Capital Gains Tax Can Be Avoided Through Property Exchanges Third-Party Intermediaries Facilitate The Exchange Process
On the surface, it seemed like a lifetime opportunity for Richard and Marjory Abbott of East Williston, N.Y.: A nearby hospital was offering a sizable sum for some rental property they had purchased 20 years ago.
Yet the Abbotts, both age 70 and semiretired, were reluctant to sell. They were concerned about the large capital gains taxes with which they’d be hit, plus they wanted to remain real estate investors a little longer.
Not a problem, it turned out. The couple not only managed to accommodate Winthrop Hospital in Mineola, N.Y., which needed their property to expand its facilities, but to stay invested in real estate and avoid taxes on capital gains.
A little-known section of the Tax Code, Section 1031, permits owners of investment or business real estate to defer paying income taxes on the profit from a sale by entering into an exchange transaction through a third-party intermediary.
What happens in a 1031 transaction is this: Owners sell their investment property, and the proceeds of the sale are held in escrow by an intermediary, who rolls over the money into another property on behalf of the client. The purchased property is usually picked out by the clients ahead of time.
The Internal Revenue Service says the exchange has to be for “like-kind” property, a term loosely meaning just about any other type of investment real estate, from condos and town houses to strip malls and undeveloped land. In some states, even the rights to natural resources, like water or timber, fit the definition.
In the Abbotts’ case, their property, which consisted of a couple of two-family homes which they had rented out over the years, was sold to Winthrop Hospital for about $750,000 and “exchanged” for part-interest in several out-of-state commercial properties leased to popular restaurants.
“For us the whole thrust was, we weren’t looking to get out of real estate … but we wanted to help out the hospital and not get hurt” by taxes, said Abbott.
He said that since the original purchase price of the property was significantly less than the sale price, he and his wife stood to lose about a third of the profits to taxes. The situation would have been different had the property been a primary residence - up to $500,000 of gain realized on a sale can be excluded under The Taxpayer Relief Act of 1997.
When the Abbotts are ready to get out of real estate investing, however, they will have to pay the taxes on their capital gains.
Because property owners don’t directly handle any cash, the transaction is considered an exchange, and therefore qualifies for the special treatment under Section 1031.
“You could conceivably defer paying capital gains forever if you hold that property until you die … then your heirs can hold onto it,” said Tim Egan, executive director for the Federation of Exchange Accommodators, a Sacramento, Calif.-based trade group representing the intermediaries, which are responsible for handling the reams of paperwork involved in the transactions.
Anyone considering such a swap should be aware of the very strict guidelines. For instance, the property being purchased in the exchange must be of equal or greater value than the property being sold. It cannot be a primary residence, nor a second home, unless it’s mainly used for income. Also, the intermediary cannot be the property owner’s lawyer or accountant.
And there are time restrictions. The exchanged property must be identified within 45 days once the exchange contract is put in motion, and the exchange must be completed in 180 days.
“Before you even list the property, you have to make a decision that you’re going to do an exchange,” Egan said. “You can’t in midstream decide to do this, just as you can’t back out once you’ve made a decision.” Ed Horan, president of Realty Exchange Corp., based in the Washington suburb of Haymarket, Va., handles close to 100 transactions a year, mostly from small-scale property owners and investors. He says property exchanges are especially useful for individuals tired of being a residential landlord; the owners can swap residential property for commercial property or land.
Among the more popular exchanges: rollovers of urban rental property into resort vacation property, he said.
Horan says some of his clients plan to make personal use of their units to the maximum allowed for investment property under the tax code - around 14 days a year, plus “maintenance” visits to repair or keep the property in shape for rental. A few clients eventually plan to convert the new unit into their full-time residence, he says, thereby linking 1031 exchanging with retirement and estate planning strategies.
Qualified intermediaries, such as Horan, provide the step-by-step exchange agreements, contracts, escrow accounts and related services needed to pass muster with the IRS. Their fees range from $700 upward, depending upon the complexity of the deal.
For John Koenig, 50, of Albany, N.Y., who oversaw a 1031 transaction on behalf of his mother, Bertha, it was worth it. He admits, however, to being somewhat apprehensive about turning over money to a third party.
After overcoming that, “I think it’s a wonderful way to shelter or preserve any kind of equity until a time you really need that equity,” Koenig said. “The tax does take quite a bite, and if you are trying to have a strategy to have a comfortable retirement, this is a good vehicle.”
The concept of property exchanges has been around for decades. But it didn’t start to take off until the early ‘90s, after the IRS established guidelines for Section 1031 transactions, according to Egan.
“It’s just starting to be known to the general public,” he said.
xxxx Exchange information The Federation of Exchange Accommodators can provide a list of third-party intermediaries who are members of the trade group. The federation can be reached at: 1127 11th St. Suite 1003 Sacramento, Calif. 95814-3808 Phone: (916) 388-1031; Fax: (916) 447-6244