Tax-deferred exchanges require planning

Dale Beede

Let’s say you have a commercial real estate investment worth $5 million you’re selling and want to defer capital gains tax as well as the recapture on your accumulated depreciation due on that sale into a new investment property.

Let’s further assume you’ve held the relinquished property for 10 years, depreciated improvements on a 39-year straight line basis and taken $482,205 in total depreciation over the time you’ve held the property.

Your purchase price 10 years ago was $2,350,000. Your recapture payment to the IRS is 25 percent of the depreciation taken, or $120,551. Based on your tax bracket, you’ll owe an additional $658,000 in capital gains tax. 

Your decision is whether to pay Uncle Sam $778,551 or instead invest the roughly $4.7 million after closing costs into a new stabilized commercial investment property and defer the tax payment until the replacement property is sold. This might seem like an easy decision for some, but not for others. 

This decision could depend on your age, whether or not you wish to continue owning real estate for investment and how difficult it could be to find replacement properties that meet your criteria. The decision also could depend on factors with the investor’s estate and their wishes for what will happen with that estate after death. Liquidity could become a factor because real estate investments aren’t as liquid as investments in stocks and bonds.

Let’s tackle the replacement property issues first. When deciding what to purchase to replace the relinquished property, you first must decide the types of properties for which you’re looking. Are you looking for passive investments in a single-tenant commercially leased property — think Walgreens or Starbucks? Or are you looking for a more active investment, such as a 30-unit apartment building you manage yourself? Do you want to invest in a farm, hotel, industrial building, office building or shopping center?

When you’ve determined what type of investment you’re buying to replace the sold property, remember you have only 45 days from the date of sale of the relinquished property to designate up to three replacement properties. You must close on at least one of them within 180 days from the sale date to protect your tax-deferred exchange.  In addition, the replacement property must be valued at least $1 more than the property sold, and debt on the new property must be equal to or larger than the former debt or not all of the exchange is protected. 

Perhaps a more difficult issue is finding replacement properties that are priced within reason and managed well. If the buyer is area bound, just finding properties for sale that meet the buyer’s criteria could be difficult. Because of time constraints in purchasing a replacement property, begin your search long before the sale of the relinquished property is completed. It might be wise to negotiate a delay in the closing date of the relinquished property if it appears your search for the replacement property will take longer than expected. 

Buyers of replacement properties often are hurried into either paying too much for a property or they buy properties ill-suited for their needs just to avoid taxes. There’s little reason to hurry into a bad deal. Remain pragmatic, consider the time constraints of the transaction and search diligently for suitable replacement properties. Time is on your side when you plan for it.