I attended a party recently where the topic of real estate exchanges came up. Before I say more, I must remind you that when I write about investing or the tax implications of owning real estate, I am simply sharing my opinion. If you are thinking of investing or have questions about taxes with regard to real estate, speak with your financial advisor and/or tax accountant because every situation is unique.
Okay, back to the subject at hand. Real estate exchanges began with two property owners exchanging properties to avoid paying capital gains taxes. As these exchanges expanded, rather than two people exchanging properties, a third party got involved. Let’s say you have a property I want, and I have a property that you don’t want but Joe Thirdparty does. So, we open an escrow. I exchange my property for yours, and before the escrow closes, you sell the property I gave you to Joe Thirdparty. Everyone’s happy.
Everything was going along swimmingly as far as the IRS was concerned until a man named Starker came along and said, “If I don’t ever close escrow, then I can find a third-party property anytime in the future.” In this scenario, I would sell Property A to Joe Thirdparty and he wouldn’t pay me. He’d owe me for it and carry the liability on his books. I’d trust he would pay me in the future when I found the property I wanted to buy (Property B). He would then buy Property B and complete the exchange in lieu of cash for Property A.
The IRS said, “Nope!” So Starker took the IRS to court where the judge, God bless him, said, “Starker’s right.” This was the genesis of today’s common 1031 Exchange. Since then, Congress has stepped in and codified the rules and regulations so we have a clear path for exchanges.
In the post-Starker world, you list a property for sale and sell it to an exchange accommodator, a middleman. The accommodator takes title to the property and sells it to a third party. The accommodator holds all the cash, kind of like an escrow account. You find a property you’d like to own and the accommodator buys it using the money in the account. He or she then transfers the property to you to complete the exchange. You end up with a more desirable property and pay no taxes.
These transactions are not allowed to drag on indefinitely, as Starker wanted. After selling your property, you must identify the exchange property within 45 days and complete the purchase of the exchange property within 180 days or by the end of the tax year. A word to the wise, 180 days and six months are not identical lengths of time—more than one investor has learned that the hard way.
So, how does all this hassle help you avoid paying taxes? Had I sold Property A to Joe Thirdparty and bought Property B in a standard sales transaction, I might have had a tax liability of thousands or even hundreds of thousands of dollars. But, by using an exchange, I avoid paying taxes until someday when I dispose of Property B. And I might postpone taxes again at that time if I do another exchange. If I die, my heirs acquire the property and get a stepped-up basis to fair market value as of the date of my death, so they can sell the property with no tax liability at all.
The moral of the story? If you want to sell one property and buy another of similar value, do an exchange. Of course, this is a very simplistic summary of a rather complex topic. If you want to learn a little more about this topic, click here. If you decide to do an exchange, find an experienced Realtor and a qualified tax professional to work with you.
If you have questions about real estate or property management, please contact me at firstname.lastname@example.org or call (707) 462-4000. If you’d like to read previous articles, visit my blog at www.richardselzer.com. Dick Selzer is a real estate broker who has been in the business for more than 40 years.