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The real estate exchange takes more patience and hard work to set up a successful exchange than it does to arrange a straight purchase and sale. Some owners and their agents simply do not understand the benefits of an exchange.
April 01, 2007 -- The real estate exchange takes more patience and hard work to set up a successful exchange than it does to arrange a straight purchase and sale. Some property owners and their agents simply do not understand the benefits of an exchange or are worried about the strict requirements imposed by the Internal Revenue Code.
The main benefit of a tax-free exchange is just that--freedom from a tax. The gain that could be realized by one or both of the principals in the transaction does not need to be recognized at the time of the closing. The tax is deferred until the property owner makes a taxable disposition of the new property at some later time.
An owner can make a series of exchanges and can defer tax indefinitely. Upon death, if the property ends up in the estate of this owner and a stepped-up basis is achieved, some tax may be avoided permanently.
The benefit from the tax postponement is apparent. The owner can reinvest the full equity in other property, including gains, without any decrease in value due to tax payments. In effect, the government extends an interest-free loan to the investor, who then is able to obtain leverage over and above that obtained from regular mortgage financing.
In addition to the tax benefits, an exchange (tax-free or not) can be used as a financing tool, since it permits the substitution of real estate equity for cash. There are many other reasons to exchange properties. Following are a few of the most common:
• Exchange between land and improved property. Some owners of income producing improved property would like to exchange for raw land with potential for long-term appreciation. Their depreciation deductions may be low and the non-depreciation land is not a problem. If the investor chooses land with a good growth potential, he has put the full amount of his equity into another investment. (The owner of the land transfers equity into a property which gives immediate income, and also may now depreciate part of the original basis in the land.)
• Exchange for more easily financed property. An investor can exchange for property that is capable of supporting a mortgage with a higher loan-to-value ratio. For example, property that qualifies for a mortgage not exceeding 50% of its value might be exchanged for a property on which a lender will make an 80% loan. Therefore, after the exchange, an additional 30% of the equity can be released in cash for other uses. The exchange can be tax-free, as is a refinance of a property already owned.
• Buyer short of cash. If a buyer does not have required cash for a purchase, and is unable to get an adequate mortgage, the seller usually will not accept the offer or will extend a large purchase money mortgage. An exchange means he can take other desirable property of the buyer in lieu of taking back a mortgage. The seller may also defer all or part of the gains tax that would have been due on a sale.
• Acquire more salable property. When a property has been on the market for some time without a buyer, the owner may be able to exchange for another that can be sold for cash more readily. Care must be taken in this type of cashout exchange, because if there is intent to resell the acquired property immediately, the tax-free exchange rules do not apply. (The new property must be acquired as a property to be held for business or investment in order to qualify.) But since the original property was held for sale (and presumably the gains tax was going to be paid on sale) the seller's accountant may find that the tax to be paid is the same after either transaction. The other owner in the transaction may make a fully tax-free exchange.
• Acquire larger income property. A professional man or woman owns a 10-unit apartment building that is too small for an on-site manager. The income is desirable and a sale would be costly because of a large gain. The equity should be exchanged up into a larger apartment property that would adapt to professional management. It could have increased income to cover larger loans and management fees. The step-up in the owners basis could give a larger depreciation. After the transaction the owner can have the same or higher income and be relieved of management problems. |
