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Tax-deferred exchange can be a legal financial bonanza

Seventh in a series of realty tax tipsSuppose I could show you a perfectly legal way to pyramid your real estate wealth without paying taxes; you could even periodically refinance your properties to take out tax-free cash. Would you be interested?

The simple method, authorized by Internal Revenue Code 1031, is the tax-deferred exchange. Starting by fixing up a small investment property, such as a rental house or perhaps a two-family duplex, you can increase its market value and then exchange your growing equity for a larger property, perhaps a fourplex or maybe a small commercial property which also can be fixed up and then exchanged for a larger investment property.

For income tax purposes, tax-deferred exchanges are viewed as one continuous investment. That is why profit tax is not due when one property is exchanged for a larger property.

Any real estate except your personal residence or dealer property (such as a home builder's inventory of unsold houses) is eligible for a tax-deferred trade. Examples include trading vacant land for an apartment building, swapping a parking lot for a warehouse, or exchanging a rental house for a small office building.

Although there was fear the Omnibus Budget Reconciliation Act of 1989 might change the definition of "like kind" exchanges to mean "same kind," fortunately that didn't happen. There is no need to limit your trading to warehouses for warehouses, land for land, or apartments for apartments.

The primary reason for tax-deferred exchanges is to avoid tax erosion and to have maximum equity available to acquire a larger property.

To illustrate, suppose you own an apartment building in which you have a $100,000 profit. If you sell the building and reinvest the proceeds you will have to pay Uncle Sam at least $28,000 in income taxes, leaving only $72,000 with which to buy your next property. However, if you instead make a tax-deferred exchange for a larger property you will have the full $100,000 profit available for trading, thus increasing the size of the property you can acquire.

Additional reasons for exchanging include: (1) Increasing your depreciable basis by acquiring a larger depreciable building, (2) Minimizing the need for new mortgages, (3) Trading out of property which is difficult to sell, (4) Pyramiding your wealth into a large estate without paying profit tax along the way, (5) Acquiring a property which better meets your goals, (6) Avoiding recapture of accelerated depreciation, and (7) Receiving tax-free mortgage refinance cash either before or after the exchange.

There are three simple rules to follow if you want a tax-deferred exchange: (1) All properties must be "like kind," meaning your personal residence and dealer property are ineligible, (2) "unlike kind" personal property such as cash or net mortgage relief received by the trader is taxable "boot," and (3) you must trade up to a more expensive property (if you trade down you will receive taxable boot).

Although the theory of an exchange presumes one continuous investment, actually there are three types of exchanges:

Direct exchanges are swaps of one qualifying property for another such property. No intermediary is involved. This type of trade occurs very rarely because if you are trading up, chances are the owner of the other property doesn't want your property.

Three-way exchanges are much more common. The three parties are (a) the "up trader" who makes a tax-deferred exchange for more valuable property, (b) the "down trader" who is cashing out and will owe profit tax upon receiving cash, and (c) the "cash-out buyer" who purchases the smaller property immediately after the exchange is completed and supplies the cash the down trader wants. Most exchanges involve two properties and three parties.

Starker "delayed" exchanges evolved out of the need to make three-way exchanges, but without the simultaneous closing of a three-way exchange and cash-out sale. Starker exchanges involve the sale of the smaller property and holding of the sale proceeds by a third-party intermediary such as a bank or attorney beyond the up trader's constructive receipt.

Starker exchanges are named after T.J. Starker, whose 1979 court decision (602 Fed.2d 1341) established the ground rules which are now found in Internal Revenue Code 1031(a)(3). The up trader has 45 days to designate the property to be bought with the sales proceeds and 180 days to complete the acquisition.

Exchange law changes made by the 1989 tax act eliminated foreign property from tax-deferred exchange eligibility and required the acquired property in an exchange among related parties to be held at least two years; otherwise, the profit is taxable to the former owner of the property.

If you want to read more about tax-deferred exchanges, the book Real Estate Exchange and Acquisition Techniques (Second Edition), by William T. Tappan Jr., is highly recommended. Further details on tax deferred exchanges are available from your tax adviser.

NEXT: How to deduct your casualty losses.

Robert J. Bruss is a nationally syndicated columnist on real estate.