The real estate market is starting to pick up again. Prices are rising. You have decided to sell the rental or other business or investment property you have owned for years. You have been holding off selling because you have fully depreciated the property. When you do sell it, the proceeds will mostly be taxable gain. Is there something that you can do?
Yes there is. Structured properly, you can sell that rental or other business or investment property and not immediately recognize any taxable gain on the sale. You do have to jump through some hoops. Generally, no gain or loss is recognized when business or investment property is exchanged for “like-kind” property.
By using the “like-kind” exchange rules under Section 1031 of the Internal Revenue Code, you can sell your rental or other business or investment property, pay no taxes upon the sale, defer the gain and taxes and use the entire net proceeds from the sale of your old real estate to purchase other business or investment real estate.
So long as the purchase price of your new “like-kind” replacement property is at least as much as the selling price of your sold real estate, you can defer the gains and taxes indefinitely. If your replacement property costs less than the selling price of what you sold, you have certain mortgages discharged or you receive other property for the sale of your business or investment real estate that is not “like-kind”, you may have to recognize some gain on the sale.
What is “like-kind” property?
If you exchange a residential rental apartment building for a residential rental apartment building, that clearly meets definition of “like-kind” property. However, “like-kind” property is not limited to identical property. As long as your replacement property is used for business or investment, it generally qualifies for “like-kind” treatment. You can replace your office building with an apartment building, your vacant land held for investment for a retail store or your industrial building for a shopping center.
If you do not want to manage the replacement property as rental real estate, you can purchase a fractional interest in a larger business or investment property as tenants-in-common with other investor partners, who would manage the real estate. You would receive monthly or quarterly rental income and still be able to defer your capital gain taxes on the sale of your old rental or other business or investment property
Do I have to exchange my rental or other business or investment property directly with the person who has the replacement property?
You do not have to exchange your rental or other business or investment property directly with the person who is selling the replacement property to you. You can have an exchange by using a facilitator who is a qualified intermediary, whom you would have hold the funds for you after the sale of your old real estate. The qualified intermediary would then use the funds to purchase replacement property, so that you, in fact, would have exchanged the rental or other business or investment property for the replacement property.
Do I have to purchase my replacement property at the same time I sell my rental or other business or investment property?
You do not have to purchase your replacement property the same day that you sell your rental or other business or investment property You can do what is called a deferred exchange. If you use a qualified intermediary and meet certain time limitations, you can still defer the gain and taxes on the sale of your real estate.
In order to qualify for “like-kind” exchange treatment for a deferred exchange, your replacement property has to be identified within forty-five days of the sale of your relinquished property. You then must close on the replacement property within one hundred and eighty days of the original sale of your real estate or, if earlier, the extended due date of your income tax return.
You can also do a reverse exchange in which the replacement property is purchased before you sell your rental or other business or investment property. The replacement property is purchased by a qualified intermediary with whom you can park the replacement property for no more than 180 days, during which time you must sell your old property.
Can I act as my own facilitator for a deferred or reverse exchange?
Short answer, no. If you take control of cash or other proceeds before the completion of the exchange, it could disqualify the entire transaction from “like-kind” exchange treatment. In such instances, all gains would be immediately taxable.
You must use a qualified intermediary. Your real estate agent or broker, investment banker or broker, accountant, attorney, employee or anyone who has worked for you in any of those capacities within the previous two years is not eligible to act as your qualified intermediary.
Be careful in your selection of a qualified intermediary. There have been reports of unscrupulous individuals acting as intermediaries who declared bankruptcy or otherwise did not meet their contractual obligations to the selling taxpayer. These situations have resulted in taxpayers not meeting the strict timelines set for a deferred or reverse exchange, thereby disqualifying the transaction from Section 1031 deferral of gain. Then all the gain would be taxable immediately.
Can I use “like-kind” exchange treatment for the sale of my vacation or other second home?
Generally a vacation or second home is considered personal use property rather than business or investment real estate. As such, it is not considered “like-kind” as either the relinquished or the replacement property. Be wary of promoters with sales pitches to use them to get “tax-free” exchanges of your vacation or second home. They are usually only looking for a fee and are not particularly interested in your tax bill.
If you are considering a tax deferred “like-kind” exchange, seek advice from a competent tax professional before you sell your old property and/or purchase your replacement property. Also thoroughly investigate any qualified intermediary before you give them any money.
By: Matthew M. Wallace, CPA, JD
Published edited September 1, 2013 in The Times Herald newspaper, Port Huron, Michigan as: Defer income taxes on exchanges of real estate