With single-family home and apartment rents rising plus bargain properties still on the real estate market, investors are looking to take advantage of attractive deals.
In fact, some real estate salespersons are reporting that large groups of investors are the biggest purchasers of distressed homes, including foreclosure sales held on the steps of many county courthouses.
In an effort to tie up some properties, investors have been asking not only about tax-free exchanges but also reverse tax-free exchanges.
Nearly 14 years ago, the federal government enhanced 1031 Delayed Exchanges that allow taxpayers to defer the capital gains tax on an investment property if they purchase a “replacement” investment property of equal or greater value within specific time frames. The enhancement, Internal Revenue Procedure 2000-37, permits the title to the “replacement” property to be held by an independent third party (typically a facilitator or attorney) until the “old” property sale closes. In other words, you can buy before you sell and still defer the gain.
According to Cris Anderson, a tax-deferred exchange specialist for Asset Preservation Inc., one of the problems with the reverse exchange is that investors still need the cash to buy the property.
“Even though something might be an absolute deal and too good to be true, an investor needs help from a lender or private party to buy the property,” Anderson said. “It’s difficult finding financing for exchange properties.”
This original concept of a 1031 Delayed Exchange, or Starker Exchange, is named after T.J. Starker, an Oregon man who made a deal with Crown Zellerbach in 1967 to exchange some of his forested property for some suitable “like kind” future property. That agreement ended up in court. Starker’s battle was the basis for congressional approval of delayed exchanges.
The clock does not start ticking on a tax-free exchange until the first property closes. Then the seller has 45 days to identify a replacement “like-kind” property of equal or greater value and 180 days to close that second leg of the exchange.
In real estate, “like kind” can apply to a variety of situations and is quite flexible. A house may be traded for an apartment building; vacant land for an office building, etc.
A house that is the owner’s primary residence cannot be traded for investment property. Nor do stocks, bonds, securities and similar equity investments qualify as “like kind.” Likewise, if you own land and build a structure on it with 1031 exchange funds, the IRS will probably not consider your investment an exchange.
One of the more complex parts of the original regulations explains that within the 45-day period following sale of the investment property, you can identify three or more parcels of property, regardless of value, that you may wish to buy for your new investment.
In other words, you can consider taking the equity from your first rental house and reinvesting it in three or more new pieces of real estate without paying taxes.
However, if the number of parcels on your list exceeds three, and their combined value is greater than 200 percent of the property sold, you are required to buy 95 percent of the total sales price of the replacement properties.
To totally defer capital-gains tax, you must pass the IRS’ acid test by:
• Trading even or up in value.
• Trading even or up in equity.
• Not pocketing any cash from the first sale.
• Identifying the new (or old) property, or properties within 45 days of the sale. (This typically means having a signed purchase and sale agreement.)
• Closing the transaction within 180 days.
“In this environment, investors are thinking twice about reverse exchanges because they don’t want to take on the financial risk and the business risk,” Anderson said
“It’s far more likely to see individuals tying up a property with a longer closing date under the conventional tax-deferred exchange.”