Exchange Your Real Estate:
Why Pay Taxes?
By: Ken Harney
Ken Harney is a nationally-known columnist on real estate for the Washington Post Writers Group. His award-winning column, "The Nation's Housing," currently appears in newspapers in over 100 major cities across the country.
He's also written three books on mortgage finance and real estate. The following is an excerpt from his book, Exchange Your Real Estate: Why Pay Taxes? (published by The National Real Estate Development Center).
Do you own real estate that's appreciated in value over the years? Would you prefer to keep all the profits you've got in that property rather than pay 28 percent of it in capital gains taxes to Uncle Sam and another 5 to 11 percent to your state government?
Then do what tax-savvy investors do: Exchange your real estate -- tax free -- with minimal hassles or cost. Take the example of retired Air Force Brig. General William R. McCall of Alexandria, Virginia. During the last two years, he's saved $34,000 in combined federal and state taxes by using tax-free exchanges to dispose of three rental houses he owned in northern Virginia. At the same time, he has acquired three newly-built houses that he rents out near the community where he and his wife plan to retire -- Naples, Fla. McCall's deft use of the exchange concept throws fresh light on a technique that many real estate owners either don't know about or misunderstand. Here's a quick overview of what he did, and how the financial tool he used -- known as Section 1031 of the Internal Revenue Code -- works.
In the late 1980s and early 1990s, McCall invested in three small rental properties in northern Virginia suburbs, not far from his Pentagon headquarters. The first was a one- bedroom condo that he bought for $52,000. The second was a townhouse he purchased for $110,000, and the last was a detached home that cost $62,500. He rented them all out, "breaking even on expenses or slightly better," he says.
Several years ago, he and his wife took a vacation in Naples, Fla. and decided that they'd eventually like to retire there. They soon bought a house outside the city -- not to rent out, but to use as a winter getaway that would become their full-time residence. Before heading south permanently, however, McCall knew he would have to dispose of his Virginia rental properties, because as he put it, "there's no way you can be a landlord from 1,500 miles away." But McCall had a looming tax problem. He knew that two of the houses had increased modestly in resale value since he bought them, and that one house had done extremely well -- nearly doubling in value.
If he sold them, he figured, he'd have a combined taxable gain around $100,000. Ouch! Twenty-eight percent of that would go to Uncle Sam, and another six percent to the state of Virginia. The alternative to outright sale: A tax-free swap. Under Section 1031, owners or real estate held for investment or for use in a trade or business can exchange their property tax-free for "like-kind" real estate. Like-kind has been construed broadly by the IRS: You can exchange a rental house for an apple orchard, for example, or a Manhattan duplex for Colorado mineral rights. The properties can be across the country or across the street. They don't have to be swapped one-for-one directly, either. Professional exchange "intermediaries" and realty brokers sell your property and hold the proceeds in escrow. Once you've located suitable replacement property, the intermediary releases your escrowed equity cash to close the deal.
The basic concept here is straightforward. If you own equity in one piece of real estate, and you merely swap it for equity in another, there should be no taxable event. Only if you receive cash or other non-like-kind assets from the transaction do you trigger capital gains treatment. The advantage of Section 1031 for real estate investors is that they can effectively have their cake and eat it, too. Their property can jump in resale value -- double, triple, whatever- -and they can use that increased equity to trade up, tax-free, to something better, bigger, more profitable.
Say you buy land for $100,000 cash. It gets rezoned for commercial use and now it's worth $500,000. Why pay taxes on your $400,000 windfall profits if you can use it as a downpayment on a commercial building worth $2 million? As long as you don't take cash for any of your profits, you can defer taxation of those gains indefinitely. Meanwhile, you've traded up from vacant land -- yielding no monthly income -- to a far more valuable piece of property producing tens of thousands of dollars in net income per year.
On a smaller scale, that's what Gen. McCall did. One by one, he put each of his houses on the market, just as he would in an ordinary sale. To help with the exchange details, he hired Realty Exchange Corp. of Haymarket, Va., a nationally active "qualified intermediary" under IRS guidelines. For about $750 per home sale, the firm put McCall's otherwise-taxable proceeds from each sale into separate escrow funds. When McCall located each of the three rental homes he wanted in Naples, the exchange intermediary sent the funds to the closing.
Here's what McCall sold and got in return:
- The condo he originally bought for $52,000 sold for $77,000. The profits were transferred, tax-free, to serve as the downpayment for a waterfront, $129,000 new, three- bedroom, two-car garage rental home.
- His $110,000 townhouse sold for $125,000. The gain was added to other equity he had in the house to serve as the downpayment on a new $118,000, three-bedroom rental home.
- His $62,500 detached house sold for $115,000. The profits paid a good chunk of the cost of McCall's nicest Naples purchase to date -- a large, $128,000 home on a golf course.
The rents on the new units more than cover his monthly mortgage, tax and maintenance costs, according to McCall. In effect, he says, "I traded three old clunkers in a flat market for three brand new houses in a growing market", and didn't incur any taxes in the process. Not bad.
Some practical advice for anyone who wants to use Section 1031 with similar success: Get solid, reliable information by ordering a copy of the nationally-acclaimed guide that explains exchanging step-by-step in plain English: Ken Harney's Exchange Your Real Estate: Why Pay Taxes?, a 100-page softbound manual for property owners. Cost, including shipping is just $24.95. Contact the National Real Estate Development Center at 301-657-8220 or KenHarney@aol.com, or mail check to NRDC, 6900 Wisconsin Ave, Suite 307, Chevy Chase, MD. 20815.