I recently wrote here about the use of UPREITs, a form of real estate partnership combined with a real estate investment trust, to create liquidity for high net worth real estate investors while allowing them to defer taxable gains on highly leveraged and appreciated real property.
Another tax deferral strategy that’s growing in popularity again because of higher tax rates is the use of 1031 exchanges. Named after the Internal Revenue Code section authorizing these transactions, they are also known as “like-kind” exchanges.
Like-kind exchanges permit one party to swap property for similar property without immediately incurring federal tax. Since virtually all types of real property are considered similar, one may exchange, for example, undeveloped land for a shopping center. A seasoned real estate investor might have acquired agricultural land for $1 million and later had the property rezoned for commercial use, raising its value to $3 million. That investor could then exchange this land for a shopping center worth $3 million that pays net rents of $300,000 per year; federal income tax on the $2 million gain would be deferred until the sale of the shopping center. If the shopping center were worth more than $3 million, the investor would need to pay its owner the difference in cash or other property. If the shopping center were worth less than $3 million, then its owner would need to pay the investor the difference. This additional amount, known as “boot”—as in getting something “to boot”—would be taxable.
It’s not easy to find two people who miraculously wish to exchange property. So strategies have been developed that permit like-kind exchanges by using four parties. In this situation, our investor sells his undeveloped land to a third party. The buyer pays the $3 million price to a third party trustee, called a “qualified intermediary,” who then uses those proceeds to buy the shopping center. The trustee then directs the shopping center owner to transfer it to the investor.
As long as the replacement property is identified and acquired within certain IRS-mandated deadlines, the real estate investor will not recognize the $2 million gain from the sale of the undeveloped land. Instead, he is treated as if he had traded his undeveloped land directly for the shopping center.
What I just described is the typical scenario: The investor wishes to sell some property and acquire like-kind property. But what if circumstances require that the replacement property be acquired before the closing of the investor’s property? What if the property that the investor wishes to acquire needs to first be improved or constructed?
The IRS has rules that may cover some reverse exchanges like these, which are often referred to as “parking” transactions and improvement or construction exchanges. Parking transactions come in particularly handy in a hot real estate market with many competing buyers, sellers have no incentive to give buyers mere options to buy or to accept delayed closings. In these transactions our investor may acquire the shopping center first and then “park” the title to it with an intermediary called an “exchange accommodation titleholder” until a buyer is found for his undeveloped land.
When taxpayers are faced with having to pay almost 24 percent of their gain to the IRS—and potentially far more when you consider city and state taxes—like-kind exchanges offer terrific tax savings opportunities. Serious real estate investors should consider ways to structure their transactions in a tax-deferred format.
(A version of this article originally appeared in Worth magazine.)