Most real estate investors are generally aware of the tax-free exchange provisions contained in Sec. 1031 of the Internal Revenue Code. These provisions allow you to exchange one piece of investment or business real estate for another without the payment of income taxes.
Normally a seller of real estate will consider an exchange so that he will not have to pay taxes on the property he is about to sell. However, even if you are about to become a buyer of real estate, you might want to consider Sec. 1031 before you sign the contract.
How can a buyer benefit from Sec. 1031? Oftentimes a buyer owns other property he is planning to sell eventually. For example, a company buying a new factory or distribution center might plan on selling its old facility after moving to the new one, or an investor may simply have some other property in this portfolio that he is planning on selling at some time in the future. If so, the buyer should consider accelerating the sale so that the purchase and sale can be tied together in a tax-free exchange.
Three-Way Deferred Exchange
The words "tax-free exchange" connote a trade of properties between two parties, each of which trades the property he owns for the property of the other. It almost never happens that way. Obviously, it is next to impossible to find someone who wants to acquire your property and who also has property you want to acquire. Fortunately, the Internal Revenue Code Authorizes what is known as a deferred three-way exchange. Under this arrangement, you sell your property and have the money placed directly in a trust, normally with the title company. When you find the property you want to buy, you have the title company use this money to but the property for you "in exchange" for the property you gave up. Even though the procedure bears little resemblance to an actual trade of two properties between two parties, the end result is the same and you are allowed to treat it as an exchange for tax purposes.
The basic requirements of a deferred three-way exchange are as follows:
First, the properties must be of “like kind.” Fortunately, almost any kind of real estate is considered to be like kind with any other, so long as they are both held for investment or for business purposes. Land may be exchanged for income property, or an office may be exchanged for a factory. However, real estate may not be exchanged for stocks, bonds, or personal property, and a partnership interest (even in a land partnership) may not be exchanged for real estate, although there are sometimes ways around the latter if properly structured.
Second, the replacement property (the property you are acquiring) must be designated in writing within 45 days of the closing of the sale of the property you are selling. You can designate more than one property, and do not have to actually purchase each and every property you designate, but there are limits. You can always designate up to three properties (the "three property rule"); or you can designate more than three if their total value does not exceed 200% of the value of the property you sold (the "200% rule"). If you designate too many properties and break both of these rules, you will lose your tax-free exchange.
Third, you must close the purchase within 180 days of the closing of the sale.
Fourth, you cannot receive or have access to the money in the trust until the 180 days elapses.
What happens if you have some money left over? If you do not spend all of the money you received from the sale of the property on the acquisition of replacement property, you are deemed to have received "boot" and will have to pay tax on your gain up to the amount of "boot" you received. For example, if you receive $10,000 cash out of the exchange, you will have to pay tax on your gain up to $10,000.
If the property you sell is subject to a mortgage which the buyer assumed or took subject to, this is treated the same as additional cash or "boot" and is subject to tax. However, you may offset this "boot" by the amount of any mortgages you assume or take subject to on the property you acquire. If you realize cash on the exchange sale and also sell property subject to a mortgage, the amount of taxable boot can become quite large. Therefore, it is a good idea to try to purchase a property with a mortgage on it that is at least as large as the mortgage on the property you are selling. In some cases the seller of the property you are acquiring can be persuaded to refinance his property with a larger mortgage in order to help you achieve that objective. That way he gets his cash out and you avoid income taxes.
Deferred tax-free exchanges can postpone the payment of taxes indefinitely, a considerable benefit in these times of high and rising capital gains taxes. Whenever you are selling, or even when you are buying, real estate, at least consider an exchange. However, the rules are exacting and complex, and professional help is strongly advised. A small mistake can render the entire transaction taxable.