TAX FREE EXCHANGES
At the April 2004 meeting Desmond Sheridan gave a presentation on tax free exchanges. The handout Mr. Sheridan used is reproduced below. Tax free exchanges can be a valuable tool in the buying and selling of real estate, but they are complex transactions with no margin for error. If you are contemplating the use of a tax free exchange seek competent legal advice. Mr. Sheridan can be reached at Isaacson, Isaacson, & Sheridan (275-7626).
ISAACSON ISAACSON & SHERIDAN, LLP
Attorneys and Counselors at Law
Suite 400 Bank of America Building
101 W. Friendly Avenue
Telephone (336) 275-7626
Henry H. Isaacson Mailing Address:
Marc L. Isaacson P. O. Box 1888
Desmond G. Sheridan Greensboro, NC 27402
Jennifer N. Fountain
Writer’s e-mail: dsheridan@iislaw.com
MEMORANDUM
TO: Greensboro Landlords Association, Inc., Inc.
FROM: Desmond G. Sheridan
DATE: April 8, 2004
RE: Tax Free Exchanges of Real Estate Under Section 1031 of the Internal Revenue Code
This is a standard letter we send to clients involved in tax free exchanges of real estate under Section 1031 of the Internal Revenue Code. This letter is not intended as a legal opinion about any exchange in particular, but only to explain the rules generally and to address some frequently asked questions. Please do not take any action based on this letter until you have consulted with a qualified tax advisor.
Example.
In 1956, your client bought real estate out on the bypass for $50,000. The real estate now has a fair market value of $1,000,000. Although there is a buyer for the property, the client is advised that the sale of the property would result in state and federal tax of as much as $300,000. The property is investment property which generates a pre-tax rate of return of 7 percent of its value (approximately $70,000 per year). Your client learns that the after-tax proceeds of the sale of this property, even if invested at 7%, would yield only a return of $49,000 per year ($1,000,000 minus $300,000 times 7%). Therefore, the sale of the property, even though at a substantial gain, would reduce his investment income. Thus, the client is reluctant to proceed with the transaction. [Note that if the client is elderly or in poor health, his heirs would be entitled under Section 1014 to a basis "step-up" in the property at the client's death. In other words, they could receive the property at a basis equal to its fair market value of $1,000,000 and, thus, have no income tax on the subsequent sale of the property. In that case, it makes even less sense for the client to sell the property and incur the tax currently.]
.
Exchanges in General.
Tax free exchanges work when property is exchanged for other property of a Alike kind.@ Most types of real estate are like kind for other types of real estate. For example, undeveloped farmland can be like kind with a shopping center. There are some unusual types of property (such as timber rights) where the like kind issue must be examined more closely.
How the Exchange is Effected.
A modern exchange is typically effected through a AQualified Intermediary@. The Qualified Intermediary must be an unrelated party. For example, the Qualified Intermediary cannot be a relative, your accountant or your attorney. We typically use an institutional Qualified Intermediary, usually a title insurance company. The title insurance company charges separate fees from us for handling the exchange. Currently, we use Investors Title Exchange Corporation as our Qualified Intermediary. Contact information is as follows:
Ms. Caroline Vogel
Investors Title Exchange Corporation
121 N. Columbia St. (27514)
P. O. Drawer 2687 (27515-2687)
Chapel Hill, NC
Telephone: (800) 326-4842
Fax: (800) 653-9811
Once you have entered into a contract for the sale of your property, we prepare a AQualified Intermediary Exchange Agreement@. This Agreement assigns your contract for sale of your property to the Qualified Intermediary. At the closing of the sale of your property, the Closing Agent (usually an attorney) must prepare the closing statement in accordance with certain requirements. It is very important that you provide us with contact information for the Closing Agent well in advance of closing so that we can send the Closing Agent appropriate instructions and documents.
We will instruct the Closing Agent to send your proceeds directly to the Qualified Intermediary. The Qualified Intermediary will then hold the funds, pending completion of the exchange. The Qualified Intermediary will place the funds in an interest bearing account. It is very important that you provide your tax identification number to the Qualified Intermediary as soon as possible so that the account can be set up properly and interest can begin to accrue.
