Beyond section 1031.

Complex exchange strategies for savvy investors.

EXECUTIVE SUMMARY

* EXCHANGING REAL ESTATE OR PERSONAL PROPERTY under IRC section 1031 enables taxpayers to postpone the tax consequences when selling investment property. CPAs should be aware of specialized exchange techniques that are available to cover more unusual situations.

* MOST EXCHANGES MAKE USE OF THE SERVICES of a qualified intermediary (QI), who acts as an independent third party to facilitate the transaction and holds sale proceeds during the exchange period.

* WITH A REVERSE EXCHANGE, AN INVESTOR MAY FIND the perfect replacement property before he or she has put the currently owned property on the market. A QI establishes a new entity that purchases and holds the replacement property until the existing property is sold.

* A CONSTRUCTION EXCHANGE IS USED WHEN it makes sense for the investor to buy a lot and build the replacement property. A QI purchases the lot and holds title to it during the construction period until the cost of the lot and the improvements equals or exceeds the value of the property being sold. Investors can use reverse construction exchanges when they have to buy the lot before they sell the relinquished property.

* PERSONAL PROPERTY AND MULTIASSET EXCHANGES involve transactions that include both real estate and personal property or personal property alone. Such exchanges are eligible for section 1031 treatment as long as the property exchanged is of like-kind. The standards for like-kind property are stricter than those for traditional real estate exchanges.

Most real estate investors recognize the obvious benefit of an IRC section 1031 exchange--the tax bill due Uncle Sam is put on hold, allowing the full amount of equity in the property to continue compounding. What some investors are just beginning to realize is that exchanging does far more than just delay income tax consequences; it is a powerful tool that can help accomplish a variety of other investment goals.

Because of these advantages (see exhibit 1, page 62), an increasing number of CPAs are advising clients to consider using a tax-deferred exchange before structuring real estate transactions. With more clients deciding to use exchanges as part of their investment strategies, it's critical that CPAs understand not only the standard exchange under section 1031 but also the basics of several more specialized exchange techniques.

Exhibit 1: Advantage of Exchanging

1 Investment property can be transferred from one location to another. Investors who move can exchange for properties closer to home. An exchange also may be a way to buy a replacement property in a site ideal for future retirement.

2 Current cash returns can be improved without sacrificing equity, Because of retirement or another life-style change, an investor may want a property that produces a higher monthly income instead of the property he or she currently owns that might increase in value over time. Exchanging allows an investor to swap for a property that produces a higher monthly income without incurring any current tax liability.

3 Greater investment appreciation may be gained without a large tax bill. Some high-bracket investors may wish to forgo current income to accumulate future equity. Using a tax-deferred exchange makes it possible for investors to "sell high and buy low" and keep the entire profit working for them.

4 Investments can be consolidated or diversified. Changes in an investor's philosophy may necessitate real estate portfolio changes. Exchanging makes it possible for an investor to sell a group of properties and transfer the equity into one larger piece of property. It's also a good tool to redistribute investment risk among a variety of property types or locations.

5 Management hassles can be reduced or eliminated. An investment property requiring frequent and time-consuming attention may be exchanged for one requiring less hands-on management or one that is professionally managed.

DELAYED EXCHANGES

The majority of exchanges today are "delayed," meaning the sale of the existing property and the acquisition of a new one take place at different times. While such exchanges are relatively easy to execute, they typically require the services of a qualified intermediary (QI). (See the sidebar on page 65 for information on selecting a QI.) Section 1031 and Treasury regulations section 1.1031 provide clear guidelines for executing exchange transactions. When an investor (the exchanger) sells his or her property, the QI coordinates the necessary paperwork and holds the sale proceeds. The exchanger then has 45 days after the sale to identify a list of potential replacement properties and 180 days after the sale to acquire one of those properties. At that time, the intermediary again coordinates certain paperwork and forwards funds to pay for the acquisition; the exchange is then complete.

Example. Brian owns a piece of undeveloped land in rural Michigan he wants to dispose of through an exchange. After consulting his CPA, Brian puts his property on the market and hires a QI, who coordinates the necessary paperwork. When the land sale closes, the QI holds the proceeds. Within 45 days Brian identifies three pieces of property he wants to buy outside Detroit and successfully negotiates a contract to buy one of the parcels. Within the required 180 days the QI releases the funds Brian needs to close the purchase and the exchange transaction is complete. Brian has successfully postponed any gain he had on the original property.

Although standard exchanges are relatively easy to complete, transactions that involve special circumstances (see exhibit 2, page 63) can be more challenging. The following complex exchange strategies offer more flexibility for unique situations.

