Investors are increasingly seeking creative transaction structures to cash in on the heated real estate market.A strategy that uses preconstruction contracts in Section 1031 like-kind exchanges is one way that is gaining acceptance among investors, especially in areas with heavy condominium development.

The phenomenon started in markets such as California, New York City, South Florida, Las Vegas and Phoenix, where high single-family home prices, scarce available land and low interest rates fueled new condominium construction during the past few years, according to Stephen Wayner, Esq., a Certified Exchange Specialist and vice president of Miami-based Bayview Financial Exchange Services.

CPAs with real estate savvy are playing a role in the phenomenon by analyzing the transaction to determine that the contract-for-contract exchange qualifies under Code Section 1031. "This is important, because if the transaction is not handled appropriately, the Internal Revenue Service may raise a red flag if it suspects the contracts being exchanged are for flipping, not investing," said Wayner.

If structured correctly, this little-used strategy can help middle-class taxpayers avoid the alternative minimum tax that might otherwise be triggered by the profit on the sale of their investment property.

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 a 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 requirement of a like-kind exchange, and then defer the gain and not pay taxes on it 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."

While the implications for real estate investment are immense, investors should enter into preconstruction condo contract exchanges with caution, according to Wayner.

"Primarily, investors should bear in mind that the condominium developer's approval generally is required in order to sell a preconstruction contract. And as a condition of approval, many developers require a share of the sale's profits," he said. "In addition, many lenders and financial institutions frown on assignment contracts and prefer to see real buyers."

Not on the flip side

There are clear differences between contract exchange transactions and flipping options, Wayner explained.

"For instance, suppose an investor puts down a $200,000 deposit on a $1 million condominium unit to be completed in the future," he said. "The unit is going to be used as an investment, and the owner/investor intends to lease it out for $6,500 a month when it is completed, representing a 6.5 percent gross return on the investment. Two and a half years later, which is three months prior to the unit's completion, the investor receives a $1.5 million purchase offer for the unit. Selling the contract for that amount grosses a $500,000 profit. He decides to place the $700,000 he received - his original deposit plus the profit - as a deposit on another to-be-built unit with a purchase price of $3 million."

By using Section 1031, the investor deferred taxes on the $500,000 profit, because his intent was to use the unit as an investment. And since he held the unit for two-and-a-half years, he avoided the rapid buy-and-sell pace that the IRS generally associates with flipping investments, said Wayner.

"The IRS generally examines an investor's intent," he explained. "If an investor conducts exchanges soon after the one-year-and-one-day holding period, which qualifies for long-term capital gain, the IRS may attempt to characterize the investor as a dealer."

"Favorable capital gains treatment applies to investors, but not to dealers. In this instance, a dealer is a taxpayer who makes a living from his or her investments, which are, therefore, taxed as ordinary income on all profits received," he added.

"If an investor signed a contract and flipped it three months later, the IRS would say it was not held for a reasonable time, therefore he didn't intend to be an investor," said Wayner. "The IRS has taken the position that two years is necessary to show reasonable time, but there are a number of cases where they have taken that position and lost. My own position is that a year and a day is all that is necessary."

After deferring gain by using Section 1031, there is nothing to prevent the investor from changing her intent and converting the investment property into a principal residence, thereby potentially qualifying for a total exemption of gain up to $500,000, under Code Section 121, according to Wayner.

"Since the 2004 Jobs Act, the requirements are a little tighter," Wayner noted. "Now, the taxpayer must hold the acquired property for five years, in addition to living in it as his personal residence for at least two years."

"For example," he explained, "Jones buys an investment property for $100,000. Instead of selling it when it's worth $400,000, he exchanges it for another investment property. In the back of their minds, he and his wife think it may be something they can live in when they retire, so in Year Three they change their minds and move in. They live in it for two or three years, then change their minds again and sell it. They get the best of both worlds - $500,000 of the gain is tax-free."

Since like-kind exchanges are not normally simultaneous, and the taxpayer may not receive cash and then use the proceeds to buy replacement property, the regulations provide safe harbors to protect the nonrecognition treatment of the transaction. One of those safe harbors is the use of a qualified intermediary.

When the taxpayer engages the services of a qualified intermediary under an exchange agreement, he is not considered to have received the funds in the delayed exchange.

Wayner recommended the use of a qualified intermediary to facilitate these types of exchanges. "An independent qualified intermediary will help ensure that a transaction is managed according to IRS guidelines," he said. "Doing this can turn a transaction that would be taxed into a transaction that will not be taxed."

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