|
Property swap tax breaks
|
 |
August 20, 1999: 8:52 a.m. ET
Investment property exchanges can save you big in taxes, but be smart about it
|
NEW YORK (CNNfn) - Marshal Hoyt never suspected his dental office would one day buy him a vacation rental home on the Jersey shore.
Then again, he never imagined the Internal Revenue Service would help him pay for it either.
That was before he found out about what are known as 1031 exchanges, named after the tax code provision that allows for a break on swaps of similar type properties.
"I didn't know you could do what we did," Hoyt confessed. "One of my patients happened to mention it to me. He knew I was selling my dental office and even though there wasn't a great deal of money [involved with the office sale], he thought that money could be reinvested."
That conversation prompted a visit to a qualified intermediary, a firm approved by the IRS to facilitate 1031 exchanges. Late last year, Hoyt traded in the condo-style office he had practiced in for years for a four-bedroom rental property in Stone Harbor, N.J. He now leases a new office where he sees patients.
By using the proceeds from his office sale to help finance the purchase of the rental home, Hoyt said was able to qualify for the 1031 tax break and deferred some $52,000 in capital gains taxes.
"It's something we always wanted to do and we get to use it a few weeks out of the year," he said. "It just worked out so wonderfully. I would do it again in a second."
Like-kind exchanges
The 1031 exchange, first established in 1921, is among the oldest surviving tax shelters in the country.
The 1031 exchanges allow individuals and corporations to trade in existing business and investment property for new property -- and defer the capital gains tax along the way.
You don't pay taxes on the transaction until you sell the replacement property. By that time, most investors are well into their retirement years and fall into a lower tax bracket.
If you play your cards right, and play by the IRS rules, you can avoid paying taxes altogether. That's because the capital gains tax you owe on replacement properties are forgiven upon your death. Your heirs won't get stuck with the bill either.
"This can be a great estate planning tool," said Margo McDonnell, president of 1031 Corp., a qualified intermediary.
As with all investments, however, McDonnell said you should consult a tax professional to make sure this option is right for you. It's true that by keeping the money locked up in replacement properties, real estate or otherwise, the IRS won't get their hands on it. But neither will you during your lifetime.
Not so fast
As you might imagine, the IRS has placed all sorts of restrictions on what legally constitutes a 1031 exchange. Besides being required to use a qualified intermediary to execute the transaction, you can't touch the proceeds of your exchanged property sale until the new one is purchased, and you must exchange your property for a similar type of property.
That's why the government refers to these swaps as "like-kind exchanges."
For example, the trade of land improved with an apartment house for land improved with a store building, or a panel truck for a pickup truck, is a like-kind exchange.
Another good example is the exchange of Hoyts' dental office for an income-producing rental property.
Machinery, buildings, land, trucks, and rental houses are all examples of property that may qualify under 1031 rules.
The rules do not apply, however, if you try to trade in a piece of farm machinery for a store building, for example. And the home you live in and the family car don't count. Neither does the exchange of stocks, bonds and other securities.
(Click here for the IRS's definition of what is and isn't allowed.)
Moving on up
Tim Egan, executive director of the Federation of Exchange Accommodators, said business in the like-kind exchange industry has been going strong since the early 1990s, when the Treasury Department adopted new guidelines for executing a tax-deferred exchange.
Over the last few years, he said, the vast majority of exchange transactions have been generated by small business and investment property owners seeking relief from Uncle Sam.
"Things have really picked up," Egan said. "The feedback we are getting from our members is that the preponderance of business these days is coming from small, mom-and-pop investors. They are the ones who benefit from this the most."
McDonnell, of 1031 Corp., said that has been her experience as well.
"All the large corporations, especially those on the West Coast, have done this for a long time," she said. "Now, it's the smaller investors who are finding out about it."
How it works
Advocates of 1031 exchanges say the best part about them is that you're able to reinvest the money you would otherwise have spent in capital gains taxes.
