In a move that some tax experts say will have profound effects on the way real estate changes hands in the United States, the Internal Revenue Service has proposed new rules greatly simplifying tax-free real estate exchanges.
The proposed regulations are so favorable to the use of the exchange technique that real estate swaps are now certain to boom in popularity, even among the most conservative, risk-adverse kinds of owners. Owners of a wide range of properties, from small rental condominiums to vast industrial sites, will now have definite, easy-to-follow steps to follow in conducting tax-free swaps.
Prior to this, many property owners feared that in the absence of clear rules, the IRS would challenge their exchanges and hit them with costly penalties. That concern would be effectively removed by the new rules.
The draft IRS rules, published in the Federal Register May 16, affect the most common form of real estate swaps known as "delayed" exchanges. Delayed and other exchanges all come under Section 1031 of the Internal Revenue Code. That section provides that no gain or loss will be recognized for federal tax purposes when the owners of "like-kind" properties held for investments or business use exchange them.
The words "like-kind" real estate have been interpreted broadly in the tax code. The owner of a cattle ranch in Montana could swap it for three beach-front town houses at Hilton Head, S.C. A rental-house owner in California could swap it, tax-free, for a parcel of land outside St. Louis.
The attraction of tax-free exchanges is implicit in the name: Conduct the swap correctly and you owe no federal tax, even if your real estate jumped in value by millions of dollars during your ownership. As long as you exchange the property for like-kind real estate with the same equity value, and you receive no cash in the transaction, the IRS considers the deal a swap, not a sale, and thus a "nontaxable event."
Say your rental house has doubled in resale value since you bought it. Rather than pay federal income tax on your profits (at your highest marginal rate), you instead trade it for another property with a similar, appreciated value -- perhaps something a little less management-intensive, something more fun to own. The rental real estate you bought for $100,000 six years ago, now worth $200,000, can be swapped tax-free for a development lot on Hawaii with a similar equity value. You receive no cash in the deal, but you use all your stored-up profits to acquire more valuable real estate, with not a cent of tax going to Uncle Sam.
You can keep on exchanging tax-free indefinitely, as long as you do not "sell" your property for money. You can even keep your tax-free status after your death. You can will your investment real estate to your heirs, who get to take it over at its then-current value (or "stepped-up basis"). Your heirs' tax liability will be limited to the gains in value on the real estate occurring during their time of ownership, not the big profits racked up during yours.
Interest in tax-free exchanging was heightened by passage of the 1986 Tax Reform Act, which eliminated preferential capital-gains tax treatment on asset sales like real estate. But the new proposed rules for delayed exchanges are going to encourage "a terrific increase in the volume of deals" across the country, according to Washington tax attorney Howard J. Levine of Roberts & Holland.
What the regulations do, say Levine and other attorneys, is to spell out long-awaited guidelines on key issues. In a delayed exchange, an owner wishing to dispose of a property must identify suitable "replacement" real estate within 45 days after relinquishing his or her property for the transaction. The owner must then acquire the replacement property within 180 days. In the rental house example cited above, you'd have to identify the Hawaiian land parcel within 45 days and take title to it within 180 days.
The proposed new IRS rules set out specific criteria for meeting these two deadlines. The rules even permit a taxpayer to identify numerous possible replacement properties for the 45-day test, and then choose the final property by the 180-day limit. The proposed regulations also remove many uncertainties connected with disqualifications for the receipt of cash -- or the right to receive cash -- by the exchanging people.
The rules also set guidelines for the use of exchange "intermediaries," who facilitate real estate swaps by functioning as middlemen. An entire industry of intermediaries, including lawyers, escrow and title companies, banks, accountants and specialized "accommodators," already exists in California. Title companies and exchange intermediaries are gearing up to handle the new wave of exchanges in other states.
Chicago Title & Trust Co. has created a separate new entity -- Chicago Deferred Exchange Corp. -- that will conduct delayed exchanges nationwide. The president of the new subsidiary, Wycliffe Pattishall, called the IRS regulations "a tremendous benefit to the marketplace.
"People who have been sitting on property unnecessarily, simply because they can't handle the tax liabilities," said Pattishall, "now can safely put their property on to the market, do an exchange without worrying about the IRS, and pay no federal tax whatsoever."