AVOIDING CAPITAL GAINS TAXES WHEN SELLING PROPERTY

Mann Report, May 2000 Issue

Georgia Malone, president of Georgia Malone & Co., Inc., New York, N.Y., is an attorney, a broker, and a real estate advisor whose clients include prominent developers and owners in New York and the national marketplace. The firm’s clients have included Aimco and Forest City Ratner. She can be reached at (212) 822-2265.

In today’s real estate market, which is currently experiencing a great deal of buying and selling -- and of course profit taking -- sellers are painstakingly aware that they must find strategies for dealing with capital gains taxes. This is also a market in which real estate owners who might be planning their estates are looking for ways to maximize their estate. They are selling properties at top of the market prices. How can they pass along this profit to descendants without it being slashed by a heavy tax? A solution that is being used throughout the industry may be the last loophole that Uncle Sam allows -- the 1031 Tax Exchange.

This strategy quite simply involves using the entire proceeds of one sale of property to buy another within a prescribed time, thus avoiding any taxes on the profits of the initial sale.



For real estate purposes let’s call it a "property exchange," and while it must be property of a like-kind, it does not mean that property must be of the same precise type. The property-for-property exchange does not have to be residential for residential, office for office, or mixed use for mixed use, etc.; it can be office for residential; raw land for office, etc.

This strategy can only be used for investment property, not for primary residences.

What is most important to emphasize at the outset is that the rules of this law, while seemingly simple, must be followed strictly. Today’s tax auditor is very scrupulous. Essentially the exchange allowance, the actual act of selling and then reinvesting has been framed with a time restriction imposed by the Tax Reform Act of 1984. By and large, a property must be chosen for exchange within 45 days after a sale has been made, and a profit has been had, and there is a total of 180 days within which to close. Both these deadlines must be strictly met in order to conform to the exchange tax allowance. During these periods, the proceeds of a sale must be put in escrow. The proceeds must never be in possession or control of the seller; she should never receive the cash nor have it under her control. There are special escrow accounts established for this situation.

Let’s look at a basic vanilla transaction:

Seller A sells a property to B for $1 million. A then has 45 days in which to select another property in which to reinvest the proceeds – owned by C. Say A selects the target purchase owned by C within five days. She then has 175 days to close on that target property C owns.

As direct as this is, there is one important qualifier. The full proceeds must be invested. What that means is that while A received $1 million, she cannot buy a property for $1 million on which there is a $800,000 mortgage to avoid being taxed on the full sale price. If she does that, then she only saves the capital gains on the $200,000 of the $1 million proceeds. She must find another property that can be purchased outright for $800,000 or a number of properties that will cover the $1 million in cash while still having existing mortgages. This can make some exchange strategies a bit cumbersome, but they are doable.

Let’s look more closely at the advantages of this strategy:

• This is a powerful tool for estate planning. If you have a property that you bought originally for $10 million that now has appreciated to $100 million, and you sell it for that sum, you avoid the tax on the profits of that sale when you "exchange" it for a $100 million property now in the market. You actually then have avoided being taxed on the $90 million profit and have passed the full $100 million to your descendants completely avoiding the capital gains tax upon your death.
  
• You do not have to "swap," meaning that you do not have to buy the property at the very same time you are selling.
  
• If you have significant capital gains in the property, with the exchange you keep the money and use it for a down payment on your new investment property. For example, if you owe Uncle Sam $1 million in taxes, by exchanging you pay no taxes now leaving more money to acquire properties. This can be done over and over again which continuously defers the capital gains tax.
  
• You may sell a property that is not providing a cash flow or profit and use the proceeds to purchase, i.e. "exchange" it for a profitable property.