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Volume 9 Issue 2

Mar/Apr 1997

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. Let’s consider three possible situations.

Situation #1

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.Fudd’s "cup of tea" and he doesn’t 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.

Situation #2

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.

Situation #3

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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