Real estate property exchanges can postpone capital gains taxes  Law Offices of Fred M. Duman & Associates 2807 Castro Valley Boulevard     Castro Valley, California 94546 Tel: (510) 537-3388 Fax: (510) 889-1114

Dear Mr. Duman:

I have been considering exchanging a rental home that I have owned for years.  It is located a substantial distance from where I now live.

I would like to exchange it for another rental in a location which is closer to me.  What can you tell me about tax-free exchanges?
                                    B.G., Danville

The "tax-free exchange" to which you refer is also known as a "like-kind" exchange, and is governed by the provisions of the Internal Revenue Code, Section 1031. This law allows the exchange of one property with another property of "like-kind", so as to postpone the income tax consequences that would ordinarily accompany the sale of the first property.

Under Internal Revenue Code, Section 1031, an owner may, under certain circumstances, postpone the income tax consequences of an ordinary sale of real property by directly "trading" the property for other "like kind" property.  While the owner may eventually be taxed, the owner can potentially postpone the tax consequences, through continually utilizing Section 1031 exchanges with successive properties.

Section 1031 specifically limits the availability of a tax-free exchange to property held "for productive use in a trade or business or for investment purposes. Therefore, neither the relinquished property or the acquired property under a Section 1031 exchange can be for personal use, such as the owner's residence.

In addition, while Section 1031 exchanges may apply to both non-real estate property (e.g. automobiles, works of art etc.) as well as real property, qualified exchanges are required to be of "like-kind".  In other words, real property must be exchanged with real property that qualifies as "like-kind" and likewise as to non-real estate property.  For example, the taxpayer may not exchange real property for non-real estate property or vice versa.

The provisions of Section 1031 do not apply to the exchange of cash, stocks, bonds, and/or inventory of a trade or business (including a real estate dealer's "inventory").

Exchanges may either occur simultaneously or may comply with the restricted provisions set out for "delayed" (or "deferred") exchanges.

An example of when a "delayed" exchange might prove useful, is in the case of a taxpayer who has found a buyer for the property offered for sale, but has not yet found the replacement property the taxpayer wishes to acquire (often referred to as the "target property").

In order to take advantage of a "deferred exchange," the taxpayer usually arranges for a third party (known as an "accommodator") to facilitate and execute the exchange on behalf of the owner(s).  The use of an accommodator, in of itself, can pose particular concerns and should, along with the exchange as a whole, be approached in an informed and careful fashion, in order to ensure that a legal "exchange" of property will occur.

There are additional requirements in connection with a "deferred" exchange not found with a simultaneous exchange.  With a "delayed" exchange, the owner must specifically "identify" (in writing) the replacement property to be acquired within 45 days of the relinquished property's transfer; and, there are limitations as to the number of replacement properties that may be identified.  The identified property must be acquired (with escrow having closed) either within 180 days of the "relinquished" property's transfer, or by the due date (including extensions) of the transferor's Federal Income Tax Returns for the taxable tax year in which the "relinquished" property was transferred, whichever occurs earlier.

The tax return due date could be much sooner than the 180 days.  The taxpayer may be required to file for an extension of the due date for the filing of tax returns in order to extend the time limit for the acquisition of the "target" property to a period within the 180 day limit.

Generally, we advise our clients that the "deferred" or "delayed" exchange is not a preferred means by which property is exchanged and should be avoided whenever possible.

Along with federal income tax law regarding exchanges of real property, the income tax law of each state where the property is located must also be considered.

In light of the numerous complex regulations and procedures pertaining to "like-kind" exchanges, we strongly urge anybody contemplating the use of an exchange to first consult with a qualified tax advisor, in order to obtain advice and counsel appropriate for the circumstances.

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