convert it to your personal residence.
However, before you can sell the acquired residence and claim your $250,000 or $500,000 principal residence exemption of IRC 121, the Oct. 22, 2004, tax changes of Internal Revenue Code 121(d)(10) now require you to own the acquired residence at least five years and live in it as your principal residence at least 24 of the 60 months before its sale.
DEATH IS THE ULTIMATE TAX SHELTER. However, if you still own your dream home and other real estate when you die, you will have achieved the ultimate tax shelter. The tax reason is any capital gain tax you would have owed if you sold your real property (and other assets) before death is forgiven upon your death.
But your net assets will be included in your estate, subject to the current $1.5 million federal estate tax exemption. To make tax matters even better, your heirs will receive a new “stepped-up basis” to market value on the date of your death on the property they inherit. For full details, please consult your tax adviser.
The new Robert Bruss special report, “How the New Tax-Deferred Real Estate Exchange Rules Can Make You Very Wealthy,” is now available for $4 from Robert Bruss, 251 Park Road, Burlingame, CA 94010 or by credit card at 1-800-736-1736 or instant Internet download at www.bobbruss.com.
Next week: Home business tax deduction savings.
(For more information on Bob Bruss publications, visit his
Real Estate Center).
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