It's easy to underestimate what a dynamic tool the tax deferred exchange can be. Setting up a long term strategy can show how equity preservation becomes a painless way to adapt your portfolio. Here is an example of someone who effectively used a tax deferred exchange strategy to accomplish specific goals and benefit handsomely.
Mr. Jones has owned a single commercial building in Albuquerque for nearly 20 years. Originally purchased for $120,000, the property required $80,000 in maintenance and upgrades over the two decades. His goals at acquisition had been simple: ease of management, depreciation, and appreciation. Most of the tax benefit of depreciation had been taken after 20 years, and Mr. Jones correspondingly built up his equity, which, he realized, wasn't getting a proper return from current rent.
He put his building on the market and it sold for $800,000 after all closing costs, creating a $600,000 capital gain ($800,000 less $120,000 less $80,000) that could generate a $90,000 federal tax liability, plus state tax liability.
To defer this liability, Mr. Jones looks for a replacement property or properties. Just north of Albuquerque, Rio Rancho is the new home of Intel and other satellite businesses. This growing community, rich in single family dwelling inventory, and a steady supply of renters seeking affordable quality homes, offers excellent replacement properties that will generate a fair market income commensurate with their equity value.
There was one technical issue in this well considered scenario. How do you properly identify these replacement properties? Not following the approved IRS procedures for identifying replacement properties will invalidate an exchange, making this step crucial and indispensible.
The IRS offers three methods to identify replacement properties. By far the most common is to specify three properties of any value and close on one, two, or three within the time limit. If an investor chooses more than three properties, Rule 2 allows any number of choices if their value does not exceed twice the sale price of the relinquished property. If that limitation proves unacceptable, Rule 3 allows a choice of any number of properties with unlimited total value. The catch is that the investor/taxpayer must close on 95% of the identified properties to have a valid exchange.
For Mr. Jones the risk of using Rule 3 is offset by his conviction that the Rio Rancho community will appreciate strongly. The added benefit that his family will become partners in the efforts and rewards clinched the decision. With financing, Mr. Jones closed on 20 out of 20 homes. If one transaction falls apart, the exchange would still be valid. If two crater, that's a $90,000 setback.
The market in and around Albuquerque over the past seven years has proven Mr. Jones' wisdom in this strategy. Plus, the flexibility of these many homes allows for a wide variety of inheritance options for his family.
It sounds like a cliché: Define your goals, craft a strategy to make those dreams come true. These two steps are critical for long term investment success. Tax deferred exchanges are a great tool in making those plans happen.