Volume 9 Issue 2
Planning Ahead for Tax-Free Exchanges
© by Tax & Business Professionals
In the January/February 1997 issue, we addressed a number of
basic concepts about like-kind exchanges. You may want to refer to that issue when reading
this, since there is a connection between the two.
As we noted in the last issue, far too often sellers of real
estate (and other assets) become aware of the possibility of tax-free exchange treatment after
they have received the sale proceeds. At that point, it is too late to obtain
like-kind exchange treatment for one simple reason ¾ the owner
has sold the property and obtained the proceeds. Once you have "got the cash,"
it is too late to disclaim sales treatment.
Careful planning is needed to obtain exchange
treatment and avoid incurring capital gains tax. While much of this planning is intended
to insure compliance with the many rules for tax-free treatment, there are other
alternatives that are frequently overlooked. Lets consider three possible
Suppose Mr. Fudd, age 60, lives in a large house on 10 acres
(Fuddmore Estates) worth $1,500,000 with a very low basis, perhaps because he inherited
the property from his parents. Mr. Fudd wants to move into a small condominium and be
relieved of the headaches and expenses of maintenance.
Selling and buying another Fuddmore-type estate (to avoid gain
using the two-year personal residence roll-over) is not Mr.Fudds "cup of
tea" and he doesnt want to pay 35%, or more, of Federal and State tax on
$1,500,000 gain. Can anything be done? Yes!
Assuming Mr. Fudd can afford to pay rent, he moves out and
rents the home and 10 acres before offering it for exchange treatment. By so doing,
Fuddmore Estates is converted to business rental property that can be exchanged tax-free
for other business or investment property not requiring maintenance, such as vacant land
or managed condos. By thinking ahead, Mr. Fudd does not have to buy another mansion, and
he can defer the tax.
Can Mr. Fudd take $175,000 from the exchange
proceeds (and pay tax on the same) to buy a condo or smaller home? Yes. If properly
handled, some cash, called "boot," can be distributed to Mr. Fudd without
causing all of the funds to become subject to tax. Stated differently, it is permissible
to fragment a like-kind exchange into taxable and tax-deferred parts.
Another scenario. Suppose Ms. A. D. Vance (hereafter
"A.D.Vance") wants to retire to her dream home in Florida after 35 dreary years
with the government in Washington, D.C. A.D.Vance lives modestly in her personal
condominium and has two rental properties in Virginia and two condominiums in Florida. Can
A.D.Vance sell her modest personal residence and avoid the gain (using the $125,000
life-time exclusion) while exchanging all four rental properties for her Florida dream
home, without incurring income tax? Yes, with some guidance and waiting.
Since A.D.Vance is over 55 years of age, she can avoid gain on
the sale of her modest condominium (up to $125,000 of gain). Can she exchange the four
rental properties tax-free for a Florida mansion? Yes, but she cannot use the property in
Florida as her personal residence immediately. Why?
Generally, business or investment property cannot
be exchanged tax-free for a personal residence. But if A.D.Vance wants to rent the Florida
mansion to others for a "period of time" and then convert it to her home, such
treatment is possible. How long is a "period of time?" Several IRS private
letter rulings suggest two years, although there is no waiting period discussed in the
Code or regulations. Common sense should prevail. Clearly, A.D.Vance must bear the risk
that the tenants might torch her Florida dream mansion or that she may not live long
enough to move in.
In a less complicated vein ¾ what
if Mrs. Cashless inherited the family farm, and needs cash for her errant son, who lost
"lots" on the new microchip venture to recycle chewing gum wrappers into
computer parts. The farm cannot easily be divided or sold in segments and, in addition,
Mrs. Cashless is at a loss to find good farm help.
Can Mrs. Cashless exchange the farm for 10 condos in Baltimore,
some of which can be sold to provide cash for her son? Yes. (Incidentally, the condos have
a manager so Mrs. Cashless is out of the real estate management game.)
Alternatively, if Mrs. Cashless wanted to borrow against the
condos to avoid selling, she could. However, since she is "cashless" and older,
she may have trouble qualifying for a loan even though she has plenty of collateral,
unless the rents will support a loan repayment plan.
While the list of possible uses for like-kind
exchanges could go on "ad nauseam," these randomly picked subjects may alert the
curious to the planning potential. If help in these areas is needed, call either of the
entities described in the box below.
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