can save tax dollars
Anyone who owns investment or business property
in a high-growth area knows what happens to the tax bill when property
values go up, especially if they've had the property for a long
time and taken deductions for depreciation.
"They can't afford to sell because
the tax bill will be more than the profit," says Jay Gordon,
chair of the tax law department for the New York office of Greenberg
Traurig LLP. "That's what I call tax-locked. They want to get
rid of the property, but they can't afford to do it. I don't feel
sorry for them because they got all these benefits over the years,
but none of my clients see it that way."
Big investors aren't the only ones who
get caught in this kind of jam, though. All across the country,
housing developments and shopping centers are popping up on what
used to be pastures and fields for crops. For family farmers struggling
to make a living, the chance to lead a comfortable, less backbreaking
life is very attractive, until they see what the capital gains taxes
will be on ground that was bought for a few dollars an acre and
has increased in value by a thousand fold.
That's why like-property exchanges are so popular. Falling under
section 1031 of the tax code, like-property exchanges offer business
owners or investors a way to trade their property for something
of similar value without reporting a profit and, thereby, defer
paying taxes on the gain.
It could be a chicken farm or a piece
of rental property. With tangible property, it could be a company
vehicle or a piece of machinery, although these can present a real
problem for business owners because the depreciation on equipment
is much faster than on real estate. You may be able to write off
the entire value of a computer system in two years, so even if you
sell it for less than you paid for it, it would still show up as
a gain on your taxes.
"Like-kind exchanges have been in
the tax code for a long time," says Prof. William Raabe, a
professor of accounting at Samford University in Birmingham, Ala.,
and the author of several taxation textbooks. "Really, what's
at the base of it is Congress thinks you can make good investment
decisions and doesn't want the tax law to get in the way. If you're
in the same investment position before and after the sale, you shouldn't
be taxed. They'll wait until you cash out down the road. If there's
really no cash on the table, how do you pay the tax?"
That doesn't mean, though, that you sit
down with another property owner and just trade deeds or titles.
It would be virtually impossible to find another person with investment
property or equipment of identical value who wants to make a swap.
There are a few major rules to follow. The way the tax code is written,
you've got 45 days from the time you sell a piece of property to
identify what you're going to buy in exchange, and 180 days -- or
the due date of your tax return with extensions, whichever is shorter
-- to make the exchange.
Also, the taxpayer can't actually receive
any cash from the sale.
"The thing people have to understand,
and they don't like to understand it, is that to make an exchange
work that's not simultaneous, the taxpayer can't touch the money,"
Gordon says. "If I sell the property, the proceeds have to
go to a qualified intermediary. You have to intend to complete an
exchange from the beginning."
Another important rule is you can only
exchange property held for investment or for business use. That
excludes your personal house or a vacation house, unless you rent
it out. You also can't exchange inventory, a partnership interest
or stocks and bonds.
The biggest problem most people have
in doing a 1031 exchange, Gordon says, is finding a replacement
property. As a result, there's an entire industry within real estate
of qualified intermediaries, or QI's, that locate properties for
like-kind exchanges and handle the transactions.