The art of the 1031 real estate exchange

Swap your property

April 11, 2001: 6:27 a.m. ET

Tax-deferred exchanges are catching on, and could save you big bucks in taxes
By Staff Writer Shelly K. Schwartz

NEW YORK (CNNfn) - Like many Wall Street investors, May and Tom Frost spent much of last year looking for an exit ramp.

The Huntersville, N.C., residents, who are fast approaching retirement age, watched helplessly throughout the summer as their nest egg shrank in size. They no longer had the time horizon to ride out market volatility and knew it was time to spread their risk. They just weren't sure how.

That's when a real estate agent made a suggestion.

"We had heard about 1031 Exchanges, but didn't know we would qualify to use them," said May Frost, now in her late 40s. "It's a wonderful tool and we are really glad we invested in property because of the way the stock market is looking right now."

By taking advantage of 1031s, a little-used tax shelter for investment real estate owners, the Frosts managed to sell their highly appreciated rental property at a South Carolina lake last fall and upgrade to a new one closer to home -- without paying a dime in capital gains taxes this year.

The newly acquired property might someday become their retirement home – but in the meantime, it'll generate substantial income.

"The lake where our old rental house was located had became very popular and the value had really gone up, so we were able to cash in without paying taxes, plus we got to keep that money in property," she said, noting that the use of a 1031 Exchange allowed them to defer "tens of thousands of dollars" in capital gains. "I would highly recommend this to anyone."

A reinvestment option
The term "1031 Exchange," also known as like-kind exchanges, is derived from the Internal Revenue Code that allows for the tax-deferred exchange of any type of business use or investment property for similar property.

Under such transactions, reported on Form 8824 for tax purposes, sellers realize no immediate capital gain or loss, which enhances their buying power on new investment property.

The seller is taxed only when the replacement property is sold – and by that time, most investors are well into their retirement years and enjoy a lower tax bracket.

And the best news of all: 1031s can be a powerful estate planning tool as well, since the tax liability on such an exchange is forgiven up the death of the investor. The heirs who inherit the property enjoy a stepped-up basis.

"This is one of the last goodies in real estate," said Kelly Yates, an attorney and house council to the Exchange Facilitator Corp. in Seattle. "Our typical customer is the mom and pop who maybe inherited land many years ago and want to move unproductive land into income-producing property. We also see the phenomenon of people in their 40s and 50s looking ahead to retirement and looking to sell a property to buy a home in Florida that they can rent and maybe retire to someday."

According to Yates, to qualify for a 1031 Exchange, you must exchange an investment, or rental, property for another investment property. You may not use the rental property for more than 14 days out of the year, or 10 percent of the rental season.

That doesn't mean, however, that you can never sell your primary residence and move into that rental property full-time.

"Most CPAs advise investors to hold onto their new rental property for a few years and to not disclose their intent to possibly move into it," Yates said. "Assuming you don't move in too quickly – three years or less – and the law doesn't change, you can convert that investment property into your primary residence without a taxable event."

Business is booming
Traditionally, 1031 Exchanges were used most by owners of large commercial real estate properties, including shopping malls and golf courses. But they're starting to catch on among smaller investors as well, especially those who own vacation rental properties and undeveloped land.



	This has been part of the tax code for 80 years and yet so many people still don't know about it.



	Margaret McDonnell 1031 Corp.

"We are definitely seeing an increase in business and an increase in the number of companies, like ours, which facilitate 1031 Exchanges, doing this throughout the country," said Margaret McDonnell, president of 1031 Corp. in Pottstown, Pa. "Our business has more than doubled in volume in the last two years."

McDonnell said the average amount of capital gains tax deferred among her smaller "mom and pop" clients, exchanging vacation rental properties, is roughly $120,000.

When the law was enacted in 1921, it originally held that property owners were required to swap their property with a single buyer through a type of barter arrangement. Because nothing was technically being liquidated, no taxes were due. Today, however, the rules are more flexible.