Exhibit 2: Complex Exchange Strategies

Special Circumstances                     Exchange Considered

The replacement property must be          Reverse or "parking"
purchased before the relinquished          exchange
property can be sold.

The exchanger wants to build the          Construction exchange
replacement property,

(1) The exchanger wants to build the      Reverse construction
replacement property and (2) the lot      exchange
must be purchased before the
relinquished property can be sold.

The sale of a relinquished property       Multiasset exchange
includes a significant portion of
personal property, which is "like-kind"
to the personal property being acquired
as part of the replacement property,

Property "held for productive use         Personal property
in a trade or business or for              exchange
investment" is being sold and
replaced with other
like-kind property.

Special Circumstances                     Sample of Steps Required

The replacement                           * A "parking entity"
property must be                          (PE) purchases the
purchased before                          replacement property
the relinquished                          and holds it until
property can be sold.                     the exchanger sells
                                          the relinquished
                                          property.

                                          * The exchanger net
                                          leases or manages the
                                          replacement property.

                                          * When the relinquished
                                          property is sold,
                                          a qualified
                                          intermediary (QI)
                                          holds the net proceeds.

                                          * The exchanger
                                          purchases the replacement
                                          property from the PE,
                                          completing the exchange.

The exchanger wants to build the          * When the relinquished
replacement property,                     property is sold, a QI
                                          holds the net proceeds.

                                          * The QI purchases
                                          the replacement lot and
                                          holds it during the
                                          construction period.

                                          * The exchanger or his
                                          or her designee
                                          supervises the
                                          construction under
                                          a written agreement.

                                          * All funds for
                                          acquisition and
                                          construction go
                                          through the QI and are
                                          never controlled by the
                                          exchanger.

                                          * When the construction
                                          is complete, the QI
                                          transfers the replacement
                                          property to the
                                          exchanger.

(1) The exchanger wants                   * The exchanger follows
to build the replacement                  various steps from the
property and (2) the lot                  reverse and construction
must be purchased before the              methods listed above.
relinquished property
can be sold.

The sale of a relinquished                * When the relinquished
property includes a                       property is sold,
significant portion of                    net proceeds are
personal property, which                  held by a QI.
is "like-kind" to the personal
property being acquired                   * When the replacement
as part of the replacement                property is purchased,
property,                                 certain values are
                                          assigned to the
                                          real estate and
                                          personal property
                                          portions.

Property "held for productive use         * Similar to the other
in a trade or business or for             methods, with documents
investment" is being sold and             tailored to the individual
replaced with other like-kind             assets being exchanged.
property.

REVERSE OR "PARKING" EXCHANGES

The deferred exchange regulations outlined above apply only to so-called forward exchanges in which an investor first sells the property he or she currently owns (the relinquished property) before closing on the new property (the replacement property). In reality, the investor may find the perfect replacement property before the relinquished property is even on the market. If the seller is willing to extend the closing date to give the investor time to sell his or her existing property, a standard delayed exchange is feasible. If the seller won't extend the closing date, the investor may consider a reverse or parking exchange.

Under this method, a third party unrelated to the exchanger purchases and holds ("parks") the replacement property. (Although several third parties can perform this function, it is typically handled by a QI.) Once the investor sells the relinquished property, he or she purchases the warehoused property--from the third party--as the replacement property, completing the exchange.

The IRS recently announced it will issue a revenue ruling on these types of exchanges. Until it does so, however, CPAs will find limited guidance in these cases:

* Coastal Terminals, Inc. v. U.S.

* re Exchanged Titles, 159 BR 303 (CD Cal 1993).

* re Sale Guaranty, 220 BR 660 (9th Cir BAP 1998).

Example. Each summer Karen and Paul spend two weeks in Breckenridge, Colorado. Last year, they fell in love with their four-bedroom condominium rental at the base of a new ski run. The owner says he might be interested in selling the property.

Karen and Paul own a small apartment complex near their home in Atlanta, which provides attractive annual cash flow but has only marginal appreciation potential. Because their CPA has suggested they look for ways to lower their tax bill, Paul and Karen are open to an investment with high appreciation potential and low cash flow. They have successfully negotiated a contract to buy the condo. However, the seller insists on closing in 60 days.

Under a standard exchange, Karen and Paul would have to sell the apartment complex in 60 days, probably at a much lower price than they might realize with a longer sale period. Rather than lose part of their equity, Karen and Paul opt to try a parking exchange.

A QI sets up a separate entity (usually a LLC or regular corporation) that acquires and warehouses the Breckenridge condo with funds loaned by Karen and Paul. (They have obtained a line of credit from their bank, secured by the apartment complex.) Within four months, they are able to sell the apartment complex at an attractive price. Once the complex is sold, the entity sells the Breckenridge replacement property to the couple and repays the loan, completing the exchange. Karen and Paul are able to successfully defer any taxes due and trade moderate cash flow for high appreciation potential. They also now have a great place to vacation.