Replacement Property.
Once you have completed the sale of your property (and funds have been sent to the Qualified Intermediary), you will have forty-five (45) days to identify replacement property. The identification must be done in writing. Please provide us with sufficient information to identify the property in advance of the deadline so that we may prepare an appropriate identification document.
You do not have to narrow your replacement property down to one (1) choice. Generally, you can identify up to three (3) properties (and close on only one), however, there are some exceptions which may allow you to identify more than three (3). Please call me to discuss this if this is an issue.
You must close on the replacement property within one hundred eighty (180) days of the sale of your exchange property. Please note that the 45 day and 180 day deadlines are inflexible and cannot be extended by the IRS. However, there are some planning techniques we sometimes use in order to give the client a longer period of time in which to make these decisions. Again, please call me to discuss if this is an issue.
Once you are ready to close on your replacement property, we will again provide instructions to the Closing Agent as to how to handle the exchange issues. Please note that we handle numerous real estate closings and would be happy to assist if the replacement property is in our market area. However, there is no requirement that you use our closing services in order to complete your exchange. Just let us know as soon as possible who will be closing the transaction (if not us) so that we can provide appropriate instructions.
At the closing of the purchase of the replacement property, the Qualified Intermediary will send the funds to the Closing Agent so that the Closing Agent can complete the transaction.
Reporting the Exchange.
Your accountant will need copies of closing statements for the sale of the exchange property and the purchase of the replacement property. The exchange transaction is reported on IRS Form 8824.
Special Issues.
Q: I have already entered into a contract to sell my property. Can I still do an exchange?
A: Yes, although completing the exchange will provide some cooperation (but no expense) on the part of the Buyer.
Q: I need to purchase my replacement property before I will be ready to sell my exchange property. Can I still do an exchange?
A: Yes, however, this is a much more complex transaction and certain rules must be closely followed. Please call me to discuss.
Q: What if I do not do an exchange? How are my taxes calculated?
A: Generally your taxable gain is the sale price of the property (net of selling expenses), less your basis in the property. Most real estate is subject to a 15% (federal) capital gains rate. However, depreciation recapture is taxed at a 25% rate. The transaction is generally subject to state tax as ordinary income.
Q: I am selling my property for $200,000. The replacement property only costs $150,000. How will my taxes be calculated?
A. The answer depends on your basis in the property. In order to pay no tax, you must spend the entire sale price of your exchange property (in this example $200,000). In order to save any tax by exchanging, you must spend more than your basis in the exchange property. Suppose your basis in this property is $110,000. If your replacement property costs only $100,000, you will still pay tax on $90,000 (the same tax you would pay if you did not do an exchange at all). However, if your replacement property costs $150,000 and your basis is $110,000, you would defer gain on $40,000 and pay tax on $50,000. The amount that you pay tax on in an exchange is called Aboot@).
Q: I have debt on the property I am selling. What effect does that have on calculating my gain?
A: Your gain is calculated based on the sale price, whether you have debt or not. That is a problem because it means that the debt must be paid off at closing, thus reducing the cash
available to purchase replacement property. Therefore, people with debt on their exchange property generally need to purchase replacement property with debt as well.
Q: What happens to a gain that is deferred with a 1031 exchange?
A: The gain does not disappear, but is rolled into the replacement property. This is done by reducing your basis in your replacement property. For example, if you have a $110,000 basis in your exchange property, sell it for $200,000 and purchase replacement property for $200,000, your basis in the replacement property will be $110,000 (the same as in your exchange property). Therefore, the gain is preserved and you would have to pay the tax if you ever sell the replacement property without doing an exchange. Also, if the property is depreciable (such as building improvements to real estate), the depreciation which can be taken over the depreciation period is reduced because your basis is reduced.
Conclusion.
We hope this letter has been helpful to you in understanding how exchanges work. Exchanges are, however, fairly complicated. It is most important to be aware of the 45 day and 180 day deadlines described above and mark them on your calendar. Please call me if you have any questions regarding this letter or if any other issues arise on which you need my help. We look forward to serving you on this matter.