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How to Pay Less Tax on the Sale of Real Estate! by James Montgomery
“It’s not how much you make that counts,” my father told me many years ago, “but how much you keep of what you make.” I did not really understand that old adage at the time, but he was passing on some wisdom that his father had given him. It’s just common sense, but it is amazing how blind most of us, including me, are to the significance of that sentence.
Let’s look at an example involving real estate. Lets say you own a commercial building that will sell for $1,000,000.00. The broker brings a signed contract. Your basis, or cost in the property after $400,000 in depreciation recapture, is $300,000. Eureka, a $700,000 profit! Then, as realization sets in, the income tax on that amount in the top bracket of 39% would be $273,000.
However, since the you owned the property for more than a year, the transaction will qualify for capital gains taxation at 25% for the depreciation recapture and 20% for the balance of the gain so the tax would be reduced to just $160,000. Uncle Sam will not get the $273,000, but will only receive $160,000. Still too much tax, though.
By employing a strategy that is set out in the Internal Revenue Tax Code, you can defer those taxes until ultimate sale or even longer. Section 1031 of the Code provides for the exchange of property for like property. 26 USC Section 1031. Any gain that would have been recognized on the sale or exchange of the property can be deferred and can be utilized to acquire the like property. The tax is not eliminated.
If the new “like” property which is now owned is sold at a future date, the gain from the exchange as well as any additional gain must be recognized for tax purposes. However, by exchanging again, that tax can again be deferred for as long as the taxpayer desires. If the taxpayer is an individual and dies, the heirs receive a “stepped up” basis in the property and can sell the property without recognizing the gain, which was deferred during the taxpayer’s lifetime.
This strategy is extremely effective to maximize “what you keep”. Preservation of principal is the key to amassing wealth. Paying more tax than necessary is certainly not the best use of principal. The $160,000 that would have been paid as taxes when re-invested at 10% would be worth $320,000 in seven years.
The Internal Revenue Code provides for a way to defer the payment of that tax, perhaps indefinitely. There are a number of requirements to be met and types of property that cannot qualify so a review of the statute is appropriate.
First, the properties to be exchanged must be held for productive use in a trade or business or for investment. What does that mean? Any real estate property used in business can qualify: land, commercial properties, office buildings, farms, ranches and rent houses all fit the category.
The properties must be in the United States and not be held primarily for sale as inventory. The U.S. Virgin Islands are considered real estate in the United States. Any property that meets the definition can be exchanged for another property; for example, a ranch could be exchanged for an office building, unimproved for improved, etc.
The statute provides for certain properties that cannot qualify: (A) stock in trade or other property held primarily for sale, (B) stocks, bonds, or notes, (C) other securities or evidences of indebtedness or interest, (D) interests in a partnership, (E) certificates of trust or beneficial interests, or (F) choses in action (lawsuit claims, etc.). So one cannot exchange Berkshire Hathaway shares of stock for Microsoft stock to defer the capital gain.
One does not need to exchange a personal residence because there are other ways to eliminate the gain on sale of those properties. There are ways to deal with partnership interests that involve changing the form of the business structure. However, those issues are involved and beyond the scope of this article.
Second, there must be an actual exchange. You cannot sell property for cash and call it an exchange. The exchange does not have to be simultaneous. You can sell property for cash today and exchange the cash for a property you find later. To qualify for what is known as a deferred exchange you must meet the time requirements that are listed below and you must use a “qualified intermediary”.
A Qualified Intermediary is defined in the regulations to the Code Section. 26 CFR 1.1031(k). The intermediary must be unrelated as to family, employee, or agent relationship. An agent is further defined as “the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period ending on the date of the transfer of the first of the relinquished properties.” Thus, an independent intermediary such as a member of the American Federation of Qualified Intermediaries is essential to successful tax treatment of the exchange.
The Qualified Intermediary acts as the middleman in the transaction so that the taxpayer does not have actual or constructive receipt of the sale proceeds. The Intermediary can handle financing, construction if necessary, or other tasks in order to complete the exchange. The Intermediary can also provide counsel in structuring the transaction and advising as to the technical requirements. A party to an exchange should also consult both their certified public accountant and their attorney before consummating either end of an exchange. Exchanges are difficult to clean up if the first part was not structured properly.
Third, there are two time deadlines that must be met to preserve the tax-free exchange. Forty-five (45) days after the front end of the exchange (the first property) is closed, the second or replacement property must be identified to the Intermediary in writing. This deadline expires at midnight on the forty-fifth (45th) day and must specifically identify the property by legal description, street address, or some other unambiguous description. Do not risk using “some other unambiguous description” unless it cannot be avoided.
The exchanger no later than one hundred eighty (180) days from the date of the first closing must receive the second, or replacement property. The exchange must be fully closed by that deadline. There are no extensions available. Miss the date and pay the tax.
The last issue in minimizing tax is the replacement property must have an equal or greater value than the relinquished property to avoid all taxes. A property worth $1,000,000 must be exchanged for property worth the same amount or more. If the property received is worth $800,000, then there would be a taxable gain, or “boot”, of $200,000.
The tax on the value of the replacement property in excess of the original basis is still deferred but the excess over the value of the replacement property is taxable at the capital gains rate. Another way to look at it would be, if there is cash or personal property received with the real estate, which means that the cash proceeds from the first part of the exchange were not fully reinvested in the replacement property, gain or “cash boot” will be recognized.
Furthermore, any mortgages on the replacement property must be equal or greater than on the relinquished property. If the mortgage on the first property was for $750,000, then the mortgage on the replacement property must be at least $750,000 or “mortgage boot” must be recognized. If the replacement property mortgage were only $600,000, then the gain would be the difference in the two mortgages or $150,000 unless the exchanger put additional cash boot into the exchange.
Fortunately, the advance planning that goes into the structuring of an exchange can easily avoid or minimize these types of consequences. Coordination with the advisers in the transaction, qualified intermediary, attorney, and accountant, is essential.
The tax-free exchange under Section 1031 of the Tax Code is an extremely important tool in maximizing the return from investments, particularly in the real estate arena, for the property owner. It is likewise a very important tool for those who structure such transactions, such as the real estate broker.
Mr. Montgomery has been involved in multi-million dollar litigation. His practice now focuses on the structuring of business entities and transactions to reduce potential liability and potential taxation, while maximizing the potential for profit. www.jamesmontgomerylaw.com
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