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Individual tax strategies
Like-Kind Exchange Tax Incentive Requires Attention to Detail
In a strong economy, where many commercial, industrial, and residential properties are commanding high prices in the marketplace, more real estate owners consider selling their properties. Inevitably, their first question relates to income taxes. With a federal tax bracket for high income earners, an increased federal tax rate on long-term capital gains, the new Net Investment Income Tax, and rising state income tax rates, the tax cost to real estate owners may actually create a disincentive to sell their highly appreciated properties.
Section 1031 of the Internal Revenue Code helps to address this issue. Under Sec. 1031, real estate owners can defer taxation on gains realized from the sale of appreciated property if the proceeds are reinvested in similar property. Simply put, a real estate owner can sell one property and acquire another, essentially maintaining a consistent economic position and therefore delay recognizing income tax on the appreciation of the property sold.
While a like-kind exchange can provide an excellent tax deferral strategy, real estate owners should beware of potential mistakes which could cause problems. If not structured properly, an exchange could leave a real estate owner with a recognized tax gain without the net cash proceeds to pay the tax liability.
The cardinal rule in a like-kind exchange is that the taxpayer must not have actual or constructive receipt of the sales proceeds for the property sold (the relinquished property).
Avoiding actual receipt is accomplished by engaging a qualified intermediary (QI) or title company to take receipt of the funds at closing. The intermediary acts on the taxpayer’s behalf to receive the closing funds and then uses those funds to acquire a new property (the replacement property). The taxpayer will not be considered to have actually received the closing funds if the agreement with the intermediary expressly limits the taxpayer’s rights to pledge, borrow, or otherwise receive the benefits of the funds held by the intermediary.
However, certain parties cannot act as qualified intermediaries, such as:
- Family members
- Related businesses owned by the taxpayer
- An agent of the taxpayer
- Certain attorneys, accountants, and financial institutions
This situation requires a close working relationship with the taxpayer’s legal and tax advisors before, during, and after the exchange. Several issues must be given appropriate consideration to ensure the realized gain can be successfully deferred.
Treatment of exchange expenses and non-transaction costs
In every real estate transaction, certain expenses are incurred by the seller. To manage the seller’s cash flow, these transaction costs are usually listed on the closing statement and treated as reductions in amounts due to the seller. A seller, therefore, can use the buyer’s cash to pay for these transaction costs in lieu of paying these expenses out of pocket.
In general, if the seller has engaged a qualified intermediary to receive the closing funds, the QI is allowed to use the funds to pay for “exchange expenses” which reduce the net proceeds retained by the QI on the seller’s behalf. Exchange expenses include bidding costs, transfer taxes, legal and accounting fees, title fees, engineering fees, survey costs, inspection and appraisal fees, recording and application fees, real estate agent commissions, and intermediary fees.
Other items typically found on a closing statement are not considered exchange expenses, such as security deposits and prepaid rent of existing tenants. These items are considered liabilities of the seller, not transaction costs. If the buyer receives a credit for these items toward the purchase price, the seller is treated as having received cash in an equal amount and simultaneously paying that amount to the buyer — a situation which causes taxable income for the seller. In order for the seller to avoid that taxable income, the seller should transfer these liabilities to the buyer at closing.
Greater or equal in value
The secondary rule of like-kind exchanges is that the seller should always exchange “greater or equal in value” and “greater or equal in equity” to avoid recognizing a gain. This is particularly problematic for real estate owners, because real estate properties are frequently encumbered by mortgage debt or other liabilities.
In some cases a seller’s mortgage may be assumed by the buyer (such as to avoid significant prepayment penalties). More commonly, a seller’s debt is paid off at the closing sale of the relinquished property, which reduces the net closing proceeds due to the seller.
The primary concern for a real estate seller is to determine the amount of reinvestment to be made into new property in order to successfully defer recognition of the gain. A seller may incorrectly assume they can acquire a replacement property for an amount equal to the net closing proceeds held by the QI on their behalf. They would be left with a new debt-free property and would have avoided recognizing the tax gain on the old property, right? Wrong.
If the relinquished property had a liability that was paid off at closing by the buyer, the reduction of that liability will be treated as cash received by the seller, and will result in taxable gain, unless the seller takes out a new liability on the replacement property for an equal or greater amount. A new liability on the replacement property is “netted” with the old liability paid off on the relinquished property and avoids inadvertent gain recognition. The seller is required to reinvest the net closing proceeds and the debt paid off, which is essentially the property’s fair market value.
Depending on the equity level in the relinquished property, the seller could structure new financing terms to obtain a higher value property.
Consider the following example:
A real estate owner sells property worth $1 million, and after an existing mortgage of $490,000 is paid off at closing, the net proceeds of $510,000 are deposited with a qualified intermediary. The seller intends to enter into a like-kind exchange. If the current lending market would allow a property to be financed using 70 percent leverage, the real estate owner could acquire a replacement property for $1.7 million by using the net proceeds of $510,000 as 30 percent equity and taking out a new mortgage for $1.19 million. As a result, the real estate owner has exchanged “greater or equal in value,” moving from a property worth $1 million to a property worth $1.7 million; and also exchanged “greater or equal in equity” by maintaining property equity of $510,000.
Use caution with cost segregation studies
Cost segregation uses engineering studies to allocate costs of various depreciable assets of a building over a shorter time frame than the typical 27 ½ years or 39 years, for residential buildings and commercial buildings. Often a real estate owner can receive significant tax benefits for depreciation deductions over 5, 7, or 15 years.
Cost segregation studies have been especially valuable in the last decade because “bonus” depreciation has allowed additional write-offs of 50 percent or 100 percent of a short-life asset’s cost (bonus depreciation is not applicable to longer-life building assets). While this depreciation strategy can provide huge tax savings in the early years of a building’s depreciable life, it poses a hazard for real estate owners seeking to enter into a like-kind exchange.
Although the like-kind classification is broad (e.g., a commercial building may be exchanged for unimproved land, and a parking ramp may be exchanged for a residential apartment building), real estate owners must be careful with properties which have been classified using cost segregation studies. By classifying assets into short depreciable lives, the real estate owner has established the position that some of the building is not actually real estate, but instead is personal property such as carpeting, fixtures, appliances, and millwork. Personal property is not considered real estate for like-kind exchanges.
In a like-kind exchange involving personal property, the personal property and real estate must be treated separately, and as a result, the replacement property acquired must be found to have an equal or greater amount of personal property.
If the relinquished property had a large allocation to personal property, the seller may be forced to perform a cost segregation study on the replacement property to identify how much personal property must be needed to complete the exchange.
How we can help
Properly executed, like-kind exchanges can allow real estate owners to take advantage of high property values in the marketplace and realign their portfolio by moving into different classes of real estate — all without incurring a significant tax cost. In determining if a like-kind exchange would work for you, consider the intricacies involved. CliftonLarsonAllen is experienced in like-kind exchanges and has significant cost segregation resources. Our experience with these types of transactions can help you evaluate you options with confidence, particularly when you are preparing for a business transition or considering your eventual retirement.