CONSTRUCTION EXCHANGES

It often makes more economic sense for an investor to purchase a lot and build the replacement property. This is particularly true if he or she can't find the ideal property at a reasonable price or if the right kind of property is hard to find. To successfully defer all taxes, the replacement property cost must equal or exceed the relinquished property price. If the replacement property value is less. only part of the taxes may be deferred.

Building the replacement property often poses a problem because the price of the unimproved lot typically is much less than the value of the relinquished property. If the taxpayer's goal is to maximize exchange benefits, he or she needs a way to increase the lot's value by having some or all of the improvements built before taking title to the property. Under such circumstances, CPAs should encourage clients to consider a construction exchange.

In a construction exchange, a third party--again set up by the QI--purchases the lot on which the improvements will be built and holds title to the property during the construction period. Once the cost of the lot and improvements equals or exceeds the value of the relinquished property, the third party transfers the new property to the investor, concluding the exchange. Exhibit 3, below, lists some other important characteristics of parking and construction exchanges.

Exhibit 3: Characteristics of Parking and Construction Exchanges

* The entity warehousing the replacement property must craft a real-world transaction that reflects some of the normal burdens and benefits faced by other investors.

* The replacement property is often leased or managed by the exchanger, who then must make the applicable rent, insurance and interest payments on the property.

* During the acquisition and construction period, cash draws requested from either a third-party lender or from exchange funds never must be controlled by the exchanger; they must flow through the QI directly to the contractor.

* The exchanger normally supervises the construction of the replacement property under the terms of the construction management agreement.

Example. ShopFast owns and operates a number of quick marts in the Southeast. Management decides to accept an offer to buy four of the properties and starts looking for larger sites nearby. When they learn the taxes on the proposed sales may run as high as $500,000, they ask their in-house CPA to suggest other options.

After discussions with a QI, the accountant reports that despite the additional steps required and higher transaction costs, a construction exchange is the best alternative. The intermediary sets up a warehousing entity specifically for this transaction. Once the sale of the four stores is complete, the entity uses part of the sale proceeds to purchase the lots management has identified for the new stores.

Construction takes approximately five months. Construction costs are first funded from any remaining sale proceeds and then through a construction loan. When the new marts are finished, the intermediary transfers them to ShopFast, completing the exchange. The goal of the exchange is met: The company has upgraded four of its existing locations while dodging a $500,000 tax bill indefinitely.

REVERSE CONSTRUCTION EXCHANGE

Another type of complex exchange essentially is a combination of the first two methods. An investor should consider a reverse construction exchange when he or she must purchase the lot to be improved before selling the relinquished property or when construction is expected to take more than 180 days.

Example. Kathleen Murphy finds a site for a rental home on a golf course in Sedona, Arizona. Because she and her husband Scott hope to move there when they retire, she decides to buy it. The lot is listed for $200,000. The Murphys are familiar with exchanges and wonder whether it's possible to sell a piece of land they currently own in North Carolina and use the Arizona lot and the house they will construct as the replacement property.

The Murphy's land has a fair market value of $400,000 and a negligible cost basis. Construction on the new rental house is expected to take more than 12 months and cost approximately $300,000. A standard exchange will require a quick sale of the North Carolina property and will defer taxes on only $200,000 of the proceeds. The Murphys can afford to buy the Sedona property now and sell the existing land later. They ask their CPA to explore a reverse construction exchange to see whether it will result in significant savings.

If Scott and Kathleen sell the existing property without an exchange, they calculate that approximately $300,000 will be left after taxes to put in other investments. If' they can structure an exchange, they can reinvest the full $400,000 in the Sedona property.

Because they want to maximize their investment return, the Murphys ask their CPA to calculate the worth of the $300,000 of aftertax proceeds in 10 years assuming they reinvest the funds in certificates of deposit yielding 6.5% or in stocks and bonds earning 10%. The CPA compares those results with the worth of the $400,000 of tax-deferred proceeds if they are reinvested in the Sedona property--assuming the property earns a 10% annual return. As exhibit 4, above, shows, a reverse construction exchange is the clear winner because it keeps an additional $100,000 of proceeds working in the future.

[Exhibit 4 ILLUSTRATION OMITTED]

PERSONAL PROPERTY EXCHANGES

This type of complex exchange works in much the same way as a standard real estate exchange, except the item or items being exchanged are personal property (referred to as depreciable tangible personal property). Essentially, a taxpayer can sell an item that qualifies as "held for productive use in a trade or business or for investment" and replace it with other property that is of like-kind. Some examples of personal property a taxpayer may exchange include

* Art held for investment.

