Disposition of Real Property and How Tax Can Be Avoided
The following article from Buckingham attorney Steven A. Dimengo discusses tax-avoidance strategies for the sale of real property.
Contemplating the sale of real property held for investment or use in a trade or business but want to avoid paying any tax, perhaps even permanently? The key question is: do you intend to maintain your investment in real property for the same holding purpose? If yes, of course you need to structure the sale as a like-kind exchange. To avoid paying tax on the entire realized gain, the fundamental rule requires that you trade your property to be sold (“relinquished property”) for a new property (“replacement property”) that has equal or greater equity and gross value. This article addresses some common questions and misconceptions.
1. Must the replacement property be of the same precise nature (e.g., commercial office building exchanged for commercial office building)?
No. Essentially all real property is deemed to be of a like-kind to other real property. So, a building can be exchanged for land. City real estate can be exchanged for a farm or ranch. Timberlands in one state can be exchanged for a tree farm in another state. Even a leasehold interest for 30 years qualifies as replacement property for other relinquished real property. Likewise, the relinquishment of a mineral interest can potentially qualify for like-kind exchange treatment. However, U.S. real property cannot be exchanged tax free for foreign real property.
2. Must the exchange be simultaneous?
No. The replacement property need only be identified within 45 days of closing on the sale of the relinquished property. There are liberal identification rules, allowing multiple possible replacement properties to be identified. One or more of the previously identified replacement properties must then be acquired within 180 days of closing of the relinquished property sale.
3. What if I don’t meet the 45 / 180 day requirements?
You are no worse off. You may even be in a better position since the funds to be released to you from the escrow that had been set up for a like-kind exchange will not be taxable until received, which may be in the tax year after sale, thereby allowing for installment sale treatment (i.e., one year deferral of tax).
4. What if my buyer wants immediate possession but I cannot acquire the desired replacement property for more than 180 days?
You can allow your buyer to tie up your relinquished property with an option that is not exercisable for a set period of time. If held in an appropriate escrow account, taxation of even the option payment can be delayed until either the exercise occurs or lapses. If the option is exercised, the option payment is deferred as part of the sales proceeds.
5. What if my replacement property must be acquired first?
No problem. You can do a like-kind exchange under special “reverse exchange” rules, which allow the replacement property to be acquired first through an agent so that you are assured of obtaining this property, while disposition of the relinquished property must occur within the 180 day period following acquisition of the replacement property.
6. What if my replacement property does not even exist but needs to be constructed?
This is also not a problem. There are special rules that allow for construction of the replacement property on land to be acquired. A taxpayer could potentially even construct the replacement property on land it had owned.
7. Can I retain cash from the sale?
Although the net cash received (i.e., cash remaining after paying the expenses of sale and any encumbering debt) must be spent on the replacement property, you can borrow against the equity of the replacement property after it is acquired. The key is that the loan process be commenced after the replacement property is acquired.
8. What if the relinquished property is held in an entity such as a partnership/LLC and the owners want to go their separate ways, with one or more doing a separate like-kind exchange?
The partners/members can enter into the sales agreement and each do his/her separate like-kind exchange of property to be received in liquidation of the entity. They must negotiate the sale in their individual capacities. At closing on the sale of the relinquished property, the property can be conveyed as part of a liquidating distribution to the partner/member.
9. What if I do not want to be involved in managing the replacement property any longer, but I need the income?
You can acquire a tenancy in common (“TIC”) interest whereby you are one of many passive owners in the replacement property receiving the income therefrom. This may include, as an example, receiving the net rental income from a large commercial tenant, such as a Wal-Mart type property.
10. Is it really this simple?
Yes, as long as the equity and value that existed for the relinquished property is maintained in the replacement property and both the relinquished property and the replacement property have been held for investment or use in a trade or business. Of course, you must also meet the 45 day identification and 180 acquisition rules described above.
These like-kind exchange rules are not available for dealer/developers, but even this is a case by case determination with respect to the property at issue. Essentially, a dealer is a person that held the property to be sold as inventory.
All of the scenarios described above require adherence to precise rules that are “form” oriented (with less regard to the substance of the transaction). In fact, this is one of the few areas of federal income taxation where form is arguably more important than substance. That is, it is critical to precisely structure the transaction to accomplish the like-kind exchange and ensure all formal requirements are met.
The bottom line is that if you intend to maintain your investment in real property that has been held for the requisite purpose (i.e., investment or use in a trade or business) and the replacement property will be held for the same purpose, the like-kind exchange planning technique is an obvious choice. It is easy to achieve as long as you follow the appropriate form.
Remember, doing a like-kind exchange not only enables the avoidance of current federal income tax, it can also avoid current state income tax for those states that leverage off of the federal tax base, such as Ohio. In addition, it can amount to permanent income tax avoidance as part of an appropriate estate plan when the replacement property is held in the estate of a decedent whereby it obtains a “stepped-up” fair market value at the date of death. The heirs can immediately sell the property without gain recognition due to such basis adjustment.
Contact attorney Steven A. Dimengo for more information.