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Methods of Exchanging Real Property
In order to properly understand the procedures and methods of tax-deferred exchanging, it is important to understand the basic structure of the tax law and in some cases, the history behind its development. Tax law is evolutionary in nature.
It can be broken down into 4 basic areas.
1. Internal Revenue Code as amended
2. Treasury Regulations, constantly changing to keep up with the amended Code
3. Rulings, developed around specific situations
4. Case Law, the courts interpretation of the Code, Regulations, and Rulings
It is easy to see why the tax law is evolutionary. As congress continues to amend the Code to accomplish social and economic agendas, the entire body of tax law grows.
The current Code leaves us with few tax shelter vehicles. The primary ones are:
1. Interest deductions on up to two personal residences
2. Retirement accounts
3. Schedule C for self employed individuals with proper record keeping
4. Investment real estate
Keep in mind that rules differ from personal use real estate to investment real estate as we discuss some of the basic concepts necessary for the understanding of exchanging.
Types of income
1. Active -- salaries, wages, business profits
2. Portfolio -- interest, dividends, royalties
3. Passive -- limited partnerships, rental real estate
Passive loss limitations
If you earn under $100,000 modified adjusted gross income and you "actively participate" in the management of the property, you can deduct up to $25,000 in losses, the balance are "suspended", to be used the following years or upon disposition of the property. The deduction is phased out between $100,000 and $150,000, $1,000 in deduction for every $2,000 of income.
Basis
This is an important concept. You can't calculate the capital gain unless you know the basis.
Original Cost + Capital Improvements - Allowable Depreciation
Gift -- donors basis or fair market value, which ever is less
Inheritance -- fair market basis at death
Property received in exchange -- fair market value less deferred gain
Capital Gain
Difference between the adjusted selling price and the adjusted basis. Capital gain is divided into three categories.
Realized Gain -- actual gain, reported in year of sale
Recognized Gain -- taxable gain, taxed now
Deferred Gain -- tax is deferred, taxed later reduces basis of property received in exchange
Depreciation
Theoretical drop in the value of an asset for tax purposes only. A non-cash expenditure. Treated as a deduction but reduces basis, which will result in a larger capital gain. This taxed depreciation is said to be "recaptured". The period over which the property is depreciated is called the recovery period and has changed many times over the years.
Residential income property - 27.5 years
All other income property - 31.5 years
Optional recovery period - 40 years
Under the Tax Reform Act of 1986, real property depreciation is straight line taken over the life of the asset. Under the Economic Recovery Tax Act of 1981 (1981), depreciation could be accelerated to the early years. This was known as "accelerated cost recovery system" or ACRS.
Each new owner establishes a new depreciable basis based on cost of acquisition minus any deferred gain. Land is considered indestructible and is not depreciable. The value of the land must be determined and subtracted from the basis of the property to arrive at the depreciable basis.
Exchanging
Why exchange real property? To save taxes, yes, but said more succinctly, to build your estate with pre-tax dollars. Using proper exchange techniques results effectively in interest free loans from the government. Other reasons to exchange include:
Increasing depreciable basis by acquiring property encumbered with a larger debt.
Acquiring sheltered income by exchanging for unimproved land for improved property.
Acquiring property without cash, when sales may be impossible.
Consolidating assets by exchanging many properties for one larger property.
Receiving nontaxable cash by exchanging and refinancing after and independent of the exchange.
Diversifying holdings without tax consequence.
Sell: $150,000
Buy: $ 50,000
Gain: $100,000
Tax Brkt: 30%
Tax: $ 30,000
Balance to invest: $70,000
Leveraged 4 to 1 results in a purchase of $280,000
10% annual appreciation results in $28,000
If you structured the sale in accordance with section 1031, and did not have to pay the taxes at that time, you could invest the entire $100,000 leveraged 4 to 1 and purchase a $400,000 property. At 10% appreciation, your increase in equity is $40,000. Multiply this $12,000 equity buildup over a 20 year investment horizon and the result is substantial.
Internal Revenue Code Section 1031
No gain or loss shall be recognized if property held for investment is exchanged soley for a property of like kind to be held either for:
1. Production of income
2. Investment
3. Productive use in trade or business
Property must be of "like kind." This means real property for real property, personal property for personal property. "Like kind" is broadly defined, that is, all real estate qualifies regardless of the "grade or quality." It is the "nature or character" of the property (realty or personalty) and not the name of the improvements (office building, apartment, hotel, etc) that determines "like kind". This was emphasized in Commissioner of Internal Revenue v. Chrichton. This case involved the exchange of mineral interests and improved real property. The mineral interests were held to be like kind property because under state law they were considered real property. In a subsequent revenue ruling, the IRS indicated that water rights also met the like kind test.
