The tax-deferred exchange remains the most important tool in planning for non-personal real estate transactions.

What can be exchanged?

There has been some discussion about curtailing the scope of real estate transactions qualifying for this treatment. For example, a motel would have to be exchanged for a motel; an apartment complex for an apartment complex.

So far, this has not developed. Any type of real estate held for productive use in a trade or business or for investment may be exchanged for any other type. A motel may be exchanged for a dairy pasture.

Note that personal residences and vacation homes do not qualify for tax-deferred exchanges.

Real estate that is "property held primarily for sale," such as a home built for sale, also does not qualify for tax-deferred exchange treatment.

Exchanges for partnership interests do not qualify for tax-deferral. If the real estate interest received is converted or contributed to a partnership shortly after the exchange, the transaction may be "collapsed" and the deferral disallowed.

The gain will not be deferred for an exchange involving foreign real estate and U.S. real estate.

If an exchange is made with a "related party," any sale by the related party or within two years after the exchange will result in the gain or loss being recognized on the date of the sale. This rule does not apply if the sale is made after the death of the related party or taxpayer within the two-year period.

Is an election required?

The tax-deferred exchange section is not elective. If you have an exchange of like-kind property, it automatically applies.

What about losses?

Not only gain, but loss may be deferred from an exchange, even when "boot" is received. Therefore, a transaction that will result in a loss should not be structured as an exchange but an outright sale.

When must a gain be recognized?

When cash or property other than real estate is received as part of an exchange transaction, those are unlike assets, called "boot." The lesser of the net boot received or the potential gain is recognized as taxable gain. When personal property is received or sold, it should be separately valued (hopefully in the contract) so this computation is made consistently between the buyer and seller.

Note that items clearing through escrow, such as the settlement of rent deposits and the payment of property taxes, may represent "cash received" or "cash paid." For example, if property taxes of $10,000 are paid through escrow, this represents "cash received" applied to property taxes. (The property tax expense will be a deduction that could offset recognized taxable gain.)

The debt relieved for the property sold is compared to the debt incurred for the property received. Any excess of debt relieved over debt incurred is "boot."

For example:

John Taxpayer exchanged Blackacre for Whiteacre. His tax basis in Blackacre was $500,000. Whiteacre has a fair market value of $1,000,000. Blackacre was subject to a mortgage of $200,000. Whiteacre is subject to a mortgage of $100,000. John also received net cash of $50,000 for the transaction.

Gain realized Received:
Whiteacre	$1,000,000
Debt relieved	200,000
Cash	50,000
Total		$1,250,000
Exchanged:
Tax Basis Blackacre	500,000
Debt acquired	100,000
Total		600,000
Gain realized		$ 650,000
Boot received:
Debt relieved	$ 200,000
Debt acquired	100,000
Net debt relieved		$ 100,000
Net cash received		50,000
Net boot received		$ 150,000
Gain recognized (lesser of realized gain or boot)		$ 150,000
Tax basis of Whiteacre
Fair market value		$1,000,000
Gain realized	$ 650,000
Less gain recognized	150,000
Deferred gain		500,000
Tax basis		$ 500,000

Allocating basis for acquired properties.

When properties are exchanged, the taxpayer should get an appraisal of the property received allocating the purchase price between land, building, and property improvements, such as driveways and swimming pools, in order to construct the depreciation schedule for the property.

Non-simultaneous exchanges.

Thanks to the Starker decision, Congress and the IRS have defined certain situations where an exchange may be made on a non-simultaneous basis.

In structuring these transactions, the net proceeds from the "sale" leg of the transaction are deposited with an intermediary. In other words, the seller may not have control of the funds during the intervening period.

Be careful when selecting an intermediary. One of my clients had his exchange funds embezzled!

In order to qualify for a non-simultaneous exchange, the replacement properties must be identified in writing by the taxpayer and hand delivered, mailed, telecopied, or otherwise sent before the end of the identification period. This step should be carefully documented. There are various persons who could be notified, but the best choice is the intermediary.

The replacement property must be received no later than the earlier of (a) 180 days after the date on which the taxpayer transfers the property relinquished in the exchange, or (b) the due date (including extensions) for the transferor's tax return for the taxable year when the property was relinquished. (You should usually extend the due date of the tax return for the year of the exchange when the sale happens late in the year.)

For example: John Taxpayer has a non-simultaneous exchange of Blackacre on December 31, 19X2. He must designate a replacement property in writing no later than February 14, 19X3. The purchase of the replacement property must be completed no later than June 29, 19X3, provided John filed for an extension. If he did not, the purchase of the replacement property must be completed no later than April 15, 19X3.

Sale of a principal residence acquired as part of a tax-deferred exchange

The tax law was changed effective for sales or exchanges after October 22, 2004 so that a principal residence acquired in a tax-deferred exchange won’t qualify for the exclusion for the sale of a principal residence unless the property has been held more than five years. This situation could happen when a taxpayer exchanges rental real estate for another home that is rented for a period of time, but is later converted from a rental home to a principal residence. A side effect of this rule is the principal residence evidently won’t qualify for the a partial exclusion if the residence is sold early due to a hardship or unforeseen circumstances.

Conclusion - Get Help!!

This is a simplified explanation of some of the issues relating to tax-deferred exchanges. These are sensitive transactions, usually with high-stakes results. We highly recommend that you get professional help beyond the real estate agent to put a deal together. An investment in fees for legal and tax consulting help can pay off in avoiding unpleasant surprises later.

If you need support with one of these transactions, call Mike Gray at (408) 918-3161.

For more articles and information about new tax real estate tax developments, visit our Real Estate Investor Tax Articles or Frequently Asked Questions and subscribe to our newsletter, Michael Gray, CPA's Real Estate Tax Letter.

IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained on this website was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.