A method by which a property owner disposes of one property and acquires another property. The capital gains tax on the transaction is deferred until some time in the future. The sale must be structured so that it is an exchange by the use of an exchange agreement and a qualified intermediary.
- Terminology in an Exchange
- Advantages of an Exchange
- Disadvantages of an Exchange
- Types of Exchanges
- Statutory Requirements
- Tax Consequences of Exchanges
- Legislative Updates
TERMINOLOGY IN AN EXCHANGE
- Relinquished or Exchange Property: The property originally owned by the taxpayer and disposed of in the exchange.
- Replacement Property: The new property the taxpayer wants to acquire in the exchange.
- Taxpayer/Exchangor: The person who owns the relinquished property and exchanges it for the replacement property.
- Seller: The person who owns the replacement property.
- Buyer: The person who wants to purchase the relinquished property.
- Intermediary: The person or company who facilitates a tax deferred exchange by holding and transferring the sale proceeds between the parties in return for a fee, and, in some cases, buying and then reselling the property.
ADVANTAGES OF AN EXCHANGE
- Defer Tax:
The taxpayer may dispose of property without incurring any immediate tax liability. This allows the taxpayer to increase his/her cash flow and use the deferred tax dollars in other investments. Thus, in effect, it can be considered an “interest free loan” from the IRS.
Moreover, if the taxpayer retains ownership of the replacement property, the tax liability is forgiven upon the death of the taxpayer and the taxpayer’s estate never has to repay the “loan.” The taxpayer’s heirs get a stepped up basis on such inherited property. Their basis is the fair market value of the inherited property at the time of the taxpayer’s death.
- Diversify Investments:
A taxpayer may split the proceeds from the sale of his/her investment property and acquire two or more properties. This reduces the risk of having all of the taxpayer’s “eggs in one basket,” and may increase the possibility of appreciation.
- Relocate an Investment and Eliminate Management Problems:
The taxpayer may relocate an investment in another part of the country to a local investment property that the taxpayer can more easily manage.
- Consolidate Investments:
The taxpayer may own two or more investment properties and consolidate them into one, larger property.
DISADVANTAGES OF AN EXCHANGE
- Reduced Basis in the Replacement Property:
The basis of the replacement property is carried over from the basis of the relinquished property. When the taxpayer later sells the replacement property, the taxpayer will realize more gain than if the taxpayer had purchased the replacement property through a straight sale and purchase.
- Increased Transaction Costs:
There are possible additional escrow fees, attorney’s fees, accounting fees, and intermediary fees, where applicable. In the Northern Virginia area, the extra closing fees and costs, including the preparation of documents, generally run between $500 and $1,500 in most transactions. Hometown Title & Escrow, LLC charges $850 for a standard 2-property exchange.
- Use of Proceeds is Restricted:
The taxpayer must use all of the net proceeds from the disposition of the relinquished property for reinvestment in real property to avoid tax consequences.
- Taxes may have to paid eventually:
(Unless the taxpayer owns the replacement property at his/her death, as discussed above.)
TYPES OF EXCHANGES
There are many ways of structuring a tax deferred exchange. The most common is a non-simultaneous, direct-deeding exchange with an intermediary. In this type of exchange, the taxpayer transfers cash to the intermediary. The intermediary transfers the cash to the seller. The seller transfers title to the replacement property to the taxpayer.
This type of exchange is non-simultaneous and is done in two parts because the replacement property is not known at the time the relinquished property is transferred to the buyer. The taxpayer has 45 days from the closing of the relinquished property to identify the property he/she wants as the replacement property. The transfer of the replacement property must close within 180 days of the transfer of the relinquished property.
- Property Requirements:
In general, all property, both real and personal, can qualify for tax-deferred treatment. However, some types of property are specifically disqualified, namely: stock in trade or other property held for sale; stocks, bond, or notes; other securities or evidences of indebtedness or interest; interests in a partnership; certificates of trust or beneficial interest; and any chose in action (i.e. interests in law suits). In most instances, tax deferred exchanges are conducted with real property.
- Qualified Purpose:
To qualify for tax-deferred treatment, the relinquished property must be held either for productive use in trade or business or for investment. The replacement property must also be held either for productive use in trade or business or for investment. Any real property other than a principal residence or dealer property (property acquired for resale) qualifies.
- Like Kind Property:
The relinquished property and the replacement property must be “like kind.” The term “like kind” is broadly defined, allowing a taxpayer, for example, to trade an investment townhouse in Reston, Virginia for an ocean front condo in Maui, Hawaii, or vice versa. All real property is like-kind, regardless of whether it is improved or unimproved. Furthermore, a fee-simple interest may be exchanged for more than one property. Personal property, however, is not like-kind to real property.
- Holding Period:
Currently, there are no regulations setting out the required period of time in which the taxpayer must hold both the relinquished property and the replacement property. A one-year period should be used as a rough rule-of-thumb until further regulations are established. If a taxpayer immediately sells his replacement property, rather than holding it for a one-year period, the exchange may not qualify for tax-deferred treatment if the IRS deems the property was, in fact, acquired for resale and is dealer property.
- Exchange Requirement:
One property must be exchanged for another property, rather than sold for cash.
- Time Restrictions for Non-Simultaneous Exchanges:
a. The taxpayer must identify the replacement property within 45 days after the transfer of the relinquished property, and
b. The taxpayer must settle on the replacement property before the earlier of (i) 180 days after the transfer of the relinquished property, or (ii) the due date of the taxpayer’s federal income tax return (including extensions) for the year in which the relinquished property is transferred.
- Multiple Properties:
a. The Three-Property Rule: A taxpayer may acquire up to three replacement properties, regardless of their fair market value.
b. The 200% Rule: A taxpayer may acquire more than three properties, if the total fair market value of all the replacement properties at the end of the 45 day identification period does not exceed 200% of the total fair market value of all property relinquished.
TAX CONSEQUENCES OF EXCHANGES
a. Basis = cost of property.
b. Adjusted Basis = Basis plus capital improvements minus deprecation.
c. Boot = cash, any liabilities assumed or taken subject to, or anything else of value received other than real property.
d. Realized Gain = Total consideration received by taxpayer (sales price of property) minus adjusted basis.
e. Recognized Gain = That portion of the realized gain which is taxable (i.e. the amount of boot received). Under Section 1031 of the IRC, the amount of gain recognized is limited to the gain realized or the boot received, whichever is less.
- Gain and Basis:
There are three simple rules for determining the amount of gain in an exchange and the basis of a replacement property.
a. To totally defer taxable gain in an exchange, the taxpayer must trade up or equal in both value and equity from the relinquished property to the replacement property.
b. The taxpayer is taxed on the greater of the trade down in value or equity from the relinquished property to the replacement property, but only to the extent of the realized gain from the exchange.
c. The taxpayer’s basis in the replacement property equals the fair market value of the replacement property less the amount of the gain deferred by the taxpayer from the exchange.
NOTE: This information is necessary general in nature. It should not be used or depended on for accomplishing an exchange.