1031 Exchange Options

You may be thinking about a vacation this summer, but Ed Horan is thinking about vacation home purchases -- and how to save real estate investors big taxes on them.

Of course, Ed Horan is almost always thinking about saving somebody taxes on real estate. That's because he's one of a tiny, loosely knit group of real estate professionals who do nothing but arrange tax-free property exchanges nationwide. Based in Haymarket, Va., Horan is what the Internal Revenue Service calls a "qualified intermediary" under Section 1031 of the federal tax code.

Horan says his firm, Realty Exchange Corp., handled about $ 27 million worth of exchanges in the past year -- often involving urban dwellers who want to buy a home at the beach, a ski resort condo, a lakefront cottage or a resort-area getaway that will eventually turn into a retirement house.

The buyers all want to have their cake and to eat it, too. They want to spend little or no cash out of pocket for their new houses, and they want to pay no federal taxes whatsoever.

Under Section 1031, they're allowed to. Owners of investment or business real estate don't have to pay capital gains taxes when they dispose of their property, even if it's quadrupled in value and is loaded with otherwise taxable profits.

All they have to do is roll over those gains via an exchange into "like kind" real estate. The exchange need not be a direct swap. Most exchanges, in fact, feel like traditional sales and purchases to the participants involved. You sell one property to a regular buyer, listing it as an exchange property. The buyer can use it any way he or she desires. The cash proceeds go into an escrow, and are later used to pay for a replacement property.

The replacement real estate merely has to fit the IRS' broad definition of "like kind." You can buy a vineyard in Oregon by swapping away your rental house in Key West.

The deal stays tax-free as long as you accept no cash in the process and your replacement property's acquisition cost is equal to or greater than the selling price of the property you sold, less expenses.

Here's how vacation homebuyers are using Section 1031. Say you've owned a modest rental house in the suburbs for a number of years. Happily for you, it has increased in resale value from the $ 100,000 you paid for it to $ 150,000 today. For simplicity's sake, say your potential capital gain tax exposure on your sale profits, including depreciation you wrote off, comes to about $ 60,000.

Depending upon where you live, your federal and state tax liability on your $ 60,000 capital gain might come to 35 percent, including 28 percent federal capital gains and 7 percent state tax. That's a hefty $ 21,000 out of pocket.

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