REAL ESTATE ExchangeS THE SOLUTION TO THE CAPITAL GAINS TAX PROBLEM

Although the 1997' Taxpayers Relief Act, created a Capital Gains treatment, it's one that's not very favorable to most people. If you own investment real estate and are thinking of disposing of it and are thinking of treating your transaction as a sale for tax purposes, you are subject to taxation based on your gain. Your gain is your profit.  Depending how you structure your transaction, will determine how much tax is due in the year of disposition and future years. For example, if you dispose of your real estate investment asset and receive all of your equity in the year of disposition, the tax on your total gain is due, what we call a (cash-out sale). If you decide to spread your equity over a number of future years, meaning that you are holding a mortgage for the buyer (known as an installment sale), for the most part you will spread your tax based on your gain over the years that you are holding the paper for. This is done by developing a profit ratio and applying it to the principal and interest deemed received in each year. If on the other hand you decide that you don't want to make Uncle Sam your partner and pay tax based on one of the methods explained, then you have an opportunity to structure your transaction as what we call a real estate Exchangeand PAY NO CAPITAL GAINS TAX  today. This is possible through Section "1031" of the Internal Revenue Code. Real Estate Exchanges are an opportunity to defer both state and federal income tax associated with ones gain at time of disposition and has been available to us since 1921' when the first Exchangelaws were enacted. So, if you are one of the many real estate investors who has been on the sidelines waiting for our government to come out with a favorable capital gains treatment so you could dispose of your real estate investment, our government has done it to us again! 

Most people think that when they dispose of their real estate asset that they are going to be taxed today, known as the new favorable capital gains rate of twenty percent (20%). But for the most part, most people will be taxed somewhere between twenty-five and thirty two percent of their gain. How is this possible, when all we here on the streets is that we can now dispose of our real estate investment assets at a favorable 20% rate. You have to understand that the formula used in calculating gain involves two steps. The first is appreciation, which is the increase of value over the purchase price. This amount is taxed at the favorable new capital gains rate of twenty percent (20%) federally. If you are located in a state like New York State don't forget to add on state income tax, which can be as much as approximately seven percent (7%). So the best possible example would be an over-all tax rate between federal and state of twenty seven percent (27%). But this twenty seven (27%) percent would only apply to a transaction that only involved raw land, because we don't take depreciation expense (cost recovery) on raw land. This rate would represent the appreciation part of the formula when determining gain. On the other side when determining gain we have to take into account depreciation expense which is required to take in the United States on business or investment held property other than raw land. The advantage in taking depreciation expense is that it’s a paper loss which is taken annually and used to create tax shelter from income. It's one of the four benefits of owning investment real estate. The disadvantage is that the total amount of depreciation that has been taken over the holding period has to be determined and is recaptured and becomes part of the gain when disposing of the asset. This portion of the gain is not taxed at the favorable twenty percent (20%) like the appreciation portion of ones gain, its taxed at a federal rate of twenty five percent (25%) and if you are in New York State don't forget approximately another seven percent (7%) for a combined rate of thirty two percent (32%). The problem that we are faced with in most marketplaces in our country today, more so in the Northeast is that we are not experiencing any appreciation which would be taxed at the favorable rate when disposing. Most people are faced with disposing at a price either close to what they paid at acquisition or at a price less then what they paid at acquisition. 

The sad thing is that if the owner doesn't receive some tax advice before disposing of the property they can be faced with a major tax nightmare. The reason being, you have to recapture all depreciation that was taken through the holding period. You do not have a loss you have a gain to the extent of the depreciation taken even if you don't dispose of the property for more than you paid for it. So how is this new favorable capital gains tax treatment better then the old capital gains rate? For most individuals the difference is about four percent (4%). Thirty two percent (32%) verus the old thirty six percent (36%) between state and federal . The solution to this problem is PAYING ZERO TAX. This is possible through a real estate Exchange. The rules are simple. You still need a buyer for your property that is being disposed of and before the closing the seller (taxpayer) must bring in a professional "Qualified Intermediary" to facilitate the Exchangetransaction. Once the Qualified Intermediary is in the transaction the rights of the relinquished property have to be assigned to the Qualified Intermediary, all the Exchangedocuments can then be added which will convert the sale to an Exchangeand the Qualified Intermediary will provide services as a Qualified Escrow also. 

THE WAKE-UP ITEM 

The Wake-Up Item , is that the Qualified Intermediary needs to provide all the necessary customary services and is not just an escrow agent. In addition, the Qualified Intermediary cannot be anyone who will be treated as a "Disqualified Person". That means the Qualified Intermediary cannot be the sellers (taxpayers) attorney, accountant/cpa, real estate professional, an employee of , a family member of or any one will has or had an "agency" relationship with the seller (taxpayer) without blowing the Exchangetransaction for I.R.S. purposes. The seller (taxpayer) then has to acquire another business or investment held property and take title to it within six months of the closing of the relinquished property. 

So, if you are tired of making Uncle Sam your partner and you want to pay zero tax instead of the present favorable capital gains rate you need to structure your transaction as an Exchangenot a sale.