Consider a section 1031 exchange.

Permanent tax reduction is possible.

Internal Revenue Code section 1031, tax deferred exchanges, provides investors with one of the last available tax shelters by allowing them to avoid paying any taxes when investment properties are sold. Why, when and how this happens are questions CPAs should be able to answer.

Section 1031 can provide permanent deferral of the gain on investment real estate properties. Investors never have to pay taxes on equity buildup as long as they keep exchanging (instead of selling) properties until their death--when the basis of the properties will automatically be adjusted to the market value on the date of death, eliminating all gain.

HOW AN EXCHANGE WORKS

Two property owners rarely want each other's properties. In reality, most exchanges involve three parties: the taxpayer who wants to sell (but defer paying taxes), the buyer for that property and a seller for another property the taxpayer wants to transfer his or her equity into. As usual, the sales contracts are signed by the taxpayer (since he or she has to be approved for any financing) but at closing a facilitator is hired to do the selling and buying in the taxpayer's place. If the taxpayer instead sells the property on his or her own, the Internal Revenue Service would not allow exchange treatment because the taxpayer would get cash to make the new purchase and receipt of cash is taxable.

However, when a taxpayer exchanges into another "like-kind" property--using the built-up equity instead of cash--the IRS view is that he or she really is continuing the original investment.

Like-kind is defined as real property, for real property. This means not only exchanging an apartment building for an apartment building but also exchanging an apartment building for a farm, vacant land, a cranberry bog or any other real property, as long as the new apartment building is not the investor's personal residence and he or she intends to hold the acquired property "for productive use in trade or business" for at least six months and preferably a year. To sell it sooner would classify the taxpayer as a dealer, which is not allowed.

Example. Ada Smith has owned a 30-unit apartment building for 12 years. She originally paid $500,000; today it is worth $800,000. As a result of accelerated depreciation, Smith's adjusted tax basis is now $120,000. If she sells the property, her gain will be $680,000. In her 28% federal tax bracket, she will have to pay $190,000 in taxes. Smith asks her CPA how she can transfer her $450,000 equity ($800,000 building value minus $350,000 debt) to another property without paying any tax.

An "assignment of contract" clause is added to the sales contract when a buyer is found for Smith's budding and to the purchase agreement for the new property she wants to exchange into. This clause authorizes the facilitator to sell Smith's property and transfer the profit to the purchase of another one. At the closing, the facilitator briefly takes title to Smith's property before transferring it to the buyer because it would be illegal for the facilitator to sell (or exchange) real property without having proper tide.

FINDING A FACILITATOR

Most facilitators today are associated with tide insurance companies because there is more security for the funds involved since the title company is bonded. Very few CPAs act as facilitators because there must be a two-year period between the time a CPA was the client's accountant and when the CPA acted as facilitator. Similarly, a taxpayer's attorney, employee or real estate broker also is considered to be "related" to the taxpayer and thus cannot act as facilitator for an exchange transaction.

ASSESSING AN EXCHANGE

To make certain such transactions will defer taxes and are financially worthwhile, CPAs can use the calculation sheet in exhibit 1, page 46, to simplify the procedure.

Example. Bob Boone, party A, purchased a small rental house in 1991 for $60,000 with a $15,000 downpayment; the house is now' worth $100,000 and Boone still owes $45,000 (line B on exhibit 1) and has a depreciated basis of $50,000 (line G). He wants a property that will generate more income and finds a fourplex that party B is selling for $200,000 subject to a $145,000 mortgage. When exchanging, the equities (line E) must balance. This can be accomplished either by refinancing one of the mortgages or giving cash (boot) or unlike property (line D) to make up the difference. In exchanging, it is better to give than to receive because any cash the investor receives will appear on line K and can defeat the tax avoidance goal.

Lines H and M show that the $44,000 gain is completely deferred. How does this affect the tax basis of the new property Boone receives from party B? The last line of the calculation sheet, line T, shows that the $44,000 gain has been subtracted from the new property's $200,000 basis. While this means the property's depreciable basis is less, Boone keeps more cash in his pocket. And he has achieved two goals: He has (1) disposed of the old propert5' and deferred all tax on the $44,000 gain and (2) exchanged it for a property' that is worth twice as much.

