Tax Deferred Exchange Tips for the Real Estate Professional, courtesy of Kevin Hummel, McFerran & Burns, PS.
Exchanges That Don’t Work
I really enjoy being positive and creative. It is absolutely exiting to help people find new solutions to their capital gains challenges, but sometimes I have to be the bearer of bad news. Sometimes I just have to give you the information you did not want to hear.
1031 Is Truly a Swap
Almost once a day, I have to remind folks that they have to swap for equal or greater value to get a full deferral of capital gains. Sure you can do a partial exchange, where you purchase something for less you sold and pay taxes on the difference between the two. You call that “Boot” in an exchange. It is totally legal and can be an advantage to defer part of your gain. I will talk about that next week in greater detail.
Keep in mind the three rules for a complete deferral of all gains in an exchange:
1. Purchase replacement property equal or greater than the property you sell
2. Use all the proceeds from the sale towards the purchase(s)
3. Replace the debt that was paid off in the sale(s)
It is the third rule that often throws off many investors. They often confuse that debt relief with their basis on the property. Some think that they only need to defer their gain, not the whole value of the sale. The IRS views the relief of debt to have the same value as the cash proceeds coming from the sale.
You can pay for closing costs out of the sale or purchase in an exchange, without having to pay taxes on them. Closing costs usually consist of: commissions, escrow fees, title premiums, and excise tax. Sometimes there are other closing costs, and the general rule for that is: If there is a condition, written into the purchase agreement, that has to be accomplished before it can close, then it can be a closing cost.
It is not uncommon for me to be asked, something like, “I replaced the roof before putting it on the market Can’t I pay for that out of the exchange?” In that case, the answer is no. Those improvements would count as a capital improvement and be added to your basis to reduce the capital gains, if you did not exchange. They were not a term of the purchase agreement, so it is not a closing cost.
There are Many Myths and Misunderstandings
There are no “stupid questions” when contemplating an exchange, except the ones not asked. As always, there is no cost to just call me, and we might also find it necessary to sit down and go through your options.
Kevin Hummel, CES®
Tax Deferred Exchange Practice Group
McFerran & Burns, P.S.
Offices in Tacoma, Kent, Seattle (Northgate), Everett and Silverdale.