Like Kind Exchange

[<Steve> 82]

Hello-

 

I am just beginnig to sell two or three of my properties that have gained some equity using lease/options. When and if the tenant buyer exercises their option to buy, I would like to pocket my original down payment on these properties, and reinvest the profit into another investment property.

 

Will I need to pay any capital gains? I depreciate these properties every year.

 

I've heard that if I reinvest the profit with in 90 days, I do not need to pay capital gains. Can I hold the profit money myself or do I need to put it some kind of escrow account with a legal firm?

 

Any comments are welcome.

<Steve>

[Dave T 0]

Hello, Steve. Welcome to the forum.

 

For the purposes of this discussion, let's assume that you have owned and used these properties as investment rentals for at least one year prior to entering into a lease/option agreement. That is, you are on title, and are NOT in a sandwich lease.

 

When the tenant/buyer exercises their option, you have 45 days from the settlement date to identify up to three replacement properties, and 180 days from the settlement date to complete the purchase of your replacement property(ies) from your list of identified properties. To completely defer the capital gains on the sale of the relinquished property, the purchase price of the replacement property must be greater than or equal to the sale price of the relinquished property. The IRS restricts the type of property that can be used in an exchange, but for our purposes, any real estate can be exchanged for any other real estate. Further, the property being relinquished and the property being acquired must both be used in a trade or business or held for investment use -- that is, they must be like-kind properties. Your primary residence is not eligible to participate in a 1031 exchange.

 

For a qualified 1031 exchange, the IRS prohibits constructive receipt of the sale proceeds, which means that you need to use a qualified intermediary to hold the sale proceeds in escrow and disburse the funds to the seller when you purchase your replacement property. Additionally, the IRS has restrictions on who can not serve as your qualified intermediary. Since your qualified intermediary will be serving as your exchange escrow agent, you should have an exchange escrow agreement drawn up by your lawyer. This agreement should be signed by yourself, your buyer, and your escrow agent before you settle on your relinquished property. For my most recent exchange, I used the trust department of my bank as my escrow agent. Their flat fee was quite modest when compared to some of the professional exchange accommodator fees I have seen.

 

Because you are prohibited from receiving any of the proceeds from the sale of the relinquished property, you will not be able to "pocket" your original down payment (though there is a way to do this outside of the exchange umbrella). All of your sale proceeds must be reinvested in your replacement property to preserve the tax deferred character of the transaction.

 

Done properly, you will not pay any capital gains on the sale of the relinquished property, nor will you have depreciation recapture to contend with. The basis of your replacement property becomes the adjusted basis of your relinquished property plus any cash you had to add to the purchase. With this basis, you calculate a new depreciation basis and start a new depreciation schedule even if the relinquished property was fully depreciated.

 

I hope this overview gives you some insight. Suggest you consult a professional tax advisor for specific details.

[<Steve> 82]

Thank you Dave T for your response.

 

Your comments are very helpful and provide some new insight for what I need to do to prepare should my tenant/ buyer(s) decide to exercise their option.

 

I am familiar with a qualified intermediary locally; however, your comments about using the trust department at the bank as an exchange agent is something I am going to look into.

 

It is also nice to know that by using the 1031 properly, I will not have to recapture the past depreciation taken and do not have to pay capital gains.

 

It is unfortunate that I can not take out my original down payment. Yet, you did mention that there is a way to do this outside of the 1031 exchange. I need to investigate this further.

 

Thanks again and for this forum!

<Steve>

[Dave T 0]

Steve,

 

I hope you did not conclude from my comments that you need both a qualified intermediary and an exchange escrow agent, because they are the same person. Instead of paying a professional accommodator a fee based on a percentage of the value of the properties involved, I am suggesting that you have your lawyer draft an escrow exchange agreement that would be acceptable to the trust department of your bank.

 

I suspect that you can pay the lawyer a flat fee for the (reusable) exchange agreement, and, pay the bank trust department a flat fee for their escrow service and spend less than you would for the professional exchange accommodator for the same results.

 

While you can not take any tax free cash out of the exchange transaction, you can do a cash out refinance on the relinquished property before entering into the exchange, or do a cash out refinance on the replacement property after the exchange has closed. This is what I would suggest if you want cash out of your equity outside of the exchange umbrella.