COMMERCIAL REAL ESTATE: Exchange alchemy – How investors can avoid paying taxes on a property sale

Living in “God’s country” can affect all aspects of our lives here in the Grand Traverse area, even the tax law. One sure sign that God is on your side is when a normally taxable transaction, like a sale of property at a gain, can be structured to avoid any current tax. There is indeed such a provision in the tax law and that is what this article will discuss.

Generally speaking, if any kind of property is sold at a gain, the tax collector is there with hand out to collect his share of the profits. For real estate investors, there is a special provision in the tax law that permits a tax-free (more accurately, tax-deferred) exchange when the investor uses the proceeds of the sale to reinvest in a new property (or properties).

The rationale is that we get a break from the normal rule (i.e., gain is taxable) when the investor, looking at a series of transactions in the aggregate, is simply moving from one piece of real estate to another without reducing his investment to cash in his/her pocket.

Historically, this tax break started as one person swapping property with another, but it has evolved to the point where an investor can sell his/her “old” property for cash and use that cash to purchase “new” property, as long as he or she complies with a very rigorous and detailed series of steps to accomplish this goal. Structuring a transaction in this manner requires the assistance of an intermediary (typically a band or title company) and a tax advisor that is knowledgeable in this aspect of the tax law. This is not something you should “try at home” on your own.

Not every real estate deal can qualify for this tax break. Besides having all the necessary steps in the right order, the kind and use of the property must qualify. Generally speaking, both the old and the new property must be held for investment purposes or for use in a trade or business (i.e., not for personal use by the exchanger as a residence or other personal use).

A typical example of qualified property would be a rental property or property used by the exchanger in his/her business. As long as both the old and new properties meet this use requirement, any type of property considered real estate under state law can be exchanged for any other type or real estate. Thus, raw land can be exchanged for a rental building, or investment in oil and gas properties can usually be exchanged for other types of real estate.

In addition, the purchase of the new property must follow very closely after the sale of the old property because there are strict time limits in the tax law. For example, the new property must be identified within 45 days from the sale of the old property and closed on within 180 days from the closing on the old property. A good rule of thumb is that you should attempt to identify your new property before selling your old property. Unless the exchange is a direct swap, the properties must be sold and purchased through a qualified intermediary (generally a bank or title company).

To completely defer the tax on an exchange transaction, all of the proceeds from the sale of the old property must be spent on the new property and all of the equity in the old property must be reinvested. Another way to say this is that you must at least equal or exceed both value and equity in the new property to defer all the tax. However, if you do not “trade up” in full, you may still defer a portion of gain into new property that is of less value than your old property. So an exchange is not an “all or nothing” proposition.

A commonly misunderstood aspect of an exchange transaction is the impact these deals have on the amount of tax basis of the new property (which is used to measure gain or loss on the subsequent sale of the new property). The basis of the new property equals the basis of the old property, plus any additional money used to purchase the new property. This is the reason that these exchange transactions are most accurately referred to as tax-deferred rather than tax-free. If the new property were to be sold not long after the exchange, the benefit of the tax deferral would be very small since the deferred gain on the sale of the old property would be taxed on the sale of the new property.

All of the rules described above outline the basics of an exchange transaction. Implementation of an exchange transaction requires careful planning before the old property is sold. Typically, the amount of tax that is deferred will far outweigh the cost of hiring an intermediary and tax advisor. Most people hire an attorney for real estate deals anyway, so the additional legal fees incurred due to an exchange are not usually a significant extra cost.

Angelo Meli is a Director in the Traverse City office of Plante & Moran LLP. He specializes in tax and estate planning and may be reached at (231) 947-7800 or BIZNEWS