Trading up real estate
Property swaps can be a great
way to avoid taxes, but they
shouldn't be approached lightly
Hawaii property values are rising again at a rate not seen since the Japanese bubble. That's prompting people who purchased undervalued investment properties through much of the 1990s to turn to a transaction known as a 1031 deferred exchange.
The transaction offers a way to capitalize on real estate investment gains and trade up to a more expensive property, without incurring capital gains taxes.
With diminishing inventory levels over the last couple of years statewide, identifying the right property for the exchange may be the single biggest challenge for investors.
The number of 1031 exchange transactions has almost doubled in the last two years, according to Mike Imanaka, vice president of sales and marketing at Title Guaranty Escrow and Title Services.
"From 2001 to 2002, they went up 34 percent. From 2002 to 2003 they went up 47 percent, and that's just year-to-date," he said.
Title Guaranty subsidiary TG Exchange Inc. handles 1031 deferred exchange transactions. Firms like TG Exchange that act as intermediaries in the transaction are often referred to as "accomodators" or "facilitators."
1031 exchange transactions involve entering into an agreement with such a company in which the investment property is transferred in exchange for another investment property the taxpayer has not yet identified. After entering into the agreement, the taxpayer has 45 days from the transfer of the property relinquished to identify a replacement property, according to the rules set down by Internal Revenue Service Code 1031. The exchange must be completed in 180 days after the transfer of the property over to an accommodator or facilitator such as TG, said Mae Nakagawa, assistant vice president at TG Exchange.
"The exchange count is really high. Typically, it's apartments or houses here, but it also includes properties on the mainland," Nakagawa said.
Changing intent
While the law was originally set up by Congress in 1921 with the idea of two people swapping like properties in a simultaneous exchange, today the rules set out the specified time periods to complete the transactions, said Mike Garcia, an attorney who specializes in 1031 exchanges and draws up contracts between the taxpayer exchanging the property and a facilitator like TG."Prior to the 1960s, all exchanges used to happen simultaneously. You had back-to-back transactions and interconnected escrows. But a taxpayer pushed the envelope and transferred the relinquished property first and received the replacement property in the future. The IRS challenged it and lost so they then went back to Congress. Congress still acknowledges deferred exchanges, but put some time limitations on them so you have 45 days to identify the replacement property and 180 days to take title to it," he said.
If a 1031 exchange is successfully accomplished, the tax savings can be considerable.
"The current tax rates for longterm capital gains for individuals is 15 percent for the federal part of the gain on the property that was sold and 7 1/4 percent for the state," Garcia said.
Not for everyone
But Garcia notes a 1031 exchange may not be for everyone."It has to be a large enough gain to make it worthwhile. If it's a $5,000 gain it may not be worth it," he said.
And with diminishing inventory supplies, people need to make sure they can identify a suitable replacement property, said Garcia.
"You shouldn't wait till closing to start looking around, otherwise you could run out of time," he said.
In addition, anyone contemplating a 1031 exchange needs to remember there are all the usual fees associated with any real estate transaction, such as escrow charges, Realtor commissions, document and closing costs, and there are 1031 fees.
Garcia's fees start at $1,300, depending on the size and complexity of the transaction.
"They pay me to do the documents and the structuring of the exchange. I take responsibility for the tax consequences, but it's the facilitator who implements it," he said.
The facilitator fees start at about $500, depending on the complexity of the exchange, said TG's Nakagawa.
"Whenever someone does a 1031, they cannot control the funds so that's the role we play. We hold the money for them," she said.
Reliability is key
It's important to select a facilitator or accommodator that is respected, Garcia said."You have to pick a respected facilitator, not just one with the lowest cost. Keep in mind they are not regulated and there have been situations, like in California, where the facilitator just took off with the money," he said. "At the end of the day, what you've done is transfer the property to the facilitator in exchange for them to transfer the replacement property back to you," he said.
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1031 defined
Rising property values are prompting more and more Hawaii real estate investors to take advantage of a section of the tax code called 1031. Here's an overview:
What is a deferred exchange?
A deferred exchange is where a taxpayer enters into an agreement to transfer an investment or rental property in exchange for another investment or rental property yet to be located or identified.
What are the advantages of a deferred exchange?
If both properties are used by the taxpayer for business or investment purposes and the transaction is properly structured according to IRS Code 1031, then the taxpayer will not incur any income tax on the property relinquished.
What is the time period for the exchange?
The taxpayer must identify the replacement property within 45 days of entering into the agreement with the facilitator or accommodator and complete the exchange within 180 calendar days after the transfer of the relinquished property.
Further information
See IRS publication 544 at the IRS internet site at www.irs.gov
Source: TG Exchange Corp.
