ost real estate investors recognize the obvious benefit of an IRC section 1031 exchange—the tax bill due Uncle Sam is put on hold, allowing the full amount of equity in the property to continue compounding. What some investors are just beginning to realize is that exchanging does far more than just delay income tax consequences; it is a powerful tool that can help accomplish a variety of other investment goals.
Because of these advantages (see exhibit 1), an increasing number of CPAs are advising clients to consider using a tax-deferred exchange before structuring real estate transactions. With more clients deciding to use exchanges as part of their investment strategies, it’s critical that CPAs understand not only the standard exchange under section 1031 but also the basics of several more specialized exchange techniques.
The majority of exchanges today are “delayed,” meaning the sale of the existing property and the acquisition of a new one take place at different times. While such exchanges are relatively easy to execute, they typically require the services of a qualified intermediary (QI). (See the sidebar for information on selecting a QI.) Section 1031 and Treasury regulations section 1.1031 provide clear guidelines for executing exchange transactions. When an investor (the exchanger) sells his or her property, the QI coordinates the necessary paperwork and holds the sale proceeds. The exchanger then has 45 days after the sale to identify a list of potential replacement properties and 180 days after the sale to acquire one of those properties. At that time, the intermediary again coordinates certain paperwork and forwards funds to pay for the acquisition; the exchange is then complete.
Example. Brian owns a piece of undeveloped land in rural Michigan he wants to dispose of through an exchange. After consulting his CPA, Brian puts his property on the market and hires a QI, who coordinates the necessary paperwork. When the land sale closes, the QI holds the proceeds. Within 45 days Brian identifies three pieces of property he wants to buy outside Detroit and successfully negotiates a contract to buy one of the parcels. Within the required 180 days the QI releases the funds Brian needs to close the purchase and the exchange transaction is complete. Brian has successfully postponed any gain he had on the original property.
Although standard exchanges are relatively easy to complete, transactions that involve special circumstances (see exhibit 2) can be more challenging. The following complex exchange strategies offer more flexibility for unique situations.
REVERSE OR “PARKING” EXCHANGES
The deferred exchange regulations outlined above apply only to so-called forward exchanges in which an investor first sells the property he or she currently owns (the relinquished property) before closing on the new property (the replacement property). In reality, the investor may find the perfect replacement property before the relinquished property is even on the market. If the seller is willing to extend the closing date to give the investor time to sell his or her existing property, a standard delayed exchange is feasible. If the seller won’t extend the closing date, the investor may consider a reverse or parking exchange.
Under this method, a third party unrelated to the exchanger purchases and holds (“parks”) the replacement property. (Although several third parties can perform this function, it is typically handled by a QI.) Once the investor sells the relinquished property, he or she purchases the warehoused property—from the third party—as the replacement property, completing the exchange.
The IRS recently announced it will issue a revenue ruling on these types of exchanges. Until it does so, however, CPAs will find limited guidance in these cases:
Example. Each summer Karen and Paul spend two weeks in Breckenridge, Colorado. Last year, they fell in love with their four-bedroom condominium rental at the base of a new ski run. The owner says he might be interested in selling the property.
Karen and Paul own a small apartment complex near their home in Atlanta, which provides attractive annual cash flow but has only marginal appreciation potential. Because their CPA has suggested they look for ways to lower their tax bill, Paul and Karen are open to an investment with high appreciation potential and low cash flow. They have successfully negotiated a contract to buy the condo. However, the seller insists on closing in 60 days.
Under a standard exchange, Karen and Paul would have to sell the apartment complex in 60 days, probably at a much lower price than they might realize with a longer sale period. Rather than lose part of their equity, Karen and Paul opt to try a parking exchange.
A QI sets up a separate entity (usually a LLC or regular corporation) that acquires and warehouses the Breckenridge condo with funds loaned by Karen and Paul. (They have obtained a line of credit from their bank, secured by the apartment complex.) Within four months, they are able to sell the apartment complex at an attractive price. Once the complex is sold, the entity sells the Breckenridge replacement property to the couple and repays the loan, completing the exchange. Karen and Paul are able to successfully defer any taxes due and trade moderate cash flow for high appreciation potential. They also now have a great place to vacation.
It often makes more economic sense for an investor to purchase a lot and build the replacement property. This is particularly true if he or she can’t find the ideal property at a reasonable price or if the right kind of property is hard to find. To successfully defer all taxes, the replacement property cost must equal or exceed the relinquished property price. If the replacement property value is less, only part of the taxes may be deferred.
Building the replacement property often poses a problem because the price of the unimproved lot typically is much less than the value of the relinquished property. If the taxpayer’s goal is to maximize exchange benefits, he or she needs a way to increase the lot’s value by having some or all of the improvements built before taking title to the property. Under such circumstances, CPAs should encourage clients to consider a construction exchange.
In a construction exchange, a third party—again set up by the QI—purchases the lot on which the improvements will be built and holds title to the property during the construction period. Once the cost of the lot and improvements equals or exceeds the value of the relinquished property, the third party transfers the new property to the investor, concluding the exchange. Exhibit 3, below, lists some other important characteristics of parking and construction exchanges.
Example. ShopFast owns and operates a number of quick marts in the Southeast. Management decides to accept an offer to buy four of the properties and starts looking for larger sites nearby. When they learn the taxes on the proposed sales may run as high as $500,000, they ask their in-house CPA to suggest other options.
After discussions with a QI, the accountant reports that despite the additional steps required and higher transaction costs, a construction exchange is the best alternative. The intermediary sets up a warehousing entity specifically for this transaction. Once the sale of the four stores is complete, the entity uses part of the sale proceeds to purchase the lots management has identified for the new stores.
