Don't get drilled on a property swap

Dear Steve,
I'm a dentist and have owned my office building for eight years. About two years ago, I began planning a larger office building for my practice. I contracted for land, went through approvals, closed on the property and started construction. I'm set to sell my present building and need all the money from the sale for construction.

But I've been told I have to pay 15-percent capital gains on the sale unless I give all the money to an intermediary, and then hope to get it back in some scheme. The main problem, apparently, is I bought the replacement property before the sale of the existing property. I will be able to lease back the old office for a while, but the new owner wants to take occupancy within a reasonable period. But how could I sell my existing office and then hope to find a replacement office? -- Dr. Jack

Dear Jack,
I'd hate to see you get drilled with capital-gains tax, doc. Of course, the best way to plan for such a swap, known as a 1031 exchange, is when you first identify that replacement property.

I'll spare you the preventive lecture. But there's still a chance you may be able to get around that painful capital-gains tax, providing you haven't accepted that check for your old building. Time is of the essence, however.

For background's sake, a 1031 exchange, otherwise known as a like-kind exchange, tax-deferred exchange, or "Starker" exchange, is a handy way for real estate investors to defer the payment of capital-gains tax on their transactions.

When you sell investment real estate, you can use the proceeds to buy another income property or properties without paying capital-gains tax, and continue to roll these properties over into others over the years until you decide to cash out the final asset(s), at which point you'll pay that 15-percent capital-gains tax rate (recently reduced from 20 percent).

This "scheme," as you call it, is used in an estimated 75 percent of all commercial building purchases on the West Coast, say national tax experts.

In a typical 1031 exchange, investors have 45 days to identify three potential replacement properties to the IRS and a 180-day period running simultaneously to close on one or all of them. Exchangers must reinvest all proceeds from the sale of their old property, and put the monies in trust with a third-party intermediary, also known as an exchange accommodation titleholder. Additionally, equity held by the investor in the new property must equal or exceed the equity held in the old one.

But IRS rulings in recent years cleared the way for a couple of nuanced 1031 transactions: the construction exchange, or improvement exchange, where you build your replacement property (i.e., that new office building you're constructing), and the reverse exchange, where you (and I mean you) buy the replacement property first before selling the exchange property. Both, particularly the latter, can get a little complicated.

A good tax accountant should be able to tell you if your deal, as it stands, can be rearranged to qualify as a 1031, and most sizable title companies can either serve as intermediaries or help you find one. Intermediaries generally charge between $250 and $3,000, depending on the complexity of the transaction.

If you can proceed under a 1031 structure, you may need to immediately identify that new property you're building to the IRS as the replacement. You'll also want the new building to be finished when you formally exchange into it. If it's only 80-percent to 90-percent ready when that 180-day period elapses, the IRS will ultimately give you credit toward just the portion of the project completed.

But proceed to a tax expert immediately, doc, and don't bite down for at least two hours after leaving the office.