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$650 covers you for one relinquished property and one replacement property.

An additional $175 will be charged for each replacement property purchased afterwards.

There's a $30 wire fee for outgoing wires.

That's it.

AND we pay interest on the funds while we
hold them.

Avoiding Capital Gains Tax


Using 1031 Exchange, Avoiding Capital Gains Tax

By Perri Capell

Last spring, Milford, Conn., resident Chris Hiza wanted to replace two rental properties he owned with other rental units that he thought would appreciate more in the long term. But instead of selling his two three-family rentals, paying taxes on the gains, and then using what was left to buy the new rentals, he made a 1031 exchange. This transaction allowed him to roll all the proceeds from selling the old properties into buying the new ones -- without taxes being taken out of the gains.

The term "1031" refers to a section of the IRS code that allows real-estate investors to defer taxes on gains from the sale of investment properties as long as they put the money into buying other investment properties of equal or greater value. The seller must identify the property he wants to buy within 45 days of the sale of his existing property and complete the purchase within 180 days. A third-party intermediary normally handles the transaction.

In Mr. Hiza's case, selling the two rentals in West Haven, Conn., without forking over federal and Connecticut state taxes on the sales allowed him to buy four three-family rental homes in a desirable part of New Haven.

"The 1031 exchange was a way to trade up for the longer term and shelter the gains," says Mr. Hiza, 43. "Since we would have had a 24% combined tax rate, this leveraged up our purchase by 24% per property. That's a lot of money."

More real-estate investors are using the 1031 exchange provision to buy and sell investment property, with the majority of sales consisting of one- to four-family rental properties and worth about $500,000 to $700,000, say tax and real-estate experts. But many owners make mistakes that cause the IRS to disqualify the exchange because they don't understand the rules governing these transactions. Mr. Hiza's 1031 exchange was successful because he planned ahead and researched properties he wanted to buy before selling his former units. This allowed him to complete his transaction within the required period.

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"Don't get into the 45-day crush," he says. "If you want to do it, start looking now for replacement property, get prequalified for financing and have Realtors, attorneys and intermediaries you can work with."

Here are some of the most common mistakes real-estate investors make when attempting 1031 exchanges, say intermediaries, attorneys and investment advisers.

Assuming they can do a 1031 exchange on a personal residence. While a variety of assets, such as boats or cattle, can qualify for 1031 exchanges, only real estate can be exchanged for real estate, and the only real estate that qualifies for an exchange is investment property. This includes rentals, property used in a business or land held for investment purposes. A building purchased to renovate and sell and land purchased for construction of homes or commercial buildings won't qualify since the owner doesn't intend to hold it for a period of time for investment reasons, says Denis Caron, vice president and Connecticut counsel for LandAmerica Exchange Co., a Richmond, Va.-based qualified intermediary company.

Trying to do an exchange on a property after selling it. "I can't tell you how often I get calls from people who say, 'I sold my property yesterday and want to do an exchange,' " says Mr. Caron, who's based in Cromwell, Conn. "I tell them to call me next time before they sell the property because it's too late now."

Sellers must set up an exchange agreement with a qualified intermediary before they sell their property, he says. Qualified intermediaries are disinterested parties with no current relationship to a taxpayer. This would exclude your current attorney, accountant, financial adviser or agent. The intermediary holds the proceeds from the sale for the taxpayer until the replacement property is acquired.

Not choosing a reputable intermediary. Intermediaries don't need to be licensed or certified, so it's buyer beware when choosing them. In addition to intermediary firms, many title companies and banks now serve as qualified intermediaries. Select an intermediary that's knowledgeable, experienced and trustworthy and will deposit your money in a trust account in a reputable bank, says Bruce D. Savett, principal and founder of Granite Peak Partners Inc., a Santa Barbara, Calif., real-estate adviser and investment company.

John P. Napoli, an attorney with Seyfarth Shaw LLP in New York City, makes sure that intermediaries for his clients set up separate trust accounts for each seller, with the seller named as the beneficiary. He notes that money held by an intermediary is not federally insured unless it is in a bank. "There have been cases where qualified intermediaries have gone bankrupt, and people have lost their money," he says. "You have to go on the reputation of the intermediary."

Not holding an investment property long enough. The IRS isn't specific about how much time you need to hold on to a property received in an exchange before selling it. However, quickly selling a property you bought through a 1031 exchange indicates that you didn't plan to hold it to generate investment income. A good rule of thumb, says Mr. Savett, is to hold a property during two tax years. As an example, a rental bought under a 1031 exchange in May 2004 and held at least until May 2005 would have been owned during two tax years. Mr. Savett encourages all investors considering a 1031 exchange to check with their tax adviser.

Not understanding the 45-day rule for identifying new property to purchase and the 180-day rule for buying it. The 45-day and 180-day periods are the most specific part of the code relating to 1031 exchanges. Sellers have until midnight on the 45th day after they've sold a property to identify up to three properties they may purchase with the proceeds from their sale. They have until midnight on the 180th day after the sale to buy at least one of these new properties.

The typical way to identify a property is to notify your intermediary in writing of the properties you want to acquire. At this point, you don't need to have a contract to buy any of the properties. However, to defer your taxes on your gain, you must be specific about each piece of property you identify and the property you buy must come from this list, says Mr. Caron.

The IRS has questioned taxpayers who haven't been specific enough about the property they want to buy, says Mr. Napoli. "One taxpayer identified 100 acres somewhere and took title to only 75 acres in the exchange," he says. This taxpayer won the subsequent IRS audit about the exchange. However, a taxpayer who only bought 50 of the 100 acres might not have because the property he bought differed so much from what he identified, says Mr Napoli.

Don't assume that the 45 and 180 days are limited to normal business days and exclude weekends. Weekends also are included in the time period, and if the 45th day falls on a Saturday, Sunday or holiday, you must have your paperwork completed by the prior business day or you'll be disqualified.

Only Congress or the IRS can extend these deadlines and have done so in cases of widespread emergency or disaster, says Mr. Caron. "It was done after [Sept. 11, 2001], the hurricanes in Florida and the fires in San Diego county," he says, "but never on a case-by-case basis."

Not giving yourself enough time to research properties to purchase. Many investors don't think through why they want to sell a property and what they want to buy, says Mr. Savett. "In a market where things have gotten expensive, often people sell a property because they think it is a good time," he says, "but they haven't thought enough about what they can buy."

Typically, 45 days isn't enough time for an investor to search out a new property and do the research on it to determine if it's a sound investment, he says. Often they end up designating and buying property that's too expensive, requires too much debt, won't appreciate or doesn't meet their needs.

"Determine what you want to do before you sell, check the current market and determine if your buying assumptions are accurate and, instead of accepting an offer on your property and closing quickly, find a buyer who will let you have a long escrow period or extend the date of the sale so you can look for properties that fit your investment strategy and qualify for the tax savings of a 1031 exchange," Mr. Savett suggests.

"I'd rather take my gain and put it in the bank instead of rolling that gain and buying a bad property," he says. "However, with ample planning, you can have both a quality investments and tax savings."

Mr. Hiza agrees. He started researching his options and knew what properties he hoped to buy before selling his former units. "I made it clear I wasn't going to buy something I didn't want just to make the deadline," he says.

-- Ms. Capell is a senior correspondent for CareerJournal.com.

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