Property swaps can save tax dollars
By Pat Curry • Bankrate.com

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.

Like-property exchanges
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.

Property-swap protocol
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.