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Finding the Perfect Parking Space

Worth Magazine, April-May 2014

By Michael Kosnitzky, Boies, Schiller & Flexner LLP

USING LIKE-KIND EXCHANGES CAN SAVE REAL ESTATE INVESTORS MILLIONS IN TAXES, BUT MOST PEOPLE DON’T KNOW ALL THE CREATIVE WAYS THEY CAN BE USED. 

I recently wrote here about the use of UPREITs, a form of real estate partnership combined with a real estate investment trust, to create liquidity for high net worth real estate investors while al­lowing them to defer taxable gains on highly leveraged and appreciated real property. Another tax deferral strategy that’s growing in popular­ity again because of higher tax rates is the use of 1031 exchanges. Named after the Internal Revenue Code section authorizing these transactions, they are also known as “like-kind” exchanges.

Like-kind exchanges per­mit one party to swap prop­erty for similar property without immediately incurring federal tax. Since virtually all types of real property are considered similar, one may exchange, for example, undeveloped land for a shop­ping center. A seasoned real estate investor might have acquired agricultural land for $1 million and later had the property rezoned for com­mercial use, raising its value to $3 million. That investor could then exchange this land for a shopping center worth $3 million that pays net rents of $300,000 per year; federal income tax on the $2 mil­lion gain would be deferred until the sale of the shopping center. If the shopping center were worth more than $3 million, the investor would need to pay its owner the difference in cash or other property. If the shopping cen­ter were worth less than $3 million, then its owner would need to pay the investor the difference. This additional amount, known as “boot”—as in getting something “to boot”—would be taxable.

It’s not easy to find two people who miraculously wish to exchange property. So strategies have been devel­oped that permit like-kind ex­changes by using four parties. In this situation, our investor sells his undeveloped land to a third party. The buyer pays the $3 million price to a third party trustee, called a “qualified intermediary,” who then uses those proceeds to buy the shopping center. The trustee then directs the shop­ping center owner to transfer it to the investor.

As long as the replace­ment property is identified and acquired within certain IRS-mandated deadlines, the real estate investor will not recognize the $2 million gain from the sale of the unde­veloped land. Instead, he is treated as if he had traded his undeveloped land directly for the shopping center.

What I just described is the typical scenario: The investor wishes to sell some property and acquire like-kind property. But what if circumstances require that the replacement property be acquired before the closing of the investor’s property? What if the prop­erty that the investor wishes to acquire needs to first be improved or constructed?

The IRS has rules that may cover some reverse ex­changes like these, which are often referred to as “parking” transactions and improve­ment or construction ex­changes. Parking transactions come in particularly handy in a hot market like today’s; with many competing buy­ers, sellers have no incentive to give buyers mere options to buy or to accept delayed closings. In these transactions our investor may acquire the shopping center first and then “park” the title to it with an intermediary called an “ex­change accommodation title­holder” until a buyer is found for his undeveloped land.

When taxpayers are faced with having to pay almost 24 percent of their gain to the IRS—and potentially far more when you consider city and state taxes—like-kind ex­changes offer terrific tax sav­ings opportunities. Serious real estate investors should consider ways to structure their transactions in a tax-deferred format.

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