Middle-class taxpayers who sell their first investment property are shocked when they find that a major portion of their gain on the sale is due on the alternative minimum tax.That's because most of them don't bother consulting with their accountant ahead of time, according to Stephen Wayner, vice president of Miami-based Bayview Financial Services.

"They don't know that they can defer gain with a Code Section 1031 exchange, and later change their new property from an investment property to a residence," he said. "But it's too late once they've closed on the original investment property."

A key finding of a survey of 700 CPAs was that clients do not tap their CPAs' knowledge of Section 1031, which allows buyers and sellers of commercial property to defer capital gains taxes by rolling the proceeds from a sale into another investment property of equal or greater value. While the majority of the CPAs surveyed said that they are familiar with the tax deferral benefits of Section 1031, almost half are not advising their clients to execute this transaction because they are not consulted on real estate transactions until after their completion.

Wayner, a real estate attorney and Certified Exchange Specialist, expressed surprise at the finding. "Recognizing that your CPA has helpful knowledge of real estate tax issues can be critical," he said. "Clients who do not avail themselves of this counsel until it is too late miss out on opportunities to build equity and increase their net worth."

Most CPAs can provide basic information on 1031 exchanges, and can direct investors to qualified intermediaries, independent third parties recognized by the Internal Revenue Service as facilitators of 1031 exchanges.

The rules

The tax advantages of a like-kind exchange are governed by Code Section 1031, which states that gain and loss are not recognized when property held for productive use in a trade or business or for investment is exchanged for property of like kind. Although exchanges of personal property must be nearly identical to qualify as "like kind," exchanges of real property can qualify despite the fact that they are dissimilar. For example, unimproved property exchanged for a commercial building qualifies, according to Matawan, N.J.-based CPA Salim Omar.

"It's a nice way to defer the tax if you're selling an investment property," he said. "You can buy a similar one to meet the requirements of a like-kind exchange, then defer and not pay taxes for a very long time."

"But if you don't do the steps exactly right, it disqualifies the transaction and you become liable for capital gain or the alternative minimum tax," Omar cautioned. "This is not one of those areas where the taxpayer's good intentions will help. Break just one of the rules, and the transaction fails."

Normally, exchanges are not simultaneous - there is a gap between the transfer of the relinquished property and the acquisition of the replacement property, resulting in a delayed exchange. This is the most common type of exchange, according to Wayner.

Under Treasury regulations, a seller has 45 days to identify the property to be received and 180 days to close on it after the relinquished property is transferred. The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized, and therefore there are no funds available to pay the tax on the gain.

The deferred gain of a 1031 exchange can be converted to a total exemption of gain - up to $500,000 - where the property is changed from investment property to a principal residence, according to Wayner.

Before the 2004 Jobs Act, there were no special rules relating to the sale or exchange of a principal residence that was acquired in a like-kind exchange within the prior five years, according to Wayner. "Under the old Section 121, he could move into the property two years later, make it his personal residence and qualify for non-recognition of gain after two years. But all that changed with the Jobs Act," he said.

Section 840 of the Jobs Act states: "If a taxpayer acquired property in an exchange to which Section 1031 applied, Subsection (a) shall not apply to the sale or exchange of such property if it occurs during the five-year period beginning the date of the acquisition of such property."

"In plain English, it means that the taxpayer now must hold the property for five years and use it as a personal residence for at least two years before selling it and saving on capital gains taxes," said Wayner. "For example, the taxpayer sells investment property on Jan. 1, 2006, which he exchanges for another investment property in a delayed exchange through a qualified intermediary on March 1, 2006. He rents out the new property during the remainder of 2006 and 2007. On March 2, 2008, he moves into the new property to use it as his personal residence. He then can sell the property on March 2, 2011, exempt from the gain under Code Section 121, up to $500,000 for a married taxpayer filing jointly."

A QI, ASAP!

A qualified intermediary is a necessary element of most exchanges. The use of the QI, as an independent party to facilitate the exchange, is a safe harbor under the Treasury Department regulations. When the taxpayer engages the services of a QI under an exchange agreement, the IRS does not consider the taxpayer to have received the funds in the delayed exchange.

The Federation of Exchange Accommodators, the professional trade association for qualified intermediaries under Code Section 1031, certifies qualified intermediaries as Certified Exchange Specialists.

"The CES credential was designed to provide a designation that will give the public confidence that they are dealing with someone who has demonstrated knowledge in the intricacies of a like-kind exchange, and to encourage exchange professionals to increase their knowledge of Section 1031 rules and regulations," said federation executive director Patricia Lilly.

Members of the federation are exchange accommodators and their primary advisors - accountants and attorneys - according to Lilly. "We also have affiliate members, who are real estate brokers and agents, property managers, banks, and escrow and title companies," she said.

Wayner recommended the use of such specialists to facilitate the described transaction.

"The trick is to time and use Sections 1031, 121 and 840 correctly. Doing so can turn property that should be taxed into property that will not be taxed," he said. "But in cases like this, ignorance is not bliss. The newness of the amendment, and the lack of fanfare with which it became law, may catch taxpayers and accountants off guard."

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