In Part 1, Managing Tax Risks of Real Estate Investments, we discussed general tax considerations for real estate including types of real estate ownership and general tax considerations. In this second of three installments, we delve into specific real estate strategies for investors to minimize, defer or to reduce their tax liabilities, all of which have a positive impact on real estate returns and values.
Tax Deferral for Gain: Like-Kind Exchange. On the disposition of the property, the owner may defer tax on the gain by exchanging it for “like-kind” property. Real property held for productive use in a trade or business or for investment may be exchanged for property of a like kind that is also to be held either for productive use in a trade or business or for investment, and neither gain nor loss will be recognized on the exchange.
In order to qualify for like-kind exchange treatment, the transaction must meet the following requirements:
(1) The taxpayer must identify the property to be received in the exchange within forty-five days after he transfers the property he relinquishes in the exchange, and
(2) The taxpayer must receive the like-kind property within 180 days after the date of his transfer or, if earlier, before the due date of his tax return for the tax year (not including extensions).
However, a gain will be recognized to the extent money or other non-like-kind property, including net relief from debt, is received in the exchange. Also, gain or loss will generally be recognized if either property exchanged in a like-kind exchange between related persons is disposed of within two years.
It is possible for an exchange to be tax free for one taxpayer but not for the other if a taxpayer did not meet the requirements that the property exchanged be held for productive use in a trade or business or for investment but the other party did meet this requirement.
The like-kind exchange rules do not apply to property held for personal use. However, other tax-advantaged rules apply to the sale and replacement of a taxpayer’s principal residence.
Properties Must Be of the Same Nature or Character. To be like-kind, the properties must be of the same nature or character, but not necessarily of the same grade or quality. Unproductive real estate held by one other than a dealer for future use or future realization of increase in value is considered held for investment. Property held for investment may be exchanged for property held for productive use in a trade or business and vice versa. Unimproved land may be exchanged for improved land. City real estate may be exchanged for a ranch. Rental real estate may be exchanged for a farm.
The Internal Revenue Service (IRS) issued a favorable determination letter to a taxpayer who held an empty lot adjoining his house as investment property, listing it for sale to developers. A developer sought to purchase the empty lot, along with another lot owned by a neighbor, in order to construct four townhouses. Two of the townhouses would be exchanged for the empty lot. The lot owner would then use the townhouses as rental property. The IRS determined that the exchange of two townhouses for the empty lot qualified as a like-kind exchange.
Even partial interests in real estate have been held like-kind property, including the following examples:
- Two leasehold interests have been held like-kind property.
- A lease for thirty years or more may be exchanged for an entire (fee simple) ownership interest.
- A remainder interest in real property held for investment qualified as like-kind to a fee-simple interest in real property held for investment or use in a trade or business.
- Undivided interests in three parcels of land held by three tenants in common were exchanged so that each received a 100 percent interest in one parcel in a nontaxable like-kind exchange.
- The fractional tenancy-in-common interests of related parties may be exchanged for a fee-simple interest in real estate.
Surrender of the interests of tenant-shareholders in a housing cooperative (stock and proprietary leases with thirty or more years to run) in exchange for condominium interests in the same underlying property qualified as a like-kind exchange.
Holding for Trade, Business, or Investment Requirement. Nonrecognition of gain from a like-kind exchange will be denied unless the property is “held for productive use in a trade or business or for investment” and is exchanged for property to be likewise “held for productive use in a trade or business or for investment.” This “holding” requirement is not met when an individual acquires property in the exchange for the purpose of selling it or otherwise liquidating it.
The IRS takes the position that the “holding” requirement is not met unless the property is owned over a period of time with the intention of making money rather than for personal reasons. The IRS determined in a letter ruling that the holding requirement was met when an individual acquired property in an exchange with the intent to hold the property for use in a trade or business or as an investment for at least two years and then to sell it. However, the IRS also takes the position that when an individual acquires the property in order to exchange it, the transfer will not qualify with respect to that individual because the property is not held for business or investment purposes. Correspondingly, property received in the liquidation of a corporation and immediately exchanged did not qualify for a tax-free exchange because it had not been held for productive use in a trade or business or for investment by the taxpayer.
Property can qualify for a tax-free exchange even when the owner has sold to the other party an option either to purchase the land or to exchange similar property for it. However, if the like-kind exchange is between related persons, an option could operate to extend the two-year period during which nonrecognition is defeated by a disposition of the property.
Exchange Requirement. For a tax-free like-kind transaction, an “exchange” must occur. A sale followed by a purchase of similar property is not an exchange. The exchange of nonqualifying property (“boot”) does not make the transaction any the less an “exchange,” but simply requires recognition of any gain to the extent of the nonqualifying property.
The simplest form of exchange, one in which parties “swap” properties they already own, is not necessarily the most common. Frequently, a person (A) who wishes to make an exchange can find a buyer (B) for his property, but not one who has the property he wants in return. The IRS has permitted a three-cornered solution to this problem as follows: A transfers his property to B, B transfers his property to C, and C transfers his property to A. Courts have also permitted a number of variations on the three-cornered exchange.
In a two-party exchange, the IRS determined that the buyer (B) could acquire the property from a third person or construct a building specifically in order to exchange it for A’s property and that the resulting exchange could qualify with respect to A, provided B did not act as A’s agent. Such a transaction does not qualify as an exchange for B, who did not hold the property for business or investment but acquired it for exchange.
Deferred Exchange. A deferred exchange is any exchange in which, pursuant to an agreement, the taxpayer transfers property held for productive use in a trade or business or for investment (i.e., the “relinquished property”) and subsequently receives property to be held for productive use in a trade or business or for investment (i.e., the “replacement property”). When B wants title to A’s property before suitable replacement property has been located, the IRC specifies a limited period of time that may elapse after property is relinquished in a transfer and the replacement property to be received is identified and transferred.
The IRC states that to be treated as “like-kind,” the replacement property must be “identified” and “received” within the following specific time frames: