Here is the Information you requested on Tax Free
Exchange Benefits
Here is your FREE copy of the Special Report that you requested.
I hope that you find it helpful.
Every year I witness buyers and sellers struggle with the same
questions and challenges, time and time again. That is why I put
together this Special report, in order to help people like you avoid
the struggles and pitfalls of those who have gone through it all
before.
Should you find that reading this report triggers any questions
pertaining to your unique real estate situation and needs, please
feel free to call me for information. Of course, there is never any
obligation when you call.
Sincerely,
Gerry O'Connor & The O'Connor Selling Team
Often investors do not realize taxation on a
personal residence is far different than taxation on land, income or
investment property.
The
Taxpayer Relief Act of 1997 changed Internal Revenue Code treatment
for the sale of a personal residence to allow a single taxpayer a
$250,000 exclusion from capital gain. Married couples receive
$500,000 exclusion. The taxpayer must have resided in the property
two of the last five years. This exemption may be used once every
two years.
If an investor sells appreciated property they
pay tax. However, property that qualifies for preferential tax
treatment under Internal Revenue code Section 1031 (IRC§1031) is
treated quite differently. IRC §1031 states:
“No gain or loss shall be recognized if
property held for productive use in a trade or business or for
investment is exchanged solely for property of like-kind.”
Therefore, an investor using IRC Section 1031
can exchange raw land for a rental home, an apartment complex for a
shopping center or rental houses for an office building. The use of
the property is a key factor in determining the tax treatment.
IRC § 1031 remained substantially unchanged
for the past 50 years until it was clarified with Treasury
Regulations in 1991. The Regulations redefined the “Starker” or
delayed exchange, including the 45 day identification requirements
for replacement property. These Regulations also encourage the use
of a Qualified Intermediary, deeming it a “safe harbor.” A “safe
harbor” is a term which defines acceptable guidelines so a
transaction will be regarded defensible.
Every dollar saved in taxes will
allow an investor to purchase 4-5 times as much real estate…
This
is possible through the use of leverage. Leverage is a method of
acquiring real estate worth many times the value of the initial
investment. Tax deferment increases leverage. To understand the
power of leverage, consider that ten percent appreciation is
converted to a 50% profit with a 20% down payment. The following
example shows the value of leverage by illustrating the benefit of
exchanging versus selling.
Assume an
investor sells a fully depreciated property and the capital gain is
$200,000. This amount is subject to taxation. Federal tax
brackets can range up to 25% for capital gain from depreciation.
State taxes can be as high as 10%. Assuming a total tax bracket of
approximately 35%, the capital gains tax would be:
$200,000 X 35%
= $70,000
If
the investor sold property with a gain of $200,000, they would pay
taxes of $70,000 and have only $130,000 left to reinvest. On the
other hand, the investor who exchanges pays no capital gains tax,
leaving the entire $200,000 to reinvest.
| |
SALE |
EXCHANGE |
|
Proceeds |
$200,000 |
$200,000 |
|
Tax Owed |
-70,000 |
0 |
|
Cash to Reinvest |
$130,000 |
$200,000 |
If each investor
purchases a building with a 20% down payment, using leverage each
could buy property worth:
|
Value |
$650,000 |
$1,000,000 |
In a single
transaction, the investor who exchanged has $350,000 more property
than the investor who sold property.
TOP
SECRET BENEFITS OF EXCHANGING
Prior to
1979, trading properties was at best complicated. Completing a tax
deferred exchange meant properties had to be “swapped”
simultaneously. Unfortunately, this made exchanging cumbersome and
risky, if not impossible.
The 1979 Starker decision in the U.S. 9th
Circuit Court of Appeals enabled the non-simultaneous or “delayed”
exchange to qualify for tax deferral. This gave investors the time
necessary to find desirable replacement properties by using an
Intermediary.
Treasury Regulations effective June 10, 1991
validated the delayed exchange and simplified the exchange process.
These Regulations which included the use of Qualified
Intermediaries, were welcomed by real estate owners who previously
uncertain of the viability of exchange transactions.
Many investors have held property for years
because a sale translated into paying substantial taxes on their
capital gain. Recent changes still do not offset the benefits of
exchanging. Typically, as an investor’s needs change over the
years, the type of investment property they want changes.
Relocation, estate building, retirement, desire to increase cash
flow, and the need to reduce management responsibilities, could all
affect the type of property investors want to own. Under IRC §1031,
property owners now have the alternative of moving their investments
(and equities) into more desirable or profitable properties.
The true power of exchanging is the ability
to meet investment objectives without losing equity to taxation.
Investors often
mistakenly believe they must acquire a property exactly like their
relinquished property. They are surprised to learn a wide variety
of properties can be considered “like-kind.”
“Like-kind” does
not refer to the type of property. Instead, it addresses the
intended use of the property. Provided the property is initially
acquired and held for either business or investment purposes, it can
qualify as a suitable replacement property under IRC Section 1031.
For example, any
of the following can be considered “like-kind” property exchanges:
a duplex for a fourplex, bare land for improved property, a rental
house for a retail center or an apartment for an office building.
Investors do not have to exchange for exactly the same type of
property as relinquished.
The tax code
lists items that are not considered “like-kind” and are expressly
excluded from non-recognition. These include: (1) stock in trade or
other property held primarily for sale; (2) stocks, bonds, or notes;
(3) other securities or evidences of indebtness; (4) interests in a
partnership; (5) certificates of trust of beneficial interest; and
(6) choses in action. In addition, the Code was amended in 1989
rendering property outside the United States as not “like-kind” to
US property.
The “Napkin
Test” was devised by California tax attorney Marvin Starr of
Miller, Starr, and Regalia, Oakland, California to provide investors
with a simple way to determine if there is potential taxable “boot”
in an exchange transaction.
Boot
“Boot” is a term
used to describe “non like-kind” property received in an exchange.
Cash, notes, personal property, reduction in mortgage (debt relief)
are all examples of “boot” and are subject to tax. Most
transactions can be restructured to help reduce or eliminate
“boot.” To avoid “boot”, an exchanger must trade across or up in
two areas: equity and mortgage.
The
Test
Example 1:
|
Property A |
Property B |
|
Sales Price |
$150,000 |
$225,000 |
|
Equity |
$50,000 |
$50,000 |
|
Mortgage |
$100,000 |
$175,000 |
In this example,
the exchanger is trading across or up in both areas. This is a
completely tax deferred exchange with no “boot.”
Example 2:
| |
Property A |
Property B |
|
Sales Price |
$150,000 |
$155,000 |
|
Equity |
$50,000 |
$40,000 |
|
Mortgage |
$100,000 |
$115,000 |
Example 2, the
exchanger has gone up in sales price and mortgage, but has gone down
$10,000 in equity. This will be taxed as “cash boot.” An exchanger
can always offset mortgage “boot” or debt relief by adding more cash
to the transaction, but they cannot offset “cash boot” by increasing
the mortgage. The “Napkin Test” applies whether the investor trades
into one property or multiple properties.
.
