Part 6 in a 12-part series on realty tax tips.
Would you like to become wealthy without paying income taxes? If you answered "yes," one of the few legal methods to accomplish your goal is to pyramid your real estate assets by trading up from a small property to a larger one, then do it again and again.
Internal Revenue Code 1031 sets the rules for tax-deferred realty exchanges of virtually any property except your personal residence or "dealer property." A qualified tax-deferred exchange involves trading equal or up in both value and equity without receiving any taxable "boot" which means unlike kind property such as cash or net mortgage relief. However, if you need cash from time to time you can refinance and take out tax-free cash if the refinancing is not part of the exchange.
"Like kind" property is required. To qualify for an IRC 1031 tax-deferred exchange, any real property is eligible except (1) your personal residence or (2) dealer property, such as a home builder's inventory of unsold homes. Qualifying examples include trading a rental house for apartments, swapping a hotel for a shopping center and exchanging an office building for a warehouse.
All these properties are considered to be "like kind" because they are held for investment or for use in a trade or business. But "like kind" does not mean "same kind" of property. To illustrate, you do not have to trade apartments for apartments or a warehouse for a warehouse.
Why exchange? The primary reason for making a tax-deferred exchange is to avoid paying income tax on your capital gain profit when selling one property and acquiring another. To avoid having your profit eroded by income tax, IRC 1031 considers an exchange of a qualifying property for another to be one continuous ownership, so no tax is due. By not paying tax on your profit you have more money available to acquire a larger property.
In addition to avoiding income tax, other reasons for exchanging include (1) trading out of a property which is difficult to sell for one which is more salable, (2) increasing your depreciable basis by acquiring a larger depreciable property, (3) minimizing the need for new mortgage financing, (4) avoiding recapture of accelerated depreciation, (5) acquiring a property that better meets your investment goals, and (6) pyramiding your wealth by acquiring more promising property without paying tax along the way.
The three types of exchanges. Although Uncle Sam views exchanges as one continuous investment, in the real world there are three basic types of property trades (which can involve more than two properties in one exchange):
1. Direct exchanges rarely occur because the owner of one property rarely wants the property owned by the other party to the exchange. For example, if you want to trade your rental house for an apartment building, the apartment owner probably doesn't want your house in exchange. Instead, he might prefer to acquire a larger property, such as a shopping center.
2. Three-way exchanges solve many of the drawbacks of direct exchanges. A three-way or three-party exchange involves (a) an "up trader" who is trading up to a more valuable property, (b) a "down trader" who is selling the larger property in the exchange and doesn't mind receiving some taxable cash profit, and (c) a waiting "cash-out buyer" who is standing by to purchase the smaller property for cash after the exchange is completed.
3. Starker delayed exchanges are much easier because after the first property is sold, usually for cash, the sale proceeds are held by a third-party intermediary such as a bank trust department, and this money is later used to buy the second qualifying property to complete the "delayed" exchange.
Internal Revenue Code 1031(a)(3) establishes the tax rules for Starker exchanges, named after the late T.J. Starker whose 1979 court decision (602 Fed.2d 1341) created this unique trading method. In a Starker exchange, the up trader must designate the property to be acquired within 45 days after the sale of the old property is completed. The property acquisition must be completed within 180 days after the sale of the old property. Meanwhile, the sale proceeds are held by a third party beyond the up trader's constructive receipt.
Additional exchange rules in the 1989 tax act. In addition to the simple exchange rules explained above, the 1989 Tax Act (1) prohibits foreign property from being part of tax-deferred exchanges and (2) if a property is acquired from a close relative it must be held at least two years by the acquiring party, otherwise any resale profit is taxed back to the relative who formerly owned the property.
For further information, the best book on tax-deferred exchanges is William T. Tappen Jr.'s Real Estate Exchange and Acquisition Techniques _ Second Edition (Prentice Hall, 1989, $19.95), available in stock or by special order at local bookstores. Your tax adviser can give you further details on how to exchange your investment or business properties and pyramid your wealth without paying income taxes on your profits.
NEXT WEEK: Home equity sharing advantages and disadvantages.
Robert J. Bruss is a nationally syndicated columnist on real estate. Write to him in care of At Home, St. Petersburg Times, P.O. Box 1121, St. Petersburg, Fla. 33731.