Selling investment real estate without paying tax

Issue January 2003

"Gee, I didn't know you could do that," is the lament often heard from owners of investment real estate who discover, too late, that they could have deferred income tax on its sale. If the real estate is investment or business property, the gain can be deferred through a like-kind exchange.

1. What is a like-kind Exchange?

Section 1031 of the Internal Revenue Code permits a nonrecognition of gain if the following conditions are met:

First, the property transferred ("relinquished property") and the exchange property ("replacement property") must be property held for productive use in trade, in business or for investment.

Second, there must be an exchange; not merely a sale followed by a subsequent purchase. This doesn't mean, though, that you trade deeds with another. Taxpayers are allowed to enter into deferred exchanges, selling property then purchasing any like kind property within certain time frames.

Third, the replacement property must be of "like kind." As a general rule, all real estate is considered "like kind" with all other real estate. Thus, raw land can be swapped for an office building etc.

2. Mechanics of deferred exchanges - How does it work?

a.Documentation & Escrow of Sales Proceeds.

The taxpayer should contact a "qualified intermediary" ("QI") before signing the P&S, and immediately begin looking for replacement property (because of the deadlines discussed below). A QI is necessary because the exchange must be properly documented to withstand IRS scrutiny. Also, the proceeds of the sale of the relinquished property must be held by a neutral party - the taxpayer cannot have direct or indirect control over the sales proceeds during the exchange period.

b. Timing Rules

The replacement property must be identified in writing before the 45th day after the day on which the relinquished property is transferred. The actual closing for the replacement property must occur no later than 180 days after the taxpayer transfers the original property, or the due date - with any extension - of the taxpayer's return of the tax imposed for the year in which the transfer is made.

3. Tax Consequences

For a fully tax deferred exchange, the replacement property must equal or be greater than the value (sale price) of the relinquished property, and all of the equity from the relinquished property must go into acquiring the replacement property.

4. Why do an exchange?

a. Convert non-income producing real estate investments, such as raw land, into income producing property, such as an apartment complex.

b. Rebuild equity by disposing of topped-out properties and acquiring new ones.

c. Exchange out of economically depressed or deteriorating areas.

d. Conserve all equity by deferring taxes, and use the preserved equity to increase purchasing power.

5. In conclusion

Use experts because it is too easy to make a mistake and lose tax deferral. Improperly documented exchanges have led to numerous disallowed exchanges. Missing the 45 day or 180 day rule deadlines will cause the entire exchange to be disallowed.