TIMING IS IMPORTANT

When is the best time to exchange into another property? Conventional wisdom says that if you've owned your income property for over five years, you're losing money. Why?

Example. Cynthia Gifford invested $40,000 in a $200,000 property (see column 4 of exhibit 2, above). The property appreciated at 10% per year for the next five years and her investment increased (via equity buildup) to $162,102 (also shown in column 4). By looking at column 9, return on equity from income, it is possible to see that by the end of the fifth year the return on Gifford's investment had diminished from an impressive 33% to a shrinking 16%. The lesson: The longer Gifford owns this property, the lower the cash flow relative to the amount of her equity. Increasing rents yearly by 7% does not alter the situation. Even at 10%, Gifford would still be getting a lower return each year. The rule of thumb used by many investors is when the equity in a property nears 50% of the property's value, it's a good time to consider moving on.

SIGNIFICANT SAVINGS

Properly executed, section 1031 exchanges can achieve significant tax savings for a wide variety of taxpayers, both large and small. Such transactions also will allow them to continue trading up into properties that will provide both greater cash flow and the potential for increased net worth.

The Birth of Like-Kind Exchanges

Nonrecognition of gain treatment is available even for property with a readily realizable value if the property "held for investment or for productive use in trade or business (not including stock-in-trade or other property held primarily for sale) is exchanged for property of like kind or use."

Revenue Act of 1921, section 202(c)

EXECUTIVE SUMMARY

* INTERNAL REVENUE CODE SECTION 1031, tax deferred exchanges, provides one of the last available tax shelters by allowing permanent deferral of the payment of any taxes when investment properties are sold.

* SINCE TWO PROPERTY OWNERS RARELY want each other's properties, most exchanges consist of three parties: the taxpayer who wants to sell (but defer paying taxes), the buyer for that property and a seller for the property the taxpayer wants to transfer equity into. A facilitator is hired to do the selling and buying in the taxpayer's place.

* WHEN A TAXPAYER EXCHANGES INTO another "like-kind" property--using equity instead of cash--the Internal Revenue Service view is that he or she is continuing the original investment. Since likekind is defined as real property for real property, this means exchanging not only an apartment building for an apartment building, but also an apartment building for raw land, as long as the new property will be held for productive use in a trade or business.

* TO ASSIST THEIR CLIENTS, CPAs SHOULD make certain the transactions will defer taxes and are financially worthwhile. This can be done using a calculation sheet specifically designed to evaluate exchanges.

[TABULAR DATA OMITTED] Exhibit 1: Exchange Calculation Worksheet

  Party A    Party B

I Balancing equities
   A. Market value: property given         $100,000   $200,000
   B. Less: mortgage balance                -45,000   -145,000
   C. Equity given                          $55,000    $55,000
   D. Plus: unlike property given
   E. Total                                 $55,000    $55,000

II Realized gain
   F. Market value: property given (line A)$100,000   $200,000
      Less: selling costs                    -6,000   - 12,000
   G. Less: adjusted tax basis              -50,000   -180,000
   H. Realized gain                         $44,000     $8,000

III  Recognized gain
   I. Net mortgage relief
                     $100,000
   J. Less: boot given (line D)
      Less: commission paid                 $-6,000   - 12,000
   K. Plus: boot received
   L. Net boot received                          $0    $88,000
   M. Recognized gain (lesser of line H or L)    $0     $8,000

IV. Tax basis of property received
   N. Adjusted tax basis (line G)           $50,000   $180,000
   O. Less: boot received (line K)
   P. Less: old mortgage (line B)           -45,000   -145,000
   Q. Plus: boot given (line J and           +6,000    +12,000
       commission)
   R. Plus: mortgage(s) on property        +145,000    +45,000
        received   S. Plus: recognized gain (line M)
          0                           +8,000
   T. Tax basis of new property            $156,000   $100,000

DOROTHY GUERRIN OVERHOLT is a real estate broker in Puyallup, Washington, who specializes in exchanging investment properties. She is the author of Exchanging Real Estate Made Simple. Additional information about the calculation sheets used in this article is available by sending her an e-mail message via the Internet to [e-mail].