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
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
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
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.