To qualify for the tax deferred status, the proceeds from your sale must go back into your replacement property, but those are pre-tax dollars you're putting to work for you.
"This has been one of the nicest things that has worked out for us," Hoyt said. "I would absolutely do it again -- in a minute."
Consider the hypothetical example, constructed by the 1031 Corp., below:
A taxpayer sells a rental duplex for $100,000. He has owned the property for many years and has depreciated down to a zero basis which would mean the entire $100,000 gain would be taxable.
Based on the new capital gains tax rates, he would be taxed at 20 percent on the actual gain from the sale -- sale price less original purchase price -- and 25 percent on all depreciation he is required to recapture.
For the purposes of this scenario, assume the tax rate is 25 percent. Based on this information, the man's tax liability through a regular sale would be $25,000, cutting his net proceeds down to $75,000. Using that money as a 20 percent downpayment, he would be able to qualify for a $375,000 investment property.
Had he executed a 1031 exchange instead, he would have had the full $100,000 to reinvest -- allowing him to purchase a property valued at $500,000.
The additional equity to reinvest will make him a more solid buyer and help him get easier financing.
(Click here for chart that breaks out this scenario more clearly.)
Fees
For a simple vacation rental property exchange, intermediary service providers -- also called facilitators and accommodators -- can charge anywhere from $800 to $1,600 depending on the type of transaction you request and the area in which you live.
Big dollar exchanges, and those that involve multiple exchanges -- the sale of 2 rental homes for 1 for example - can cost much more.
McDonnell said it's important to realize that the term "exchange" does not mean you are executing a direct swap, or barter exchange, with another property owner. You use a real estate agent as you normally would to sell your property and you can buy any replacement property you want -- as long as it conforms with IRS rules.
The only difference is you have to use a facilitator to complete the transaction for you within certain time limits, and that third-party facilitator has to hold your proceeds for you while the transaction is being made.
At the end of the holding period, the property title and the full ownership go back to you.
Drawbacks
The biggest drawback of the 1031 exchange is that you can't touch the proceeds from the sale of your existing property without triggering a taxable event.
If you exchange an investment property valued at $100,000, you must purchase a property of the same or greater value and all of your equity must go into the newly purchased property.
For those who are selling rental property that has appreciated substantially, that can be a drawback.
There is a complex loophole, however, that in some cases allow investors to complete their exchange, and refinance shortly thereafter, McDonnell said. By doing so, it enables the property owner to unlock some of that value.
There's one other thing to watch out for, too.
Kent Noard, a certified financial planner and enrolled agent in San Jose, Calif., said all too often clients come to his office with an agenda of using the 1031 exchange strictly to avoid taxes. That isn't always wise, he said.
"The benefit of doing this is to move from a property that has plateaued in value to another good property," Noard said. "Often I see people moving from a bad property to another bad property just to avoid the taxes."
Always consider the investment potential of the property you are looking to acquire, he advised. If it's potential is no better than your current property, you might instead consider selling your existing real estate asset, paying the taxes and investing what's left in the stock market.
"The benefit of the 1031 is real, but you have to be very careful about selecting a good investment property that will continue the growth potential of your assets rather than centering on the taxes you'll avoid," Noard said. "People lose sight of the financial side."
Lastly, if you're considering a like-kind transaction, you'll want to do your homework.
Egan, of the Federation of Exchange Accommodators, said you should start by looking into the facilitator with whom you are considering doing business.
"It makes some people nervous that they have to hand over control of their exchange proceeds to a third-party for a period of time and some people wonder how they can protect themselves," he said. "The best way to do that is to ask these companies whether they are fidelity bonded."
Those that are have been through a rigorous review of their financial history, they are required to have numerous internal controls in place to protect client's money during the holding period and they can guarantee your money will be repaid dollar for dollar in the unlikely event that something happens to it.
Egan noted, though, "there has not been any significant losses or problems [with squandered proceeds] in this industry in the last five years." 
|
|
|
|
|
 |
|
