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TAX DEFERRED EXCHANGES By Jaime G. Suarez, MS, GRI Certified Real Estate Broker June 7, 2006 Copyright, BONA REAL ESTATE, 2006 It is also called 1031 TAX DEFERRED EXCHANGE. It is a method where the owner of income or commercial property can postpone the taxes on the capital gain when he/she sells his/her property. Is the difference between the sales price and the cost. The law allows to deduct the cost of the sale. The accrued depreciation also needs to be added. It is the accumulated depreciation over the years since the investor purchased the property. The government allows a deduction in the income taxes for the depreciation. Normally the depreciation that most people are allowed is the STRAIGHT LINE DEPRECIATION. This is the kind of depreciation that is the same the first year and also the subsequent years. On residential property, the depreciation is calculated by dividing the cost of the building (not the land) by 27.5 years. In commercial property, it is divided by 31.5 years. For example, if an owner sells a property that costs him $100,000 and sells it years later for $140,000 with $10,000 of selling costs, he/she will have ($140,000 minus $10,000, minus $100,000 =) $30,000 of capital gain. Let us assume that he owned it for 5 years and during those 5 years, he/she had accrued depreciation in the amount of $2,500 a year. Then $2,500 x 5 = $12,500. Adding the $12,500 to the $30,000 = $42,500 of total capital gain The taxes here will be about 1/3 or about $14,000 which will be due at the close of escrow or when the investor prepares his/her taxes, the following year. If on the other hand the investor exchanges, instead of selling, he/she will not have to pay the $14,000 in taxes right away. The government will postpone the payment of these taxes using what is called a TAX DEFERRED EXCHANGE. Now he/she can buy a bigger property and grow faster financially 1. Must be income producing Real Estate property. Not a business, not personal property and not a residence ( a home where the owner lives). 2. The property must be exchanged for a LIKE PROPERTY, in other words exchanging income producing property for another income producing property. 3. The new property must be of the same or higher price. 4. Must locate the new property and close the escrows concurrently, unless it is converted to a TAX DEFERRED DELAYED EXCHANGE. 5. Must NOT use or receive any money. Any money received is called BOOT and he/she will have to pay capital gain taxes on it. Also called a Starker Delayed Exchange, it is an exchange where the seller does not have to close the escrows concurrently (at the same time). It gives the owner who is exchanging, additional time to complete the transaction. However, he/she must LOCATE and IDENTIFY the property within 45 days from the close of escrow. The escrow on the delayed exchange MUST BE CLOSED WITHIN 180 days within the escrow of the "old property." Yes, it does cost more. In addition to the Brokers/agents and specialized escrow services, it requires the services of an ACCOMMADOATOR who will agree to purchase the property being exchanged and transfer it to the new buyer. Also, he/she will agree to hold the money in a trust until the last escrow is closed. By law, the seller who is exchanging cannot hold or receive the money from the transaction, it has to be held by the accommodator in a trust, otherwise the exchange will be disqualified by the IRS and will be considered as a sale. In that unfortunate event, the seller will have to pay the required taxes. The services of the accommodator are about $ 2,000 depending on the transaction. Owners need to use the services of a Broker who has experience handling exchanges. Less than 5% of all Real Estate Brokers and agents in the USA have handled an exchange. For more than 26 years I have participated in exchanges not only as an owner of income property but as a Broker and agent in several transactions, including Delayed Exchanges with the use of an accommodator. As the owner/Broker of Bona Real Estate, I am personally committed to supervise, train, and direct my agents and managers in the field of Investment Property, Commercial, and Exchanging. Principals are welcome to consult with me directly, in the course of their transaction, with the agents of Bona Real Estate #1, Inc. NOTE: My best advice3; "always consult before the close of escrow with a CPA or a qualified Tax Consultant in reference to the effect on your personal income taxes." President Clinton implemented the Taxpayer Relief Act of 1997. Presently, there is a capital gain tax exclusion in the sale of a principal residence where the owner has resided for 2 of the last 5 years on the first $250,000 of gain for a single taxpayer and up to $500,000 of gain for a couple. The taxpayers may take advantage of this tax exclusion every 2 years, for an unlimited number of transactions. This law eliminates the prior provisions and one-time exclusion for those 55 years old or older. Consequently, the owners of a home may at any time trade their property for income or commercial property. But there is no need to make the sale a part of an exchange transaction. The sale will get the benefits of the $250,000 to $500,000 of no tax capital gain described above. Let us suppose that the 2 houses are the same. In this case one house will be considered the personal residence and will be treated as a RESIDENCE with the capital gains exclusion. The other one will be considered a RENTAL or INVESTMENT PROPERTY and that portion can be made a part of an EXCHANGE if the Capital gain is rather high. However, one should evaluate the cost of an accommodator vs. the payment of the taxes on the capital gain, which may not be too high, depending on the property. Only a Tax consultant or CPA can advise you specifically in your case.
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