How to avoid capital gains bite A tax-free property exchange can save a bundle

WITH NO SIGN of capital gains tax relief emerging from Congress, real estate owners across the country are taking a fresh look at one of the federal tax code's most important money-saving tools for investors: tax-free property exchanges.

"I think it's finally sinking into [real estate owners'] heads," said Ed Horan, president of Realty Exchange Corp., based in the Washington suburb of Haymarket, Va.


"There's no way that this Congress and this president are going to come up with a capital gains package that does much for real estate."

The current federal capital gains rate is 28 percent. Even if Capitol Hill Republicans persuade Bill Clinton to cut the capital gains ceiling to 19.8 percent, "you're still going to be handing over one-fifth" of your proceeds to the government, Horan said. NTC "A lot of people are deciding that it's just not worth it," and are looking for creative uses of tax-free exchanging to cut their tax bills to zero.


Take the case of a recently retired New York policeman who not only sold a group of small rental properties tax-free, but simultaneously set himself up in retirement doing what he wanted -- golfing anytime he chooses in South Carolina. According to Friedrich R. Trinklein, president of Garden City, N.Y.-based New York Deferred Exchange Corp., the policeman had purchased moderate-cost three-family homes in several boroughs of New York City over a period of two decades. Thanks to market appreciation and good management, his real estate equity nest egg grew to well over $500,000, Trinklein said, and represented the bulk of the policeman's personal net worth.

But if the policeman sold the buildings outright, the federal government and New York state would take a substantial chunk out of that equity in the form of taxes. Instead, he opted to use a deferred exchange. Each of the properties was put up for sale, subject to the sale being recognized as part of an exchange of property under Section 1031 of the Internal Revenue Code. That section permits owners of investment or business real estate to exchange their property for like-kind replacement property.

Such exchanges rarely are direct, one-for-one swaps. Instead, sellers use exchange "intermediaries" who put the cash proceeds from the property sale into an escrow fund, and then purchase a replacement property.

Sellers who wish tax-free treatment cannot receive cash from the sale.

In the New York policeman's case, he sold nine rental houses to different purchasers over a period of months via a deferred exchange, but never received any money. But as each property was sold, the intermediary -- Trinklein's firm -- acquired ownership shares in a South Carolina golf course and transferred them to the policeman. At the end of the multistage deal, the policeman owned a substantial chunk of the golf course, and never paid a cent in capital gains taxes.

Some other creative uses for tax-free exchanges:

"Bifurcated" home sales for professionals with offices in the home.

You can't do a tax-free exchange of your personal residence under Section 1031. But a bona fide home office is business property and can be swapped for other real estate.


Say you're a doctor with a substantial practice from a large home office wing. If the office space represents 35 percent of the total space of your home, the equity value of that 35 percent can be exchanged tax-free as part of a home sale transaction for something else you'd like -- say, a down payment on a resort rental condo.

You still get to use the existing arsenal of tax tools -- such as the $125,000 exclusion for sellers 55 years or older -- on the 65 percent of the home that's your residence.

Heads-up estate planning.

An elderly Long Island man who purchased farmland in the mid-1940s for $20,000 had a problem last year: His acreage in the North Fork area was now worth $1 million. The 28 percent federal tax bite discouraged him from selling the land outright. Instead, he figured out a way to pass along his full equity value to his children. He asked each of his five children, spread across the country, to select a home or parcel of land they'd enjoy owning some day. He then sold his farmland via a deferred exchange, and had the intermediary acquire each of the five designated properties.

Currently either rented out or held for investment, the properties will -- after the Long Island man's death -- pass to each child at a "stepped-up" tax basis eliminating any tax.

A word of caution: Tax-free deferred exchanges should never be attempted without competent intermediary and tax advice.


To obtain a list of professional intermediaries active in your area, send a stamped, self-addressed envelope to: "1031 Help," Box 15070, Chevy Chase, Md. 20815.

Pub Date: 4/06/97