If you're not aware of how exchanging works, you're missing one of the biggest opportunities in real estate today! Exchanging is the tax code's most powerful reward for owners of investment real estate. Let's cover the basics:
In general, an exchange is accomplished by selling your property and buying another. The process is much simpler than most people think. It's really just a sale and a buy, with a few curveballs tossed in for good measure.
It might be the word "exchange" that confuses people. Instead of "exchanging," the process should really be called "continuing." If you merely continue your investment, the IRS says, "Okay, since you're continuing your investment you don't have to pay tax on your gain at this time." Your gain is carried forward to the replacement property. If you someday sell the replacement property, the gain would be taxed then.
But, instead of selling, what could you do? Exchange! If you kept doing this your entire life, all the gains would be forgiven when you die because of the "stepped up basis rules."
As long as the only thing you receive in the exchange is "like-kind real property" you're merely "continuing" your investment and your gain is not taxed. "Like-kind real property" is any real property held for investment or use in a trade or business.
If you receive any "unlike-kind property," part, or all, of your gain may be taxed. The three types of "unlike property" are:
- Boot (defined as "any non-cash asset," i.e. a boat or a car)
- Net Loan Relief (when you owe less after the exchange than you did before the exchange)
Now, let's talk about the mechanics of an exchange. Since everyone's situation is unique, be sure to get good legal and tax advice before you actually do an exchange. Also, keep in mind that I'm going to simplify the process and show you one way to do an exchange.
The first step is to put your property up for sale. That's right, for sale. The reason is that the owner of the replacement property you want probably doesn't want your property — he or she wants your cash equity. And how do you convert your equity into cash? By selling your property.
Now you may be thinking, "If I sell my property I've got to pay tax on my gain." But here's the good part. If you clearly demonstrate that your intent is to do an exchange, the rules allow you to sell your property. But instead of receiving your equity proceeds (which would be "unlike property") at the closing, these proceeds are placed into a qualified escrow account. You don't receive the money and you don't even have the right to withdraw or use the money from the escrow. The beauty of this arrangement is that, yes, you've sold your property and converted your equity to cash but you haven't received any unlike property. This is called a delayed exchange.
To complete the delayed exchange you must meet two time tests:
- You have 45 days from the day you sold your old property and the money was placed in the qualified escrow to "identify" a replacement property.
- You have 180 days to actually acquire the replacement property.
Now, it's not 45 days plus 180 days. Both of the time periods begin on the day you sell the old property.
Look at the power of this! By doing a delayed exchange, you have sold your old property, placed the proceeds into a qualified escrow account, identified a replacement property (within 45 days) and purchased the replacement property (within 180 days).
It's really just a sale and a buy, but it's treated as an exchange. And, as long as the only thing you receive is like-kind property, you don't have to pay any tax on your gain! Fantastic!
Many title companies and escrow companies are geared up to be the qualified escrow holder. If you're searching for a company to act as your escrow holder, merely call them up and ask if they handle delayed exchanges. If they answer something like, "Well, ahhh, most of our closings get delayed!" you've called the wrong company!
Once the dust has settled, you have sold your old property and purchased another. But, if you do it right, you're treated as if you did an exchange. And, if the only thing you received is like-kind property, you're merely "continuing" your investment, and you don't have to pay tax on your gain! What a country!
This material is designed to provide information in regard to the subject matter covered. It is understood that Tom Lundstedt, is not engaged in rendering legal, accounting or other professional services. Everyone's situation is unique, so – before you, or your clients take any real world action – be sure to check with the proper professionals.