The real estate exchange takes more patience and hard workto set up a successful exchange than it does to arrange a straight purchase andsale. Some property owners and their agents simply do not understand the benefitsof an exchange or are worried about the strict requirements imposed by theInternal Revenue Code.
The main benefit of a tax-free exchange is just that--freedomfrom a tax. The gain that could be realized by one or both of the principals inthe transaction does not need to be recognized at the time of the closing. Thetax is deferred until the property owner makes a taxable disposition of the newproperty at some later time.
An owner can make a series of exchangesand can defer tax indefinitely. Upon death, if the property ends up in theestate of this owner and a stepped-up basis is achieved, some tax may beavoided permanently.
The benefit from the tax postponementis apparent. The owner can reinvest the full equity in other property,including gains, without any decrease in value due to tax payments. In effect,the government extends an interest-free loan to the investor, who then is ableto obtain leverage over and above that obtained from regular mortgagefinancing.
In addition to the tax benefits, anexchange (tax-free or not) can be used as a financing tool, since it permitsthe substitution of real estate equity for cash. There are many other reasonsto exchange properties. Following are a few of the most common:
Exchange between land and improvedproperty. Some owners of income producing improved property would liketo exchange for raw land with potential for long-term appreciation. Theirdepreciation deductions may be low and the non-depreciation land is not aproblem. If the investor chooses land with a good growth potential, he has putthe full amount of his equity into another investment. (The owner of the landtransfers equity into a property which gives immediate income, and also may nowdepreciate part of the original basis in the land.)
Exchange for more easily financedproperty. An investor can exchange for property that is capable ofsupporting a mortgage with a higher loan-to-value ratio. For example, propertythat qualifies for a mortgage not exceeding 50% of its value might be exchangedfor a property on which a lender will make an 80% loan. Therefore, after theexchange, an additional 30% of the equity can be released in cash for otheruses. The exchange can be tax-free, as is a refinance of a property alreadyowned.
Buyer short of cash.If a buyer does not have required cash for a purchase, and is unable to get anadequate mortgage, the seller usually will not accept the offer or will extenda large purchase money mortgage. An exchange means he can take other desirableproperty of the buyer in lieu of taking back a mortgage. The seller may alsodefer all or part of the gains tax that would have been due on a sale.
Acquire more salable property.When a property has been on the market for some time without a buyer, the ownermay be able to exchange for another that can be sold for cash more readily.Care must be taken in this type of cash-out exchange, because if there is intentto resell the acquired property immediately, the tax-free exchange rules do notapply. (The new property must be acquired as a property to be held for business or investment in order to qualify.) Butsince the original property was held for sale (and presumably the gains tax wasgoing to be paid on sale) the seller's accountant may find that the tax to bepaid is the same after either transaction. The other owner in the transactionmay make a fully tax-free exchange.
Acquire larger income property.A professional man or woman owns a 10-unit apartment building that is too smallfor an on-site manager. The income is desirable and a sale would be costlybecause of a large gain. The equity should be exchanged up into a largerapartment property that would adapt to professional management. It could haveincreased income to cover larger loans and management fees. The step-up in theowners basis could give a larger depreciation. After the transaction the ownercan have the same or higher income and be relieved of management problems.