Property not qualifying
1. Stock in trade
2. Partnership interests
3. Stocks, bonds, notes
4. Dealer property
Multiple Properties
Nothing in Section 1031 prevents a taxpayer from exchanging out of or into multiple properties.
Tax Consequences
Exchanges can be fully deferred or partially deferred. Any unlike kind property received in the exchange is considered boot and is recognized (taxable) in the year of the exchange. Boot is:
1. Cash or the equivalent of cash
2. Any unlike kind property
3. Mortgage relief
4. Any combination of the above
Cash paid offsets mortgage relief boot. The lower of the gain or the boot is taxable in the year of the exchange.
For a completely tax deferred exchange you must trade up in equity, value, and loan.
Basis of Property Received
This is referred to as substitute basis and is the Fair Market Value of the property received minus the deferred gain (or plus any deferred loss).
The Process
As it is in any real estate transaction, you must first identify the objectives of the property owner. What do they want to accomplish? Management problems, lack of control, cash flow, tax concerns; sometimes the owner is not sure of all the circumstances and it may take some time and counciling to make the determination. A basic requirement is that all participants receive the same value that they give. The end result should be that there are as many winners as there are participants. Determination of value to the participants in a real estate exchange is not complete without considering the improvement the transaction will make in the owner's life. The analysis must take into consideration the personal circustances of the participants lives.
Two-Party Exchange
As mentioned before, to structure a completely tax deferred exchange, the investor must acquire property (properties) with equal or greater equity and a larger fair market value than the property transfered (up in equity and value). This assumes that there is gain realized and that the taxpayer pays boot and assumes a larger loan.
Example:
Mr. Carey owns an industrial property valued at $372,000 with a loan of $351,000. His basis is $355,000.
He exchanges with Mr. Ims apartment complex which is valued at
$420,000 and has a $381,000 loan against the property. His basis is $392,000.
Step 1: Balance the Equities
Basic Structures of a Multiparty Exchange
The very common three-party exchange is comprised of a sale and an exchange, or an exchange and a sale.
It can be broken down into 4 basic areas.
1. Internal Revenue Code as amended
2. Treasury Regulations, constantly changing to keep up with the amended Code
3. Rulings, developed around specific situations
4. Case Law, the courts interpretation of the Code, Regulations, and Rulings
It is easy to see why the tax law is evolutionary. As congress continues to amend the Code to accomplish social and economic agendas, the entire body of tax law grows.
The current Code leaves us with few tax shelter vehicles. The primary ones are:
1. Interest deductions on up to two personal residences
2. Retirement accounts
3. Schedule C for self employed individuals with proper record keeping
4. Investment real estate
Keep in mind that rules differ from personal use real estate to investment real estate as we discuss some of the basic concepts necessary for the understanding of exchanging.
Types of income
1. Active -- salaries, wages, business profits
2. Portfolio -- interest, dividends, royalties
3. Passive -- limited partnerships, rental real estate
Passive loss limitations
If you earn under $100,000 modified adjusted gross income and you "actively participate" in the management of the property, you can deduct up to $25,000 in losses, the balance are "suspended", to be used the following years or upon disposition of the property. The deduction is phased out between $100,000 and $150,000, $1,000 in deduction for every $2,000 of income.
Basis
This is an important concept. You can't calculate the capital gain unless you know the basis.
Original Cost + Capital Improvements - Allowable Depreciation
Gift -- donors basis or fair market value, which ever is less
Inheritance -- fair market basis at death
Property received in exchange -- fair market value less deferred gain
Capital Gain
Difference between the adjusted selling price and the adjusted basis. Capital gain is divided into three categories.
Realized Gain -- actual gain, reported in year of sale
Recognized Gain -- taxable gain, taxed now
Deferred Gain -- tax is deferred, taxed later reduces basis of property received in exchange
Depreciation
Theoretical drop in the value of an asset for tax purposes only. A non-cash expenditure. Treated as a deduction but reduces basis, which will result in a larger capital gain. This taxed depreciation is said to be "recaptured". The period over which the property is depreciated is called the recovery period and has changed many times over the years.
