(This is Part 6 of an eight-part series.)
If you enjoy paying capital gain taxes when selling aninvestment or business property, you probably won’t want to learn how topyramid your real estate wealth by legally avoiding taxes on profitable sales.However, if you prefer to build realty wealth without paying taxes, as millionsof other investors and major corporations do, read on.
Or you might enjoy selling your rental property at a profit,perhaps an apartment or commercial building, and using those funds to acquireyour ultimate dream home without paying capital gains tax. Read on.
Purchase Bob Bruss reports online.
UNCLE SAM ENCOURAGES TAX-DEFERRED EXCHANGES. Eversince 1921, Internal Revenue Code 1031 has encouraged real estate investors totrade one (or more) “like kind” investment or business property foranother property (or more) of equal or greater cost and equity without payingprofit tax.
Uncle Sam views a tax-deferred exchange as one continuousinvestment so no tax is due. However, “like kind” property means allproperties in the trade must be held for investment or use in a trade orbusiness.
“Like kind” does not mean “same kind” ofproperty. To illustrate, you can trade your vacant land for a rental house. Oryou can trade your apartment building for a shopping center, or a warehouse foran office building. However, your personal residence is not “likekind” so it is not eligible.
Over the years, IRC 1031 has evolved to make tax-deferredrealty exchanges easier than ever before. After 1984, when so-called Starkerexchanges became legal in IRC 1034(a)(3), direct property trades were no longernecessary.
For example, today you can sell your investment property,have the sales proceeds held by a qualified third-party intermediary beyondyour “constructive receipt,” and then use that money to acquireanother qualifying replacement property of equal or greater cost and equitywithout paying any tax.
Even major corporations use Starker exchanges. Toillustrate, a few years ago a major oil company avoided capital gains tax byselling its valuable gas station property across from Disneyland in Anaheim,Calif., having the sales proceeds held by a qualified third-party accommodator,and then using those funds to acquire several other qualifying properties.
THE EASY STARKER-EXCHANGE RULES. Starkerexchanges have replaced direct property exchanges of one investment propertyfor another. Although direct realty exchanges are still available, Starker exchangesare much easier.
In a Starker exchange, the first qualifying property issold to a buyer whose cash payment is held by a qualified third-party”accommodator” such as a bank trust department, title companyexchange affiliate, or independent exchange firm. The funds must be held beyondthe “constructive receipt” of the up-trader.
After the sale of the first property closes, theseller-trader has 45 days to designate to the accommodator up to three suitableproperties for acquisition. During the 45 days, those property designations canbe changed. But the Starker exchange acquisition(s) must be completed within180 days after the sale of the old property.
More than one property can be traded on either side of theexchange. To illustrate, I can trade three rental houses for one warehouse. OrI could trade one office building for two rental houses.
However, if the up-trader receives any cash or net mortgagerelief out of the trade, that is called taxable “boot” because it is”unlike kind” personal property.
ADVANTAGES OF TAX-DEFERRED EXCHANGES. Whethera direct or a Starker delayed exchange is made, the prime advantage isavoidance of capital gains tax. But there are at least 10 additionaladvantages, including:
(1) Avoid tax erosion of investment property equity bypaying taxes; (2) eliminate or minimize the need for new mortgage financing onthe acquired property; (3) replace an undesirable property with a moredesirable one; (4) increase depreciable basis for greater depreciation taxdeductions; (5) acquire a business or investment property with improved profitpotential; (6) make a partially tax-deferred exchange by trading down to asmaller property which is easier to manage; (7) avoid the special 25 percentfederal depreciation recapture tax; (8) refinance either property before orafter the trade (but not as a direct part of the exchange) to take out tax-freecash; (9) take advantage of an unexpected desirable purchase offer to sell acurrently owned property and avoid tax on its sale; and (10) completely avoidany capital gains or depreciation recapture tax by still owning the finalproperty in your pyramid chain of tax-deferred exchanges when you die.
HOW TO TRADE INVESTMENT PROPERTY FOR YOUR DREAM HOME. Althoughpersonal residences do not qualify for a tax-deferred exchange, because theyare not “like kind” held for investment or use in a trade orbusiness, smart investors and their tax advisers have figured out how to makesuch a trade.
The simple solution is to trade your investment or business”like kind” property for a “like kind” rental home, whichwill eventually become your personal residence.
Because all properties in an IRC 1031 “like kind”tax-deferred exchange must be held for investment or business use, that usuallymeans the acquired property must be a rental at the time of its acquisition.Most tax advisers suggest renting it to tenants for at least 12 months afterpurchase, thus showing rental intent at the time of the trade.
But in 2004 Congress partially plugged this tax-bonanzaloophole.
After Oct. 22, 2004, it is no longer possible to quicklycombine an IRC 1031 exchange with an Internal Revenue Code 121principal-residence-sale $250,000 tax exemption (up to $500,000 for a qualifiedmarried couple filing a joint tax return) after the owner lives in the acquiredproperty for 24 of the last 60 months before its sale.
Now the acquired property should be rented for at least 12months before the owner converts it into a personal residence and makes it aprincipal residence for the required 24 out of last 60 months before selling.
However, the big change was a principal residence acquiredin an IRC 1031 trade must now be owned at least 60 months before it can qualifyfor the IRC 121 tax exemption.
HOW TO AVOID TAX WHEN THE INVESTOR DIES. Asmentioned earlier, if you own your investment and/or personal residence at thetime of your death, any deferred capital gains and 25 percent depreciationrecapture taxes that would be owed if you sold before dying are completelyforgiven by Uncle Sam.
For deaths in 2006 and 2007, the net assets in your estateup to $2 million will also be exempt from federal estate tax. In addition,assets left to a surviving spouse, regardless of amount, are fully exempt fromfederal estate taxes.
Another benefit for your heirs is the inherited assets,whether real or personal property, receive a new “stepped-up basis”to market value on the date of your death. This stepped-up basis is a majoradvantage when your heirs decide to sell the inherited property. For fulldetails, please consult your tax adviser.
Next week: Tax savings from your home business.
(For more information on Bob Bruss publications, visit his
Real Estate Center).
Copyright 2007 Inman News