Multiparty exchanges are now the norm, where the property owner sells to an outside buyer. The proceeds are held by a third-party facilitator or intermediary, while the taxpayer identifies and closes on a new property they find elsewhere.

"This has been part of the tax code for 80 years and yet so many people still don't know about it," McDonnell said. "And the worst part is that they're selling property, putting the money in the bank and buying a new property so they're doing everything they need to do for a 1031 exchange, but they're not getting the benefit because they didn't structure it that way."

The rules
A few rules: You must indicate your intent to utilize the 1031 Exchange before you sell your original investment property.

Unless you complete a swap or two-party exchange, where one property owner trades their investment with another property owner outright, you'll need to use a third-party facilitator or intermediary.

Most charge about $1,000 (between $800 to $2,000) for the standard 1031 Exchange on a rental property – though fees for larger commercial transactions can climb as high as $25,000 or more.

Make sure you read your contract carefully to find out how that facilitator plans to hold your money -- whether the money will be placed in FDIC accounts or backed by Treasurys during the 180 day period. Look at exchange agreement and look how funds are invested. In FDIC accounts? Or backed by treasuries? And it's a good idea, too, to call your local Better Business Bureau to find out if any complaints have been filed against that organization.

"Consumers should remember that the exchange industry is not regulated," Yates said. "You have this industry holding vast sums of other people's money. I'm less concerned about the form of the documents used since that's only an issue in case of an audit. The real issue is making sure that the money is going to be there on the day you go to close on your replacement property. There have been cases where intermediaries went bankrupt with that money."

The means are available to ensure your funds are held by a bank under qualified escrow.

Once you close on the replacement property, you have 45 days to identify up to three new investment properties of equal or greater value, and a total of 180 days in which to close on one of those new properties.

If you fail to meet the deadline, you'll lose eligibility for the 1031 Exchange and the you'll lose the tax break, meaning you'll owe capital gains on the sale of your original investment property. You'll also likely lose the fees you paid to the facilitator who helps you construct the deal.

Like-kind exchange is key
Keep in mind that 1031s apply only to the exchange of "like-kind" properties. The exchange of land improved with an apartment house for land improved with a store building, for example, qualifies as a like-kind exchange. Same goes for the exchange of undeveloped land for a vacation rental property.

And McDonnell points the tax-shelter isn't just designed for real estate. Any type of business use or investment property qualifies, she said, including the exchange of office equipment or machinery, corporate jets and even livestock.

"The key is that it's truly for the exchange of like-kind property," she said.

	THE RULES
		Once you close on the replacement property, you have 45 days to identify up to three new investment properties of equal or greater value and a total of 180 days in which to close on one of those new properties.

The 1031 Exchange would be almost too good to be true, however, if there weren't some drawbacks. The biggest one is that the basis – or the stated cost – of your newly acquired property remains the same as the basis of the property you transferred.

"This is one thing people don't often think about," McDonnell said. "The basis on their replacement property is lowered by the amount they deferred in gains. That comes into play the next year when they start depreciating on their new property."

In essence, you're forced to subtract what you deferred in gains from the purchase price of your new property – which lowers the depreciation tax break to you.

Getting help
For anyone considering following in her footsteps, Frost said her best advice is to use a facilitator you trust. Ask for references and do a little digging to make sure you're dealing with a reputable company.

"We would have never done this without the help of an expert," she said, noting she used Realty Exchange Inc. in Charlotte, N.C. "We had to buy and sell our properties ourselves, but they told us every regulation and every rule."

She also notes that anyone considering a 1031 Exchange had best have their ducks in a row before drawing up the paperwork. The clock starts ticking the second you close on the sale of your original investment property.

"There are timelines, like the 45-day rule to identify new properties, and if you don't have everything lined up you can miss those deadlines," she said. "It sounds like a long time, especially the fact that you have 180 days to close on a new place, but it's really very short. But that was the only negative. It all worked out and I would definitely do it again."