REAL ESTATE EXCHANGES

Exchanges or trades of real estate are completed for the major purpose of deferring tax on the gain of property until the investor is in a better tax situation to sell- often many years later. If the investors follows the Internal Revenue Service Code section 1031 and has had a property used in a trade or business or held for the production of income, he/she can exchange his investment property for another "like- kind" property and defer the tax on any gains under the subsequent property is disposed of .

In fact, this can be done not only once, but as many times as desired: and the each time the tax obligation may be deferred on the gain of any property owned. The tax may even be avoided entirely if the investor dies before selling the last property. The IRS grants a step up in basis to the heirs at that time, although the property does not escape estate taxes.

Caution: To complete this type of transaction, a number of conditions must exist and a myriad of regulations must be complied with. In addition, if you complete an exchange, most CPA's feel the client has a excellent chance to be audited.

BOOT

All gains may be deferred, but that makes the assumption that the properties purchased and sold are equal in value and terms. Assume Property A, with the sale price of $100,000 and a loan of $50,000, was being exchanged for Property B, also having a sale price of $100,000 but no loan, Property B has a higher equity (the difference between the value of a property and the mortgage. Equity represents the net value after all the obligation have been paid.)

Property A Sales Price = $100,000

Mortgage= $50,000

Equity= $50,000

Property B Sales Price= $100,000

Mortgage = $0

Equity= $100,000
To Balance equity, owner of property A pays owner of Property B $50,000 BOOT (cash or equal value)

This money or anything of value is considered to be unlike property and subject to taxation. Whatever it is of value that changes hands to equalize the equities- cash, diamonds, a boat- is called "boot".

Another item that is considered boot is called net mortgage relief or reduction in the net mortgage obligation. Assume E's property has a mortgage of $300,000 will be transferred to F. F had a mortgage of $125,000 and this will be transferred to E. Has E's net mortgage obligation been reduced? Yes, to the amount of $175,000 ($300,000- $125,000).

LIKE KIND

A "like kind" transaction means that one can exchange a property used in a trade or business or held for the production of income with another property used in a trade or business or held for the production of income. Can land be used in a trade or business? Yes. Can it therefore be transferred for an industrial building with similar investment intent? Yes. And you can later exchange the industrial building for a medical building, a vacant piece of land, and so on. As long as the transaction conforms to the IRS 1031 section, you are simply trading one type of property for another type of real estate investment property, and the trade can qualify as like kind and the tax may be deferred. But be aware that specific wording is required in the deposit receipt and specific actions by the escrow company(ies) are necessary for this to work.

STRUCTURING AN EXCHANGE

There are considerable difficulties in structuring and completing an exchange due to the number of individuals involved- brokers, attorneys, buyers, sellers, escrow agents, title companies- as well as proper documentation from these various parties. Obviously, all of these entities must agree to the exchange. Any subsequent disagreement by any one of the parties can ruin the whole transaction and completely negate months of work.

Unfortunately this does happen, particularly as the number of properties is increased in the exchange. It is also an area for the unscrupulous seller/buyer. Some have been known to want to change the terms of the exchange just before closing, and if the agent stops the exchange to consult an attorney or ask for additional time, the entire exchange may blow up leading to no deals or commissions whatsoever. It pays to know your clients, but the other agent and agent's clients remain unknown factors, putting some problems beyond your control.

Additionally, all the terms and conditions must b e spelled out so that there are no misunderstandings as the closing date nears, and all clearances and documents must be completed by that date. If the property is out of area or out of state, remember that the regular exchanges must occur simultaneously. If the planning for the exchange has not allowed for difference in time zones, the IRS may treat the transactions as taxable and not deferred exchanges.

DELAYED EXCHANGES

A unique exchange method which can mitigate some of the problems such as the number of parties, finding an acceptable trade in a very short period of tome, etc, is the delayed exchange. Through this very specialized process, you can "sell" your property now and find another property (or "upleg" as it is called) within a short period of time thereafter- 45 days- and close it within 180 days. The main ingredient in the delayed exchange is that the seller NOT have constructive receipt of the proceeds from the first sale. The money mus t be held by an independent third party (trustee, escrow company) and be used on ly for the purchase of the subsequent upleg. Should the seller be able to receive those funds, the IRS may simply treat it as a taxable event. An attorney may need to be consulted to be sure the transaction conforms to Section 1031 requirements.

EXCHANGE COMPUTATIONS

As a part of the exchange, its is necessary to establish what amounts are taxed; what the new basis of the new exchanged property is; equity and several other figures. The regular methods for computation are most imposing. But I have devised a formula from the table below which will give you the right answer every time. Further, if you are confused about the intricacies of the transaction, it may even make the process more understandable.

1. Sales Price of Property A

2 Basis of Property A (Adjusted basis plus land)

3. Mortgage of Property A

4. Equity of Property A (1 minus 3)

5. Sales price of Property B

6. Basis of Property B (for information only- not used in this calculation. Disregard if not available)

7. Mortgage of Property B

8. Equity of Property B (5 minus 7)

9. Cash or boot received by Property Owner A from Property Owner B to equalize equities (4 minus 8). If negative number, use 0. Boot is transferred from the smaller equity to the larger equity (i.e. if A has an equity of $150,000 and B has an equity of $100,000, B pays $50,000 of value to A to balance equities.)

