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Avoiding capital gains: tax-deferred exchanges allow savings in real estate deals.

Planned properly and used effectively, real estate swaps can shelter the total cash value of a transaction.

They also can help build a larger investment portfolio.

Tax-deferred exchanges have been used for decades. But they now have added importance in negating the impact of a capital gains tax that averages 38 percent nationally.

In many instances, an exchange is the only way a property owner can transfer the monetary value of an asset into one or more assets without losing money because of the capital gains tax.

More than half of all commercial real estate transactions in trend-setting California are accomplished through such exchanges.

Dan Robinson, president of Dan Robinson & Associates Inc. in Little Rock, is one of those who would like to see tax-deferred exchanges become more common in Arkansas.

"Hopefully, we're going to have some activity in central Arkansas because we have the network capability and a title company |Beach Abstract & Guaranty Co. in Little Rock~ that is working with us," Robinson says. "All we need is someone who wants to save some money."

Robinson is allied through the New America Network of Commercial Realtors with Apex Property Exchange Inc. of Massachusetts. Apex, a 3-year-old enterprise, is a professional intermediary that facilitates tax-deferred exchanges. The cost of Apex's service is a $1,000, plus a percentage based on the size of the transaction and the volume of exchanges a client conducts.

Apex acts as an independent third party that allows a buyer to sell a property and reinvest the money in a property of equal or greater value without paying any immediate capital gains taxes.

In fact, the taxes can be deferred indefinitely from a tax-estate planning standpoint.

Apex also serves as a strategic asset manager for clients who want to maximize savings on capital gains taxes.

The savings on capital gains taxes can mean even more to smaller investors than large corporations. Still, the most active exchangers traditionally have been oil companies and paper companies with their vast real estate holdings and other assets.

"There are literally hundreds of thousands of real estate transactions that aren't occurring simply because of the capital gains tax," says Michael Marcus, an executive vice president at Apex.

To qualify for a tax deferral, a facilitator must take title to a property on behalf of a seller and convey the property to a buyer. The facilitator also must hold the sales proceeds in escrow.

Under current regulations, a seller has 180 days to reinvest the sale proceeds into a "like-kind" property. Typically, the seller already has lined up a property or several properties for the facilitator to purchase on his or her behalf.

"You can use those other properties as a backup or perhaps put four smaller ones together that equal or exceed the value of the property sold," Robinson says.
Comparison Of A Taxable Sale And A Tax-Free Transaction
A corporation purchased a property for $500,000, depreciated it
by $200,000 and sold it for $1,200,000. The mortgage balance is
 Taxable Sale Exchange
Original Price $ 500,000 $ 500,000
Depreciation -$ 200,000 -$ 200,000
Basis $ 300,000 $ 300,000
Sale Price $1,200,000 $1,200,000
Basis -$ 300,000 -$ 300,000
Capital Gain $ 900,000 $ 900,000
Taxable Gain $ 900,000 $ 0
Capital Gain Rate x 38% x 38%
Capital Gain Tax $ 342,000 $ 0
Sale Price $1,200,000 $1,200,000
Mortgages & Liens -$ 850,000 -$ 850,000
Sale Proceeds $ 350,000 $ 350,000
Sale Proceeds $ 350,000 $ 350,000
Capital Gain Tax -$ 342,000 $ 0
Cash Available $ 8,000 $ 350,000
Cash Available $ 8,000 $ 350,000
Est. Closing Costs -$ 50,000 -$ 50,000
Net Cash Available -$ 42,000 $ 300,000

During the late 1970s and early 1980s, there was confusion over exactly what "like-kind" properties were.

A prevalent school of thought held that if the property sold through an exchange were an apartment complex, then the property to be acquired should also be an apartment complex.

Such interpretations obviously restricted the options available.

"Like-kind" later was used to denote the approximate values of properties involved in an exchange.

Almost all investment properties are eligible for tax-free transactions. Real property (land and buildings) just happens to be the most frequent variety exchanged. But factory equipment, airplanes, freighters, trucks, trains, oil rigs, artwork and electronic equipment also can be transferred on a tax-free basis.

"When people can find a way to not pay capital gains taxes without being audited, they will do it," Marcus says.

One Man's Strategy

Joe Whisenhunt of Bee Branch in Van Buren County is a commercial real estate developer who has used tax-deferred exchanges to his advantage.

"When I get ready to sell something, I never consummate a deal unless I am able to transfer that investment into another investment to take advantage of the tax laws," Whisenhunt says. "I've done it, oh gosh, probably 15 or 20 times. It has been the linchpin in building my real estate portfolio."

Whisenhunt has parlayed millions in pretax dollars into millions more by deferring capital gains taxes through real estate exchanges. He has a diverse real estate portfolio geared primarily toward retail tenants.

When Whisenhunt agrees to sell one of his assets to an interested buyer, he locates a suitable property to take its place and arranges what is known as an accommodated exchange.

The accommodated exchange is the most common type of tax-deferred exchange.

A typical arrangement involved two Little Rock properties in the 1970s -- undeveloped land at the southeast corner of Kanis and Shackleford roads owned by a service station jobber and a service station on Wright Avenue owned by First Pyramid Life Insurance Co.

