Volume 9 Issue 1 -- January/February 1997
"Gee, I didn't know you could do that," is the lament often heard from owners of real property who discover, too late, that they could have deferred (or avoided) income tax on its sale. Many people who own real estate give little thought to planning for the transfer of ownership. For example, whether the real estate is a personal residence (home) or investment or business property, the gain can often be deferred with proper planning. (The following discussion does not apply to real estate dealers who have an "inventory" of real property, unless it is clear that some of the property is "not held for sale," but rather for "investment.")
For some time, Congress has allowed real estate and other assets (like trucks) held for investment or business purposes to be exchanged for similar assets (hence, the term "like-kind exchange") without paying income tax. Such "like-kind" tax deferrals often involve two, three, and four parties, so professionals are often involved. Leaving the technicalities aside for the moment, if, instead of receiving the proceeds of a sale, the proceeds are invested in replacement property without the seller-owner getting their "mitts on the money" (actual or constructive possession), gain can be deferred. In addition to deferring the gain, under current tax law, if real estate is involved, the would-be seller is free to pick any kind of replacement real property.
For example, let's say you own vacant investment land (called Property-A) in "X-ville" which has appreciated but generates no rent to pay increasing property taxes. You believe you can sell Property-A and buy three condos in "X-ville" with positive cash flow, since there is a shortage of housing in "X-ville."
Instead of simply selling Property-A and "taking the money," there are alternatives that defer the tax. Let's assume Property-A was purchased 15 years ago for $20,000 and is paid off, and you are now offered $120,000 for it. Let's further assume that State (7%) and Federal (28%) capital gains taxes total 35%. Ignoring real estate commissions on the $100,000 of capital gains, 35% or $35,000 will go to taxing authorities, and there will be $85,000 left to invest ($120,000-$35,000). Rather than pay the $35,000 in tax on Property-A now, the entire $120,000 (again ignoring commissions and costs) could be "rolled-over" to obtain $120,000 of replacement property ("3-Condos," hereafter) using the like-kind exchange mechanism.
There are two basic ways to do a like-kind exchange: (1) "simultaneous" and (2) "deferred." In a simultaneous exchange, the 3-Condos replacement property and Property-A are exchanged (sold) simultaneously. Since both the sale of Property-A and the purchase of 3-Condos occur simultaneously (on the same day), the owner never gets his/her "mitts on the money" so the gain is deferred. While such simultaneous exchanges can be accomplished, they require the coordination and cooperation of the purchaser of Property-A and the seller of 3-Condos. Often, due to a lack of prior planning and cooperation of the buyer and seller, simultaneous exchanges are impractical.
A deferred exchange is the more common type. Usually the would-be seller (owner of Property-A) does not want to run the risk of delaying a potential sale and losing an interested buyer while looking for suitable replacement property (3-Condos) for a simultaneous exchange. In this more common situation, the would-be seller of Property-A can use an agent to hold the sales proceeds while looking for replacement property. Under the deferred exchange rules (often called "Starker" exchanges, after a well-known Tax Court case), the former owner of Property-A has 45 days to identify the replacement property (3-Condos) and 180 days (approximately) to purchase the same. Assuming these events happen within the prescribed time periods, the State and Federal taxes are postponed or deferred until the replacement property is sold.
What if Property-A is to be condemned for a new road; can the gain on the condemnation proceeds be deferred using the same like-kind exchange concepts? Yes. Owners of real estate who have condemned property can use essentially the same like-kind deferral concepts to defer gain on condemned property.
Gain on personal residences can be deferred using another tax mechanism, often called a "two-year roll-over" that allows the deferral of gain on the sale of a personal residence if a replacement home is purchased within two years of the sale. If the home's value has inflated, the "two-year roll-over" can defer income tax on the sale of the old home if the cost of the new home equals or exceeds the amount received for the old home.
Stated differently, if the old home sells for $150,000, the replacement home has to cost approximately $150,000 to defer all of the potential gain. (Note, in both like-kind exchanges and two-year roll-overs, some cash can be received and taxed without causing all of the gain to become subject to capital gains tax.)
Please remember that this newsletter is not designed to address the technical details (and there are many) of like-kind exchanges. Instead, a newsletter of this type focuses on introductory and planning concepts.
In our next issue, we will discuss more advanced like-kind exchange considerations.
By Tax and Business Professionals, Inc.
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