* An airplane used in a business.

* Construction equipment.

* A company-owned boat.

* A classic car held for investment.

The good news is that such items can be exchanged; the bad news is that the process of doing so is often more difficult because the definition of like-kind is much stricter for personal property. To qualify for exchange, Treasury regulations section 1.1031 (a)-(2) (b) requires that personal property be in the same general asset or product class. (Revenue procedure 87-56 defines asset classes; product classes are found in the Standard Industrial Classification Manual.)

Although these types of exchanges have been widely overlooked, individuals and companies are discovering the tax benefits of doing a carefully structured personal property exchange--despite the restrictions of applying like--kind treatment.

Example. Ann Marie plays the violin for a major U.S. symphony. She decides to sell her current instrument and upgrade to a more expensive one. Because her violin has quadrupled in value, she will have a sizable tax bill if she sells it outright. With properly structured documents tailored to her situation, she can acquire the new violin in an exchange and reap the same benefits enjoyed by real estate investors.

A personal property exchange is also a good idea for a company about to upgrade the corporate jet it owns for business travel. If the plane has been aggressively depreciated, a sale can trigger a sizable gain. (Recapture of depreciation on personal property is not taxed at the lower capital gains rate but, rather, at the more onerous ordinary income rate.) In this case, a personal property exchange may prove especially beneficial.

MULTIASSET EXCHANGES

This last type of complex exchange is a combination of a standard deferred exchange and a personal property exchange. Some investments, such as restaurants, hotels, nursing homes and television stations, include both real estate and a significant amount of personal property (described above). With careful planning, taxpayers can use a 1031 exchange to defer taxes on both types of property in one coordinated transaction.

As noted earlier, the definitions of like-kind property that govern personal property exchanges are strict. However, with a sizable portion of the value in some exchanges often allocated to personal property, overcoming these additional hurdles is worth the effort. A multiasset exchange is worthwhile if the acquired property includes personal property items in the same product or asset class as the relinquished property.

Example. Pinnacle Care Facilities LLC owns five nursing homes in Maine. To keep pace with the state's growing elderly population, Pinnacle has begun selling older, smaller locations and acquiring newer, larger facilities. When the company receives an offer for one of its locations, Pinnacle's owner quickly surveys the area and locates a larger facility that matches the company's expansion goals. She then contacts her CPA, who arranges a meeting with a QI. Together, the three parties coordinate the strategy necessary to successfully complete a multi-asset exchange. Using this exchange method allows Pinnacle to defer taxes not only on the sale of the real estate but also on the significant amount of personal property--furnishings, equipment, appliances, linens--included in the sale.

WORTH THE EFFORT

Complex exchanges are becoming increasingly popular because they make the benefits of exchanging available in transactions where a standard exchange can't be used. Although such exchange methods often are more sophisticated and more costly, they generally are worth the effort. It is to the CPA's advantage to recognize situations in which complex exchanges can be used successfully and to recommend them to clients as appropriate. The potential for significant tax savings also makes it in the client's best interest to understand the benefits of such transactions. CPAs may want to use the information here as an opportunity to contact clients to ascertain whether they understand the opportunities complex exchanges can offer them.

MORE TIME IS MONEY ...

The benefit of an IRC section 1031 exchange? The tax bill due Uncle Sam is put on hold, allowing the full amount of equity in the property to continue compounding.

How to Find a Qualified Intermediary

Perhaps the best way for CPAs to approach the search for a qualified intermediary (QI) is to understand who is not eligible to perform the service. A "disqualified" party is anyone who is or has been the taxpayer's agent by acting as his or her employee, attorney, accountant, investment banker/broker or real estate agent in the two years before the closing of the relinquished property. An investor also may not use a blood relation as an intermediary. Because of the long list of parties who cannot serve, many investors frequently enlist the services of a professional QI.

Virtually anyone can call himself or herself a QI. Nevada is the only state requiring QIs to be officially certified. It's important for a CPA to help a client select an intermediary with the necessary knowledge, experience and safeguards to structure the exchange correctly and hold the exchange proceeds safely. CPAs also should look for knowledgeable staff, bonded transactions and prompt service.

In searching for an intermediary, one referral source is the Federation of Exchange Accommodators (FEA), which is the primary professional trade association for this industry. The FEA can be reached at 916-388-1031 or through its Web site, www.1031.org.

RONALD L. RAITZ, CCIM, is president of Real Estate Exchange Services, Inc. in Marietta, Georgia, which provides consulting and intermediary services for section 1031 tax-deferred exchanges. His e-mail address is [e-mail]. BRIDGETTE M. RAITZ, CPA, is a commercial real estate consultant.