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Trading spaces: 1031 swaps still a good deal.

Some things that are popular in California--like Thai chicken pizza--may never catch on in New York. But no matter what coast you are on, taking full advantage of the tax code's special provisions for property owners is always in style.

That's why the Section 1031 exchange, a method of protecting capital gains on real estate from unnecessary tax liability that was made popular by California property owners, is increasingly in favor here in New York as property values continue soaring.

With falling tax rates on capital gains seemingly reducing the value of a tax break these days, many property owners have asked me, "Are 1031 exchanges still a smart more?" My answer: in most cases, yes.

New York property owners tan defer the tax on capital gains when they transfer a property by essentially "trading" that property for another property of equal or greater value.

Under IRS Section 1031, "like-kind property" (which includes most real estate) may be exchanged without recognition of taxable gain or deductible loss. There are few restrictions on the types of properties that may be traded--a residential property may be traded for a commercial one, or vice versa.

Some might think that because the federal capital gains tax has been cut, these taxes aren't worth worrying about. But investors still must pay state and local taxes on their capital gains, and the impact can be substantial. Let's see just how costly capital gains tax can still be.

Say a property owner bought a multifamily residential building in 1994 for $1 million The property shows accumulated depreciation of $364,000, leaving a tax basis of $636,000. On the market, the property will sell at $1.5 million--leaving the seller with a realized gain of $864,000. If the taxpayer was to recognize this gain, their total tax liability, including federal, state and local taxes, would be $261,000. Capital gains taxes eliminate more than hall of their 10-year return on investment.

Instead, the taxpayer may exchange the property for another of like or greater value, thereby deferring the tax liability. The taxpayer may even borrow additional funds to exchange for a property of greater value, increasing their tax basis for another round of depreciation.

The trade does not need to happen simultaneously--the owner may place the proceeds from the sale of a property with a qualified intermediary, such as a trust company. However, the replacement property must be identified within 45 days of the sale of the original property, and usually the deal must be closed within 180 days.

There is an additional safe harbor available, which occurs when a property owner acquires the replacement property before divesting of the property to be relinquished. In this case, the exchange must meet several complicated requirements.

Before initiating any transfer of property, it is wise to speak to an accountant who is well-versed in this method. I'd like to point out two caveats: First, do not trade for a property of lower value and recoup the remainder of the value in cash.

The cash received will be deemed "boot" and will therefore be taxable. Second, this method does not apply to the sale of an interest in a real estate partnership.

An interest in a real estate partnership is considered personal property, not real property, and therefore does not qualify for 1031 treatment.

However, if all members of a partnership agree to trade a property, and receive a property of equal value or greater value, the partnership itself tan defer the recognition of the capital gain.

Don't think of this method as simply a way to shelter hard-earned real estate value from taxes. It can also be a means to effect a lifestyle change.

Consider two men: One is 63, and owns an apartment building worth about $10 million. He's tired of being a landlord, and wants to retire. The other man is 37, and owns a long-term lease on the ground underneath a Wal-Mart, land that is also worth about $10 million.

He gets a practically guaranteed 4% return every year (since Wal-Mart isn't going anywhere) but he's young, wants to work, and would welcome the higher return potential of a residential property.

This is the perfect situation for a property trade. The older man gets the return he wants and can retire, while the younger man has a chance to enlarge his revenue stream. Best of all, neither man is currently liable for capital gains taxes on any appreciation of their properties.

By continuing to exchange like-kind property, a property owner may conceivably defer capital gains taxes throughout their lifetime, regardless of how much their property appreciates in value.

For investors considering transferring property but wishing to remain in real estate, the concept of a like-kind tax deferred exchange is a very attractive strategy.

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Article Details
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Author:Saul, Michael
Publication:Real Estate Weekly
Geographic Code:1U9CA
Date:Jun 23, 2004
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