Residential income property - 27.5 years
All other income property - 31.5 years
Optional recovery period - 40 years
Under the Tax Reform Act of 1986, real property depreciation is straight line taken over the life of the asset. Under the Economic Recovery Tax Act of 1981 (1981), depreciation could be accelerated to the early years. This was known as "accelerated cost recovery system" or ACRS.
Each new owner establishes a new depreciable basis based on cost of acquisition minus any deferred gain. Land is considered indestructible and is not depreciable. The value of the land must be determined and subtracted from the basis of the property to arrive at the depreciable basis.
Exchanging
Why exchange real property? To save taxes, yes, but said more succinctly, to build your estate with pre-tax dollars. Using proper exchange techniques results effectively in interest free loans from the government. Other reasons to exchange include:
Increasing depreciable basis by acquiring property encumbered with a larger debt.
Acquiring sheltered income by exchanging for unimproved land for improved property.
Acquiring property without cash, when sales may be impossible.
Consolidating assets by exchanging many properties for one larger property.
Receiving nontaxable cash by exchanging and refinancing after and independent of the exchange.
Diversifying holdings without tax consequence.
Sell: $150,000
Buy: $ 50,000
Gain: $100,000
Tax Brkt: 30%
Tax: $ 30,000
Balance to invest: $70,000
Leveraged 4 to 1 results in a purchase of $280,000
10% annual appreciation results in $28,000
If you structured the sale in accordance with section 1031, and did not have to pay the taxes at that time, you could invest the entire $100,000 leveraged 4 to 1 and purchase a $400,000 property. At 10% appreciation, your increase in equity is $40,000. Multiply this $12,000 equity buildup over a 20 year investment horizon and the result is substantial.
Internal Revenue Code Section 1031
No gain or loss shall be recognized if property held for investment is exchanged soley for a property of like kind to be held either for:
1. Production of income
2. Investment
3. Productive use in trade or business
Property must be of "like kind." This means real property for real property, personal property for personal property. "Like kind" is broadly defined, that is, all real estate qualifies regardless of the "grade or quality." It is the "nature or character" of the property (realty or personalty) and not the name of the improvements (office building, apartment, hotel, etc) that determines "like kind". This was emphasized in Commissioner of Internal Revenue v. Chrichton. This case involved the exchange of mineral interests and improved real property. The mineral interests were held to be like kind property because under state law they were considered real property. In a subsequent revenue ruling, the IRS indicated that water rights also met the like kind test.
Property not qualifying
1. Stock in trade
2. Partnership interests
3. Stocks, bonds, notes
4. Dealer property
Multiple Properties
Nothing in Section 1031 prevents a taxpayer from exchanging out of or into multiple properties.
Tax Consequences
Exchanges can be fully deferred or partially deferred. Any unlike kind property received in the exchange is considered boot and is recognized (taxable) in the year of the exchange. Boot is:
1. Cash or the equivalent of cash
2. Any unlike kind property
3. Mortgage relief
4. Any combination of the above
Cash paid offsets mortgage relief boot. The lower of the gain or the boot is taxable in the year of the exchange.
For a completely tax deferred exchange you must trade up in equity, value, and loan.
Basis of Property Received
This is referred to as substitute basis and is the Fair Market Value of the property received minus the deferred gain (or plus any deferred loss).
The Process
As it is in any real estate transaction, you must first identify the objectives of the property owner. What do they want to accomplish? Management problems, lack of control, cash flow, tax concerns; sometimes the owner is not sure of all the circumstances and it may take some time and counciling to make the determination. A basic requirement is that all participants receive the same value that they give. The end result should be that there are as many winners as there are participants. Determination of value to the participants in a real estate exchange is not complete without considering the improvement the transaction will make in the owner's life. The analysis must take into consideration the personal circustances of the participants lives.
Two-Party Exchange
As mentioned before, to structure a completely tax deferred exchange, the investor must acquire property (properties) with equal or greater equity and a larger fair market value than the property transfered (up in equity and value). This assumes that there is gain realized and that the taxpayer pays boot and assumes a larger loan.
Example:
Mr. Carey owns an industrial property valued at $372,000 with a loan of $351,000. His basis is $355,000.
He exchanges with Mr. Ims apartment complex which is valued at
$420,000 and has a $381,000 loan against the property. His basis is $392,000.
Step 1: Balance the Equities
Basic Structures of a Multiparty Exchange
The very common three-party exchange is comprised of a sale and an exchange, or an exchange and a sale.
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