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So
what is the goal? The goal is to take
advantage of this opportunity to get the time
valued use of Uncle Sam’s money and use
that money to help buy your investments. When
you sell a piece of investment property, assuming
the property has increased in value, the proceeds
will be comprised of three parts:
(i)
Basis: Your initial investment in the property,
(less depreciation)
(ii)
Capital Gains: Your profit from the increase
in value of the property; and
(iii)
Taxes: Uncle Sam’s portion of your capital
gains which is currently taxed at a maximum
rate of fifteen (15%) percent.
The
tax deferred exchange lets you take Uncle
Sam’s portion and reinvest it without
paying him, yet.
So how does it work? The rules are
very strict and must be followed precisely;
otherwise, the transaction will be overturned
causing taxes to be paid with penalties. At
a minimum, there are two properties involved:
the “Relinquished Property” and
the “Replacement Property”. The
Relinquished Property is the investment property
that you currently own and that you are selling.
At some point between the time you contract
to sell the Relinquished Property and the
time you close on that sale, you must enter
into a written agreement with a Qualified
Intermediary who will hold your sales proceeds
until you reinvest them in another piece of
investment property, the Replacement Property.
All time requirements run from the date upon
which you close on the sale of the Relinquished
Property and must be strictly adhered to.
Within forty-five (45) days after closing,
you must identify potential replacement properties.
(If you identify more than three properties,
stricter rules apply.) Within one hundred
eighty (180) days after closing on the Relinquished
Property, you must close on the Replacement
Property. As a part of this process, the Qualified
Intermediary will provide the proceeds held
on your behalf to purchase the Replacement
Property.
Again the requirements are very stringent
and will require the professional drafting
of documents and guidance through the process.
What
kind of property can be used for the exchange?
The rule is “like-kind” property.
Within the realm of real property, what is
considered “like-kind” is liberally
construed provided the properties involved
are investment properties or properties held
for productive use in a trade or business.
Typically, the property involved on Hilton
Head Island is investment property. The tax
deferred exchange begins with a piece (or
several pieces) of investment property. A
personal residence will not qualify. On the
other hand, raw land and rental property clearly
do apply. Second homes that are not rented
will most likely not qualify. At a minimum,
that will be an aggressive stance to take
with the IRS.
So
what do you mean about “investing using
Uncle Sam’s money”? Let’s
say that ten years ago, you originally purchased
an oceanfront villa (we will call it “Villa
A”) for $200,000. You now have a contract
to sell Villa A for $700,000. (Villa A is
your “Relinquished Property” using
tax deferral language.) With your basis in
the property being $200,000 and your sales
price being $700,000, upon the sale you would
have capital gains in the amount of $500,000.
At the current maximum capital gains rate
of 15%, you would normally owe Uncle Sam $75,000
in capital gains taxes. However, because you
are doing a tax deferred exchange, Uncle Sam
is going to permit you to take his $75,000
and use it to purchase your next piece of
investment property (your “Replacement
Property”) and pay him for those taxes
at some later date; provided, of course, that
you meet all the requirements for executing
the tax deferred exchange. (Note: The result
is even more dramatic if you have depreciated
the property where your basis is less than
the original $200,000 you invested in the
property.)
How
can I turn this “tax deferral” mechanism
into a “tax avoidance” mechanism?
Interestingly enough, should you either
hold onto the Replacement Property or continue
to “roll” the capital gains into
new investment properties using the tax deferred
exchange mechanism, upon your death the property
will go into your estate and your heirs will
get a stepped-up basis in whatever investment
property you own at that time. What this means
is that there is no longer any capital gains
on the property because the basis gets “stepped-up”
to the then current value of the property.
Using our previous example, the original basis
was $200,000. If at the time of your death
the current value is $700,000, your heirs
or devisees will get a stepped-up basis meaning
their new basis in the property is $700,000.
When they decide to sell the property, capital
gains taxes will be calculated based upon
the stepped-up $700,000 basis, not the original
$200,000 basis. As a result, Uncle Sam just
lost $75,000 of his capital gains taxes. As
a result, you will have turned a tax deferral
mechanism into a tax avoidance mechanism.
(Obviously, there will still be estate tax
issues with which to contend.)
Are
there other scenarios for completing a tax
deferred exchange? Yes. For instance,
you can do a reverse exchange where you buy
the Replacement Property before you sell the
Relinquished Property. Or, you could have
multiple properties on either the Relinquished
Property side of the deal or the Replacement
Property side of the deal or both. Or, you
could have a three party deal. Any of these
scenarios will work; however, the rules get
tricky and are beyond the scope of this discussion.
Nevertheless, should you want to discuss anything
about tax deferred exchanges, please feel
free to contact us as we handle these types
of deals regularly.
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