Construction takes approximately five months. Construction costs are first funded from any remaining sale proceeds and then through a construction loan. When the new marts are finished, the intermediary transfers them to ShopFast, completing the exchange. The goal of the exchange is met: The company has upgraded four of its existing locations while dodging a $500,000 tax bill indefinitely.
REVERSE CONSTRUCTION EXCHANGE
Another type of complex exchange essentially is a combination of the first two methods. An investor should consider a reverse construction exchange when he or she must purchase the lot to be improved before selling the relinquished property or when construction is expected to take more than 180 days.
Example. Kathleen Murphy finds a site for a rental home on a golf course in Sedona, Arizona. Because she and her husband Scott hope to move there when they retire, she decides to buy it. The lot is listed for $200,000. The Murphys are familiar with exchanges and wonder whether it’s possible to sell a piece of land they currently own in North Carolina and use the Arizona lot and the house they will construct as the replacement property.
The Murphy’s land has a fair market value of $400,000 and a negligible cost basis. Construction on the new rental house is expected to take more than 12 months and cost approximately $300,000. A standard exchange will require a quick sale of the North Carolina property and will defer taxes on only $200,000 of the proceeds. The Murphys can afford to buy the Sedona property now and sell the existing land later. They ask their CPA to explore a reverse construction exchange to see whether it will result in significant savings.
If Scott and Kathleen sell the existing property without an exchange, they calculate that approximately $300,000 will be left after taxes to put in other investments. If they can structure an exchange, they can reinvest the full $400,000 in the Sedona property.
Because they want to maximize their investment return, the Murphys ask their CPA to calculate the worth of the $300,000 of aftertax proceeds in 10 years assuming they reinvest the funds in certificates of deposit yielding 6.5% or in stocks and bonds earning 10%. The CPA compares those results with the worth of the $400,000 of tax-deferred proceeds if they are reinvested in the Sedona property—assuming the property earns a 10% annual return. As exhibit 4, above, shows, a reverse construction exchange is the clear winner because it keeps an additional $100,000 of proceeds working in the future.
PERSONAL PROPERTY EXCHANGES
This type of complex exchange works in much the same way as a standard real estate exchange, except the item or items being exchanged are personal property (referred to as depreciable tangible personal property). Essentially, a taxpayer can sell an item that qualifies as “held for productive use in a trade or business or for investment” and replace it with other property that is of like–kind. Some examples of personal property a taxpayer may exchange include
The good news is that such items can be exchanged; the bad news is that the process of doing so is often more difficult because the definition of like–kind is much stricter for personal property. To qualify for exchange, Treasury regulations section 1.1031(a)-(2)(b) requires that personal property be in the same general asset or product class. (Revenue procedure 87-56 defines asset classes; product classes are found in the Standard Industrial Classification Manual. )
Although these types of exchanges have been widely overlooked, individuals and companies are discovering the tax benefits of doing a carefully structured personal property exchange—despite the restrictions of applying like–kind treatment.
Example. Ann Marie plays the violin for a major U.S. symphony. She decides to sell her current instrument and upgrade to a more expensive one. Because her violin has quadrupled in value, she will have a sizable tax bill if she sells it outright. With properly structured documents tailored to her situation, she can acquire the new violin in an exchange and reap the same benefits enjoyed by real estate investors.
A personal property exchange is also a good idea for a company about to upgrade the corporate jet it owns for business travel. If the plane has been aggressively depreciated, a sale can trigger a sizable gain. (Recapture of depreciation on personal property is not taxed at the lower capital gains rate but, rather, at the more onerous ordinary income rate.) In this case, a personal property exchange may prove especially beneficial.
This last type of complex exchange is a combination of a standard deferred exchange and a personal property exchange. Some investments, such as restaurants, hotels, nursing homes and television stations, include both real estate and a significant amount of personal property (described above). With careful planning, taxpayers can use a 1031 exchange to defer taxes on both types of property in one coordinated transaction.
As noted earlier, the definitions of like-kind property that govern personal property exchanges are strict. However, with a sizable portion of the value in some exchanges often allocated to personal property, overcoming these additional hurdles is worth the effort. A multiasset exchange is worthwhile if the acquired property includes personal property items in the same product or asset class as the relinquished property.
Example. Pinnacle Care Facilities LLC owns five nursing homes in Maine. To keep pace with the state’s growing elderly population, Pinnacle has begun selling older, smaller locations and acquiring newer, larger facilities. When the company receives an offer for one of its locations, Pinnacle’s owner quickly surveys the area and locates a larger facility that matches the company’s expansion goals. She then contacts her CPA, who arranges a meeting with a QI. Together, the three parties coordinate the strategy necessary to successfully complete a multiasset exchange. Using this exchange method allows Pinnacle to defer taxes not only on the sale of the real estate but also on the significant amount of personal property—furnishings, equipment, appliances, linens—included in the sale.
WORTH THE EFFORT
Complex exchanges are becoming increasingly popular because they make the benefits of exchanging available in transactions where a standard exchange can’t be used. Although such exchange methods often are more sophisticated and more costly, they generally are worth the effort. It is to the CPA’s advantage to recognize situations in which complex exchanges can be used successfully and to recommend them to clients as appropriate. The potential for significant tax savings also makes it in the client’s best interest to understand the benefits of such transactions. CPAs may want to use the information here as an opportunity to contact clients to ascertain whether they understand the opportunities complex exchanges can offer them.