NEW YORK -- Jan. 14, 2005 -- Real estate entrepreneurs who buy and sell investment properties have been saving thousands of dollars in capital gains taxes since the IRS approved 1031 exchanges in 1990. But investors must adhere to IRS guidelines -- and more than one has paid high capital gains taxes following a sale and purchase because he didn't follow the rules.
Some of the most common mistakes include:
Misidentifying qualifying properties. Simply put, investment real estate must be exchanged for investment real estate. Residential property does not count, nor does a real estate purchase that you intend to quickly turn around, such as a warehouse that will be fixed up and resold or land slated for new homes. Real estate is not the only asset that can shield capital gains through a 1031 exchange -- many investments count, such as investing in cattle or boats -- but you can't sell a warehouse, buy a herd of cows, and tell the IRS it qualifies for a 1031 exchange.
Trying to do an exchange after the fact. "I can't tell you how often I get calls from people who say, 'I sold my property yesterday and want to do an exchange,'" says Denis Caron, vice president and Connecticut counsel for LandAmerica Exchange Co. "I tell them to call me next time before they sell the property because it's too late now." Only a qualified intermediary -- a disinterested party with no relationship to the taxpayer -- may set up a valid 1031 exchange, and an investor must make arrangements for the exchange before he sells a qualifying property.
Choosing a poor intermediary. According to John P. Napoli, an attorney with Seyfarth Shaw LLP in New York City, a good intermediary will set up a separate trust account for each seller, naming the seller as beneficiary. Intermediaries aren't federally insured like bank accounts, he notes, and "qualified intermediaries have gone bankrupt, and people have lost their money," he says. Anyone can be an intermediary simply by saying so -- there is no licensing requirement, nor are they certified. Caveat emptor.
Calling a non-investment an investment. The IRS has no hard-and-fast rule on what constitutes an investment, but a property turned around quickly raises red flags that invite IRS questions. Bruce D. Savett, principal and founder of Granite Peak Partners Inc., a Santa Barbara, Calif., real-estate adviser and investment company, suggests holding an investment for at least two tax years and checking with a tax adviser before committing to a sale and purchase.
Confusion over the 45-day/180-day rules. While a lot of 1031 exchange rules are open to interpretation, the 45-day and 180-day rules spell out the timing instructions clearly: A seller must identify up to three potential properties they plan to purchase within 45 days of selling an investment property. By midnight on the 180th day following sale of an investment property, they must buy one of the properties identified. Properties must be identified clearly and if the final purchase must closely align with one of the properties identified. "One taxpayer identified 100 acres somewhere and took title to only 75 acres in the exchange," explains Napoli, adding that the IRS allowed this exchange, but may not have allowed it if he bought only 50 acres.
Assuming that weekends don't count. Business people tend to consider only business days -- weekends don't count. But an investor that waits 45 business days to identify properties or 180 business days to buy 1031 exchange properties will be out of luck shielding capital gains taxes. Include weekends in calculations. On occasions, Congress or the IRS can extend these deadlines, but it's rare and usually involves some kind of widespread emergency, such as after 9/11.
Preparing to sell without preparing to buy. It takes most buyers more than 45 days to shop for properties and research its merits. While an investor may get a good price for the property sold, a lack of preparation could force him to overpay for a new investment property or buy something that doesnt suit his needs.
Source: Real Estate Journal, Franceds Capell, senior correspondent for CareerJournal.com
© 2005 FLORIDA ASSOCIATION OF REALTORS
