October 12, 2000

IRS OKs reverse exchanges  

You know that little rental house you've nursed for years as a retirement nest egg? Up until now, you had to sell it and then buy an

investment property of equal or greater value to defer your capital-gains tax.

That process, known as a 1031 Delayed Exchange, has been enhanced by Revenue Procedure 2000-37, giving the green light to Reverse Exchanges. The new rules, which went into effect Sept. 15, 2000, permit the title to the "new" property to be held by an independent third party (typically a facilitator or attorney) until the "old" property sale closes. "The new guidelines really provide a safety valve for those consumers already doing conventional exchanges," said Dennis Helmick, a Puget Sound-area attorney and president of Exchange Facilitator Corp., a company specializing in tax-deferred exchanges.

"This way, they can tie up the new property even if they don't have a buyer for the old property." The initial Internal Revenue Service regulations for 1031 Exchanges, issued nearly 10 years ago, specifically excluded Reverse Exchanges. However, some consumers have gambled for years and structured Reverse Exchanges, much to the chagrin of accountants and attorneys who warn of a possible audit.  The new revenue procedure provides the same "safe harbor" protection for Reverse Exchanges that Delayed Exchanges now enjoy.

  "The IRS has basically said that it will closely scrutinize exchanges without a facilitator in the middle of the exchange," Helmick said. "The same is now true for Reverse Exchanges, yet they will be more complex and perhaps more expensive for the person doing the exchange."

This original process is called a 1031 Delayed Exchange, or Starker Exchange. It is named after T.J. Starker, an Oregon man who made a deal with Crown Zellerbach in 1967 to exchange some of his forested property for some "suitable" future property. That agreement ended up in court.

Starker's battle was the basis for Congressional approval of delayed exchanges.

"The new regs will bring some challenges for buyers and sellers," said Rob Keasel, Certified Public Accountant in the firm of Anderson Zurmuehlen & Co.

"For example, will lenders actually finance properties for the buyer when a facilitator holds title to that property."

To totally defer capital-gains tax, you must pass the IRS' acid test by:

• Trading even or up in value.

        

• Trading even or up in equity.

• Not pocketing any cash from the first sale.

        

• Identifying the new (or old) property, or properties within 45 days of the sale. (This typically means having a signed purchase and sale agreement.)

• Closing the transaction within 180 days.

Also, never underestimated Uncle Sam's desire to have you hire a professional third party to oversee reverse or delayed-exchange transactions. If you attempt an exchange on your own and it fails, the consequences could be drastic.

One of the more complex parts of the original regulations explains that within the 45-day period following sale of the investment property, you can identify three or more parcels of property, regardless of value, that you may wish to buy for your new investment.

In other words, you can consider taking the equity from your first rental house and reinvesting it in three or more new pieces of real estate without paying taxes.

However, if the number of parcels on your list exceeds three, and their combined value is greater than 200 percent of the property sold, you are required to buy 95 percent of the total sales price of the replacement properties.

You also need to know what the term "like kind" means. In real estate, almost any sort of property usually qualifies: A house may be traded for an apartment building; vacant land for an office building.

A house that is the owner's primary residence cannot be traded for investment property. Nor do stocks, bonds, securities and similar equity investments qualify as "like kind." Likewise, if you own land and build a structure on it with 1031 exchange funds, the IRS will probably not consider your investment an exchange.

Of course the day you have to pay your capital-gains tax will come eventually. So if you want to sell your investment property, you should weigh the costs of a like-kind exchange against the amount you would have to pay in capital-gains tax if you simply sell the property. Professional facilitators charge about $1,300 to $1,500; private attorneys could cost more.

To find a competent exchange facilitator in your area, consult a real-estate broker, escrow agent, title company or attorney for references.

They may be able to help you do a like-kind exchange that allows your retirement nest egg to grow even bigger until the day you really need the cash.

Previous columns:

• New NAR economist sees lower rates ahead, 10-05-2000
• Dot-coms offer help to renters, 09-28-2000
• Helping the kids buy that 1st house, 09-21-2000
• Dorm option: Do you really want to play landlord?, 09-14-2000
• Location, location, schools, 09-07-2000
• Beware the predatory lenders, 08-31-2000
• Fix-up, remodel or move, 08-24-2000
• Limiting renters in condos, 08-17-2000