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Like-Kind Exchanges
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Real estate
tax shelter puts more money in investors’ pockets.
By William Poe
More and more real estate investors are avoiding capital gains taxes—and
increasing the value of their holdings—by taking advantage of the
only significant real estate tax shelter available today for individuals
and organizations.
The tax shelter is called “like-kind exchanges,” and it’s the driving
force behind many real estate investment transactions.
“Like-kind exchanges add value to property investments, and it’s
one of only a few tax shelters left,” says David Herdlick, partner
in the real estate services group of Rubin, Brown, Gornstein & Company.
Above:
David Herdlick, partner in the real estate services group of Rubin,
Brown, Gornstein & Company.
“It used to be that mainly real estate people took advantage of
like-kind exchanges,” adds Janet K. Poppen, president of Poppen
& Associates, CPAs. “Now, a lot of people are trading properties
if they are knowledgeable, especially higher income investors, because
they don’t qualify for rental loss rules anymore.”
Although like-kind exchange infers a trade of like-kinds of properties,
like-kind trades rarely occur, Herdlick says. More often, properties
are bought and sold, sometimes through a qualified intermediary,
he adds. And “like-kind” is really a misnomer in that, Herdlick
says, “it’s a very liberal definition. You can go from raw land
to a 20-unit apartment building; it only has to be real property
for real property.”
Under federal like-kind exchange rules, investors can avoid capital
gain (but also cannot deduct any loss) on qualified property. The
effect of the tax treatment is to put more money in the pockets
of investors, so they can purchase more valuable property.
In a qualified like-kind exchange, the investor saves between 20
and 25 percent (depending on how long the property was held) in
federal capital gains taxes that he or she otherwise would pay,
plus an additional six percent income tax for Missouri or a three
percent income tax for Illinois, explain Herdlick and Poppen. That’s
a savings at the high end of 31 cents on the dollar for a Missouri
resident and 28 cents on the dollar for an Illinois resident.
“Like-kind exchange allows you to purchase more valuable real estate,
because you don’t have to pay the tax,” Herdlick says. “It’s really
a way for the real estate investor to continue to trade up and buy
into more and more quality properties.”
Poppen adds that personal property, trucks and automobiles, office
furniture, and computers and information systems may also qualify
for like-kind exchange treatment. And owners do not have to be individuals.
Organizations including partnerships, corporations and limited liability
companies also may qualify, Poppen adds.
According to Herdlick and Poppen, here’s how like-kind exchanges
work:
- A
property owner sells a property. The owner then has 45
days to identify a new property and 180 days to close
on purchase of the new property to avoid a capital gain
on the sale of the first property.
- Both
the exchange (original) property and the replacement (new)
property must meet like-kind criteria. For example, an
apartment building can be exchanged for farmland held
for investment, and an office building can be exchanged
for an industrial building. But property cannot be exchanged
for interest in a partnership or for units in a real estate
investment trust.
- Both
the original property and the new property must be held
by the owner for use in business or trade, or for investment
or rental purposes. The owner cannot also be a dealer,
in which case the property is treated as inventory for
tax purposes.
- New
Internal Revenue Service interpretations allow for a deferred
exchange whereby an owner can purchase the replacement
property before disposing of the original property, but
certain “safe harbor” provisions must also be met.
- Qualified
intermediaries, which essentially take the place of either
the original buyer or the seller, may be allowed
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Poppen warns
that so-called “boot”—usually cash or a liability—that may be assumed
in a property exchange neither qualifies for like-kind tax treatment,
nor makes the entire transaction taxable. “Even if you get boot,
you may still be able to defer some gain.”
Investors, Herdlick says, also need to be aware of “Starker exchange”
rules that come into play in deferred exchanges. “The rules are
pretty straightforward, but they need to be followed.”
Herdlick, who deals with like-kind exchanges most every week, says
like-kind exchange is one of the few tax shelters that remained
standing after the tax reform act of 1986 and is used with increasing
frequency in recent years.
“I’ve seen it everywhere with all kinds of property,” Herdlick says.
“And you see more like-kind exchanges in good economic times when
property values are rising, businesses are growing and they need
more space and bigger buildings.”
William V. Poe is principal of Poe Communications, a St. Louis
advertising and marketing communications firm. |
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