Tax Reform Multiplies Second Home Possibilities (Part 3)

Different Types of Exchanges

Simultaneous Exchange: Title to the relinquished property is transferred directly to the buyer. The buyer pays cash to the intermediary. The intermediary pays cash to the seller who transfers title to the replacement property directly to the taxpayer. The taxpayer thus avoids receiving any cash during the transaction, which would be immediately taxable.

Delayed Exchange: An exchange in which the relinquished and replacement properties close on different dates but not more than 180 days apart. The majority of exchanges are delayed exchanges.

Often, the taxpayer does not yet know what replacement property he or she wants to acquire but is required to close the sale on the relinquished property. When that is the case, a deferred exchange is necessary. The structure of the deferred exchange with intermediary is essentially the same as the simultaneous exchange with intermediary, except that, because the replacement property is not known at the time the relinquished property is transferred to the buyer, the two legs of the exchange take place at different times.

The exchanger has 45 days to identify the property he wants as the replacement property (perhaps a lakefront rental). The transfer of the replacement property must still close within 180 days of the transfer of the relinquished property.

The Straight Swap: The two-party swap, or exchange, is the purest form of switching properties. As the name implies, only two parties are involved and they exchange their properties. Both steps of the transaction occur simultaneously. Title to the relinquished property is conveyed by the taxpayer to the seller, and title to the replacement property is conveyed by the seller to the taxpayer. But rarely do straight swaps come out equal in real estate. But you never know . . . offer to trade your rental duplex in the inner city for a deluxe Colorado ski condo!

Reverse Exchange: Sometimes a more costly and difficult method. If you follow all of its requirements, you should be in the clear. If you fail to meet all of the procedures, your exchange may still be successful, but will be subject to second-guessing by the IRS in the event of an audit. The ruling (Revenue Procedure 2000-37) came late to the party. The basic Code Section 1031 will not let a taxpayer buy the replacement property, or new property, until after he or she has sold the existing property or relinquished property. Nonetheless, taxpayers have fallen into situations beyond their control where they needed to take title to the new property before the sale of the old property closed. For example, someone is scheduled to close the sale of his old property on Wednesday and the purchase of his new property on Friday. On Tuesday, he learns that the buyer of his old property must delay the purchase for a couple of weeks because the buyer's lender needs an additional appraisal completed before it will fund the loan. The seller of the new property demands that the buyers close on Friday, as the two parties agreed, or the seller will sell the property to someone else and keep the earnest money.

In this situation, the buyer's best alternative is to do a "reverse exchange" and have their qualified intermediary (or exchange facilitator) take title to the new property and hold, or "park" it until the old property closes. Then, the intermediary transfers the new property to the seller to complete the exchange. These parking arrangements are the meat of the new ruling.

What are the Delayed Exchange time periods?

The 45-Day Identification Period: You must identify the replacement property by midnight of the 45th day following the close of the first leg. You won’t lose your leg, but you might lose your shirt. That’s because if you complete the deal without playing within the IRS’ field of play, you could open yourself to tax liability. Your offer to buy the replacement property does not have to be accepted during this time period and it is easy to identify a property. You are not required to wait until your first leg closes to identify a property. You should contact your Intermediary if you want to identify more than three properties.

The 180-Day Replacement Period: By midnight of the 180th day following the close of the first leg, you must complete your exchange by taking title to the replacement property you identified or your carriage to tax-free land turns into a pumpkin on the side of the road. These two time clocks - 180 days and 45 days - begin to tick when the first leg closes.

Playing the dealer: If you wheel and deal properties quickly and often, the IRS might think you are in the business of simply playing for a living. You are not supposed to exchange for the sole intention of reselling the property. This type of activity does not qualify for an exchange. So, how long do you have to hold it before you can dish it? Lots of gray matter has been massaged over this issue. Attorneys grab their thumbs and invoke the infamous Rule of Thumb before all sides of the deal to “please wait at least one year.”

What is "Boot"?

"Boot" is an informal term that refers to non like-kind property. You will pay capital gain tax if you receive any net boot. Two common forms of boot are debt boot and cash boot. Debt boot refers to loans against the first leg property that are paid off at closing. Cash boot refers to your net equity in the first leg property. To avoid paying taxes on the boot you received as part of the first leg you must give boot as part of the second leg. First, you must acquire a property that costs as much as your net sales price. Second, you must reinvest the net equity - that is give cash boot. Third, incur new debt that is equal to or greater than the debt you paid off.

Realized Gain: The difference between the net sale price and the adjusted basis.

Recognized Gain: That portion, if any, of the realized gain that is subject to tax. If you sell, the realized and recognized gain will be the same. If you exchange, the recognized gain will be zero. For a transaction to result in total non-recognition of gain, the taxpayer must receive property with an equal or greater market value and equity investment than the property exchanged, and receive no boot.

Replacement property basis: The exchange allows the tax to be deferred by carrying over the taxpayer’s adjusted basis in the relinquished property to the replacement property.

Capital Gain Tax Rates: Long-term capital gain appreciation is taxed at 20%. Depreciation of real property is recaptured at a 25% rate. The total tax will be a combination of these two components.

How is money held and protected? The intermediary does not take any of your interest. The funds are protected from theft by using a Qualified Trust Account. The bank is co-trustee and your signature and approval is required before any funds can be withdrawn. The funds can only be used as you direct.

How should you select an intermediary?

1.        Recognize you are selecting a service provider NOT a product.

2.      Determine what benefits/value you desire from that service provider.

3.      Your Intermediary should be knowledgeable about exchanges, escrow, and real estate law.

4.     Your Intermediary must be accessible. What good is an intermediary if you can't get your questions answered?

If you pay for service, expect a service. Really, who needs to reach a voice machine five times in a row?

Once you have completed your tax-deferred exchange, you can always trade again when another property or area piques your interest. Tax-free.

Copyright Inman News. Used with permission.

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