Let’s say Mrs. Brown owns several apartment buildings that she acquired some years ago. She wants to preserve the value of the buildings for her children, but she no longer wants the responsibility of managing them. She would like to sell them and acquire something — such as vacant land or an office building — requiring less management.
She can sell the buildings for way more than she paid for them and use the sale proceeds to purchase something else, but she has a problem: If she sells the buildings and buys another property, she will be taxed by both the Maine and federal governments on the difference between what she paid for the buildings (her “basis”) and the price she receives from the sale, plus any depreciation she has, or could have, taken over the years. Combined, these taxes would consume a big portion of her sale proceeds.
There is another way.
When business or investment property is exchanged for other property of a “like kind,” no gain or loss is recognized for tax purposes. The requirements are:
- The property disposed of must be held for use in a trade or business or held for investment.
- The transfer must be an actual exchange, as opposed to a sale followed by a purchase
- The relinquished property and the replacement property must be of a like kind, such as real estate for real estate.
What if the party who wants to buy Mrs. Brown’s apartments doesn’t own any like-kind property to exchange? That’s OK. The exchange doesn’t need to be simultaneous. There are strict time limits imposed, but Mrs. Brown can transfer her property in exchange for a promise by the buyer to deliver like-kind property at some point in the future. This is called a “deferred exchange.”
A deferred exchange doesn’t need to be limited to just two parties. The proposed buyer of the apartments may see no advantage to him in the exchange, and may not want the responsibility of finding, acquiring and transferring a like-kind property. The tax-deferred exchange can still be accomplished by using a “qualified intermediary.” A qualified intermediary is a person or entity who has essentially no connection to the transaction or the transferring party. It can’t be Mrs. Brown’s attorney, accountant, broker or other agent.
To complete the transaction, Mrs. Brown enters into a purchase and sale agreement with the buyer of her apartments that specifically discloses that the transaction is intended to be part of a like-kind exchange. She then enters into an agreement with a qualified intermediary for their services. The contract with the buyer is then transferred, or assigned, by Mrs. Brown to the intermediary.
At the closing, the intermediary directs Mrs. Brown to deed the property directly to the purchaser. The purchase price is paid to the intermediary to hold for Mrs. Brown’s benefit, but completely out of her control.
After that closing, Mrs. Brown has 45 days to find and identify in writing a replacement property of the same general kind as the property she relinquished. It doesn’t need to be identical, only the same generic type, such as trading an office building for an apartment building or a subdivision. Once identified, she has 180 days to close the purchase of the replacement property. This closing is a mirror image of the closing on the relinquished property. Mrs. Brown enters a purchase and sale agreement as buyer which is assigned to the intermediary. The intermediary directs the seller to deed the property directly to Mrs. Brown, and uses the money he’s been holding for her to pay for it.
Once properly completed, Mrs. Brown has effectively sold a property at a substantial profit, and acquired a new, more desirable property, with no capital gains tax recognized on the transaction. The gain is not eliminated, it is just postponed. If Mrs. Brown ever sells the replacement property, the gain will be measured by the amount she receives minus her tax basis in the old relinquished property, but selling is not her intent.
If she leaves the property to her children in her will, the children will receive what is called a “stepped up basis.” Their basis will be the fair market value of the property on the date of Mrs. Brown’s death. If the children sell the property for the date of death value, all of the profit from the sale of the relinquished property, all of the tax depreciation Mrs. Brown has taken over the years, and all of the appreciation in the replacement property, will never be taxed.
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