The service station jobber had planned to develop a station on its property. However, the area wasn't developing quickly enough, and the company wanted out.

First Pyramid, meanwhile, had gained title to the service station on Wright Avenue through foreclosure. The company didn't want the property or the raw land at Kanis and Shackleford in west Little Rock, which is now home to the restaurant Alley Opps.

But the insurance company agreed to trade the service station for the vacant land because it would be easier to sell. First Pyramid then found a buyer for the undeveloped property and provided financing to facilitate the deal.

If a purchase opportunity presents itself, a different type of strategy sometimes is used to allow a tax-deferred exchange.

Whisenhunt often employs a straw man trust to take title to a property when he wants to make a quick buy. The strategy keeps him from paying taxes until he can market one of his properties and find a willing buyer to accommodate an exchange. The buyer acquires the property held by the straw man trust and then swaps it for the other property.

This method was used when the site of what would become Megamarket Shopping Center became available in west Little Rock.

Markham Partners Land Trust bought the 18-acre site for about $2.1 million in December 1985. Powell Brothers Inc., led by C.K. and Jack Powell, later acquired the undeveloped land from the trust and swaped it in August 1986 for Whisenhunt's 4.78-acre Kroger Center on Shackleford Road.

"Follow the guidelines, make sure you have 'like-kind' properties and you're home free," Whisenhunt says. "If you can program it properly, you can almost double your assets with pretax dollars."

Whisenhunt sold the land beneath the developed Megamarket Shopping Center in March for $4.6 million. He consummated the deal through another of his investments so he could offset the capital gains with losses from American Medical Data Systems of Memphis, Tenn.

This example illustrates one of the reasons for using independent third parties to accomplish tax-deferred exchanges. If there had been environmental liabilities associated with the undeveloped Megamarket site, Powell Brothers could have taken on unwanted exposure by momentarily holding title to the land.

An independent third party, which would have held the land rather than Powell Brothers, insulates a player from such concerns.

Title insurance companies and abstract companies provide the third-party service for clients.

Abstract companies try to break even on escrow fees and then make a profit on fees generated from issuing title insurance and closing transactions.

The Future

There is a growing movement to amend the Tax Reform Act of 1986, which drastically changed the playing field for real estate investors.

Whisenhunt believes a reduction in the capital gains rate will be a part of those changes.

"It may come down to 15 percent |or even~ as low as 10 percent, but it won't be this first time around," he says.

Whisenhunt accuses Congress of "messing with" a vital part of the nation's economy.

America's love affair with real estate is what attracted the roving eye of revenue-hungry legislators in the first place. Congress attempted to take a larger slice of the growing real estate pie, and the taxpayers ended up holding the bag.

"The federal government had a desire to close all the loopholes, and in doing so shot itself in the head," Whisenhunt says. "The beautiful part of it is they can turn things around as fast as they caused the problems to happen."

That likely will involve restoring the value of real estate by reclassifying passive losses and/or revamping the depreciation schedule.

Landmark Swap

When did the country's first documented tax-deferred exchange of real estate occur?

Many consider a deal that took place more than 62 years ago in Baltimore a landmark transaction, if not the first. The Internal Revenue Service challenged the validity of the tax deferral. However, the U.S. Board of Tax Appeals ruled Feb. 19, 1935, that the exchange was legal and not subject to an immediate capital gains tax.

The case established a pattern for the thousands of tax-deferred exchanges that followed.

Mercantile Trust Co. of Baltimore, as trustee for the Charles D. Fisher estate, held title to two parcels of real estate in downtown Baltimore known as 114-116 E. Baltimore St. The properties, occupied and leased by a restaurant, were adjacent to the Emerson Hotel.

The estate of E.O. Wylie owned the Emerson Hotel and wanted to acquire the adjoining properties in exchange for 223 W. Lexington St., which was under a longer-term lease to F.W. Woolworth & Co.

The two parties agreed to trade properties, with Mercantile also paying $33,000 in cash to the Wylie estate.

Title Guarantee & Trust Co. was the facilitator. On March 11, 1929, the title company entered into a written contract:

* With the trustee of the Wylie estate for the Lexington Street property for $267,000 cash.

* For the sale of the Baltimore Street property to the Emerson Hotel Co. for $300,000 cash.

Thirty-five days later, the Wylie estate deeded the Lexington Street property to the title company. The title company then deeded it to the trustees of the Fisher estate. And the trustees of the Fisher estate deeded the Baltimore Street property to the title company, which in turn deeded it to the Emerson Hotel Co.

The title company received $8,573 in commissions and title fees. The remaining $24,427 was reported as a net capital gain by the Wylie estate.

The taxable portion of a swap sometimes is called the "boot." The slang term is a reference to cowboy boots. In horse trades, one party sometimes would throw in a pair of boots to make the swap even.

The same is true of tax-deferred exchanges. It's just that cash is now preferable to footwear.
COPYRIGHT 1991 Journal Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

Article Details
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Author:Waldon, George
Publication:Arkansas Business
Article Type:Industry Overview
Date:Nov 11, 1991
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Next Article:The forecast is clear: Arkansas not hit as hard by recession as many other states.

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