Like-Kind Exchange Aids Investment Property Investors


Now that taxes on long-term gains have risen for high-bracket taxpayers, a tax-deferred property exchange is a better deal than it has been in recent years.

It can also solve a logistical problem if you relocate when you retire and you don't want to be an absentee landlord.

Rather than keep the original property, doing a like-kind exchange enables you to own another investment property in your new retirement location.

The new property might provide much-needed retirement income.

Also known as a 1031 exchange, by doing this swap rather than selling the old property and buying a new one, you can defer and perhaps avoid the capital-gains tax bill.

Investors recognize the benefits of these swaps. Nearly 160,000 individual taxpayers reported them in 2010, the latest year on record. They filed IRS Form 8824, for Like-Kind Exchanges.

Fewer than 110,000 individuals reported such exchanges for 2000. By 2005 that number was nearly 300,000. With tax rates on cap gains back up, like-kind swaps may rebound as well.

Here's one way such a deal works. Say that a hypothetical Ed Byrd lives in Ohio. He's about to retire and move to Texas.

For years, Byrd has owned a small apartment building in his hometown. But he does not wish to be a long-distance landlord.

Due to depreciation deductions, Byrd has a low basis in this property. A sale would generate a steep tax bill. With Byrd's high income, he would owe a 20% tax on long-term cap gains. That's up from 15% in prior years.

He also would owe the new 3.8% Medicare surtax on net investment income. And his itemized deductions would be reduced, effectively raising his tax rate on the sale.

All of these higher taxes have different income thresholds. The Medicare surtax, for example, kicks in at $200,000 of modified adjusted gross income for singles and $250,000 for couples filing jointly.

Affluent Taxpayers Beware

The bottom line is that taxes on property sales are now higher for upper-income taxpayers. So an exchange that defers or avoids tax can pay for itself, sometimes in just a few years.

To qualify, Byrd can sell his Ohio apartment house. He must arrange for the proceeds to be held by an unrelated intermediary. This can't be the seller's relative, employee, current attorney or accountant. A lawyer you haven't used in the past two years is OK. Look for one familiar with 1031 swaps.

Any kind of investment property can be the replacement. Byrd might find real estate that will demand little of his time yet deliver retirement cash flow.

Once he finds the new investment, Byrd can have the intermediary buy it for him, using the proceeds from the recent sale. To qualify for tax deferral, Byrd can't pocket cash or benefit from lower property debt.

There is a catch: time limits on the transaction. You must list potential replacements within 45 days of selling your original property. And you must buy the new one within 180 days of the sale.

Finding, negotiating, and closing a deal on investment property can take time. So line up a replacement property while selling the old one.

After one exchange, you can keep swapping and keep up the tax deferral. If you refrain from a nonexchange sale until your death, your heirs will get a basis step-up to current value and your lifetime appreciation won't be taxed.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

This article appears in: Investing , Mutual Funds

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