is the goal? The goal is to take advantage of this opportunity
to get the time valued use of Uncle Sams money and use that
money to help buy your investments. When you sell a piece of investment
property, assuming the property has increased in value, the proceeds
will be comprised of three parts:
Your initial investment in the property, (less depreciation)
Gains: Your profit from the increase in value of the property;
Uncle Sams portion of your capital gains which is currently
taxed at a maximum rate of fifteen (15%) percent.
The tax deferred
exchange lets you take Uncle Sams portion and reinvest it
without paying him, yet.
does it work? The rules are very strict and must be followed
precisely; otherwise, the transaction will be overturned causing
taxes to be paid with penalties. At a minimum, there are two properties
involved: the Relinquished Property and the Replacement
Property. The Relinquished Property is the investment property
that you currently own and that you are selling. At some point
between the time you contract to sell the Relinquished Property
and the time you close on that sale, you must enter into a written
agreement with a Qualified Intermediary who will hold your sales
proceeds until you reinvest them in another piece of investment
property, the Replacement Property. All time requirements run
from the date upon which you close on the sale of the Relinquished
Property and must be strictly adhered to. Within forty-five (45)
days after closing, you must identify potential replacement properties.
(If you identify more than three properties, stricter rules apply.)
Within one hundred eighty (180) days after closing on the Relinquished
Property, you must close on the Replacement Property. As a part
of this process, the Qualified Intermediary will provide the proceeds
held on your behalf to purchase the Replacement Property.
requirements are very stringent and will require the professional
drafting of documents and guidance through the process.
of property can be used for the exchange? The rule is like-kind
property. Within the realm of real property, what is considered
like-kind is liberally construed provided the properties
involved are investment properties or properties held for productive
use in a trade or business. Typically, the property involved on
Hilton Head Island is investment property. The tax deferred exchange
begins with a piece (or several pieces) of investment property.
A personal residence will not qualify. On the other hand, raw
land and rental property clearly do apply. Second homes that are
not rented will most likely not qualify. At a minimum, that will
be an aggressive stance to take with the IRS.
do you mean about investing using Uncle Sams money?
Lets say that ten years ago, you originally purchased an
oceanfront villa (we will call it Villa A) for $200,000.
You now have a contract to sell Villa A for $700,000. (Villa A
is your Relinquished Property using tax deferral language.)
With your basis in the property being $200,000 and your sales
price being $700,000, upon the sale you would have capital gains
in the amount of $500,000. At the current maximum capital gains
rate of 15%, you would normally owe Uncle Sam $75,000 in capital
gains taxes. However, because you are doing a tax deferred exchange,
Uncle Sam is going to permit you to take his $75,000 and use it
to purchase your next piece of investment property (your Replacement
Property) and pay him for those taxes at some later date;
provided, of course, that you meet all the requirements for executing
the tax deferred exchange. (Note: The result is even more dramatic
if you have depreciated the property where your basis is less
than the original $200,000 you invested in the property.)
I turn this tax deferral mechanism into a tax
avoidance mechanism? Interestingly enough, should you
either hold onto the Replacement Property or continue to roll
the capital gains into new investment properties using the tax
deferred exchange mechanism, upon your death the property will
go into your estate and your heirs will get a stepped-up basis
in whatever investment property you own at that time. What this
means is that there is no longer any capital gains on the property
because the basis gets stepped-up to the then current
value of the property. Using our previous example, the original
basis was $200,000. If at the time of your death the current value
is $700,000, your heirs or devisees will get a stepped-up basis
meaning their new basis in the property is $700,000. When they
decide to sell the property, capital gains taxes will be calculated
based upon the stepped-up $700,000 basis, not the original $200,000
basis. As a result, Uncle Sam just lost $75,000 of his capital
gains taxes. As a result, you will have turned a tax deferral
mechanism into a tax avoidance mechanism. (Obviously, there will
still be estate tax issues with which to contend.)
other scenarios for completing a tax deferred exchange? Yes.
For instance, you can do a reverse exchange where you buy the
Replacement Property before you sell the Relinquished Property.
Or, you could have multiple properties on either the Relinquished
Property side of the deal or the Replacement Property side of
the deal or both. Or, you could have a three party deal. Any of
these scenarios will work; however, the rules get tricky and are
beyond the scope of this discussion. Nevertheless, should you
want to discuss anything about tax deferred exchanges, please
feel free to contact us as we handle these types of deals regularly.