10. Cash or boot paid by Property Owner A to Property B (8 minus 4). If negative number, use 0. Same definition as 9

11. Mortgage relief (3 minus 7). If negative number, use 0. This is the difference in existing mortgages that is a benefit to Property Owner A (i.e. if A is transferring a mortgage of $50,000 and receiving a mortgage of $25,000, he has been relieved of $25,000 of indebtedness). Do NOT include new mortgages which the seller may add to the property.

12. Realized gain- 5 plus 9 plus 3 minus 2 minus 7 minus 10.

13. Recognized gain= 9 plus 11 minus 10. If negative number, use 0. If this figure is greater than realized gain (12), use realized gain (12). This is the amount taxable (recognized for tax purposes).

14. New basis= 2 plus 7 plus 10 plus 13 minus 3 minus 7. (Subtract land value if applicable) Old depreciable basis of A maintains old depreciation schedule. New gain in basis above previous adjusted basis must utilize 1986 and later depreciation schedules. Therefore there may be two different schedules of depreciation for federal taxation purposes. State regulations may be different.

No matter how many properties are involved or differences in prices, terms or economics conditions, if you want to know how much one owner must pay to another, look at either 9 or 10. The taxable gain is shown on line 13 and the new basis on line 14. As you become more conversant with exchanges, some of the other forms will be useful. Until then, this form gives you the right answer and that's at least 75% of the battle.

EXAMPLE 1

Assume you, as owner A, are trading your multi family unit worth $100,000, $50,000 mortgage and $60,000 basis. You are trading for Property B with a value of $100,000 with no mortgage.
Property A Property B
Sales Price 1. $100,000 5. $100,000
Basis (includes land) 2. $60,000 6. Not known
Mortgage 3. $50,000 7. 0

4. Equity A (1 minus 3) = $50,000

8. Equity B (5 minus 7)= $100,000

9. Boot received by A (4 minus 8)= negative number, use 0

10. Boot paid to B (8 minus 4)= $50,000

11. Mortgage relief (3 minus 7)= $50,000

12. Realized gain (5 plus 9 plus 3 minus 2 minus 7 minus 10)= $40,000

13. Recognized gain (9 plus 11 minus 10)= 0. No tax on this transaction

14. New basis (2 plus 7 plus 10 plus 13 minus 3 minus 9) = $60,000. In this case, it is the same as the old basis. Same depreciation schedule is utilized.

EXAMPLE 2

Property A Property B
Sales Price 1. $3,500,000 5. $7,000,000
Basis (includes land) 2. $2,000,000 6. Not known
Mortgage 3. $1,800,000 7. $5,000,000

4. Equity A (1 minus 3) = $1,700,000

8. Equity B (5 minus 7)= $2,000,000

9. Boot received by A (4 minus 8)= negative number, use 0

10. Boot paid to B (8 minus 4)= $300,000 paid to B

11. Mortgage relief (3 minus 7)= $negative number, use 0

12. Realized gain (5 plus 9 plus 3 minus 2 minus 7 minus 10)= $1,500,000

13. Recognized gain (9 plus 11 minus 10)= 0. No tax on this transaction

14. New basis (2 plus 7 plus 10 plus 13 minus 3 minus 9) = $5,500,000. $2,000,000 old basis maintains prior depreciation schedule. $3,700,000 uses later depreciation schedules.

EXAMPLE 3


Property A Property B
Sales Price 1. $750,000 5. $900,000
Basis (includes land) 2. $500,000 6. Not known
Mortgage 3. $300,000 7. $700,000

4. Equity A (1 minus 3) = $450,000

8. Equity B (5 minus 7)= $200,000

9. Boot received by A (4 minus 8)= $250,000 paid by B

10. Boot paid to B (8 minus 4)= negative number, use 0

11. Mortgage relief (3 minus 7)= negative, use 0

12. Realized gain (5 plus 9 plus 3 minus 2 minus 7 minus 10)= $250,000

13. Recognized gain (9 plus 11 minus 10)= $250,000 taxable to A

14. New basis (2 plus 7 plus 10 plus 13 minus 3 minus 9) = $900,000. $500,000 retains old depreciation schedule (Pre 1986) and $400,000 uses later schedule.

Reverse exchanges (2001) : The IRS now allows you to acquire the replacement property BEFORE selling the old property. However, title to the replacement property MUST be held by a third party as intermediary until the exchange is completed.

1031 real estate exchanges: (2003) You can defer tax by transferring your gain to another property. A new facet from the IRS allows you to transfer your property into a tenants in common ownership. The transfers are to a single ownership where there are no more than 35 investors, each of whom must have a direct ownership stake proportionately in profits and losses but can't be in business together. That means the TICs structured as partnerships do not qualify.