Like-kind property exchanges can reduce tax bite

Question: To augment my personal income from my practice, I own several rental real estate properties. Because of the strong real estate market, and the cash flow my properties generate, their fair market values have risen significantly. I am tempted to sell them but don't want to affect my investment return with a tax bite on the gains. I understand that I can make a property swap and defer the tax. What is involved in the swap, and do you recommend it?

Answer: The transaction you are pursuing is a like-kind exchange under Internal Revenue Code Section 1031. It has been in our tax laws since 1921 and is an effective way of protecting your equity in your real estate investments from capital gain taxes.

A like-kind exchange allows the taxes due on a real estate sale to be deferred (not eliminated) as long as qualified replacement property is purchased. In fact, if the rules of Section 1031 are followed, the deferred tax application is a mandatory, not an optional, tax result. The method for opting out of the like-kind exchange rules is to not fulfill the many onerous tax law requirements of this code section.

To qualify for deferred tax treatment on your sale of real estate, it is important that the sale and purchase contracts include exchange cooperation language. Language should include your intent for the transactions to qualify under the exchange tax laws. In addition, your relinquished and replacement properties must be "like-kind." To be like-kind, under the tax laws, the two properties must be similar in nature or character. All real property is generally like-kind to each other. This relaxed definition of like-kind makes exchange transactions very attractive for real estate.

There are three main types of exchange structures to consider for your real estate.

A simultaneous exchange is where you sell your relinquished property and purchase replacement property at the same time. It can be difficult finding a buyer for your property who also has suitable property, so including a third party who has your desired replacement property in a "three-party swap" is allowable.

A second type of exchange is a delayed exchange, sometimes labeled as a Starker (not Stark) transaction, named after the taxpayer who first applied with the IRS for its sanction of deferred tax treatment. A Starker exchange allows you to sell your property first and then sets forth statutory time periods to identify and purchase replacement property.

Rules are very strict with a Starker exchange. First, you must exchange your property for replacement property within 180 days. Next, the potential replacement property must be identified within the first 45 days of the 180-day exchange period. You are limited on the number of identified replacement properties (three-property rule) and the fair market value of the identified replacement properties (200% rule). There are absolutely no extensions for the 45-day or 180-day rules, and Saturdays, Sundays and holidays do count.

Finally, in a Starker exchange you cannot have access to proceeds from the sale of your property during the exchange period. You may not borrow, pledge or otherwise receive any benefit of this money until certain time has elapsed, or activities have occurred. To violate any of these provisions would cause the sale to be taxable.

The third type of exchange is known as a "reverse Starker" transaction and was recently sanctioned by the IRS. It allows you to purchase replacement property and then "park" it or the relinquished property with a qualified intermediary until you are able to sell your property. The same 45-day identification and 180-day exchange rules from a delayed exchange also apply to a reverse exchange.

The reverse exchange is more expensive and complicated than a delayed or simultaneous exchange. But sometimes it isn't possible to sell your property before the right replacement property comes along.

Question: I plan to change my federal tax withholdings to increase my paycheck and avoid unnecessary excess funds being held by the IRS until I file my tax return and request a refund. Does the IRS allow such a change? Is my practice allowed to accommodate my request? If so, how do I make the request?

Answer: You must submit your request for change in federal tax withholding on a completed and signed Form W-4. The completed form is kept in the practice records.

A flat amount or percentage of income cannot be used to accomplish your requested withholding amount.

Instead, it will be necessary to translate your desired federal tax withholding amount into a number of exemptions and designation of filing status that will provide the same results.

This mathematical exercise can be onerous, so you should use the Internal Revenue Service withholding calculator on its Web site (link) or consult your tax adviser.

You are allowed to change your withholding every payroll period, if you like, so if the results don't meet your goals, you may adjust your exemptions by completing another Form W-4.

Recently released tax regulations no longer require your practice to submit W-4 forms that have 10 or more exemptions to the IRS.

Instead, the IRS has developed internal procedures for identifying problem taxpayers who don't timely pay their tax obligations.

Submitting W-4 forms to the IRS created reluctance for employees to aggressively modify their tax withholdings. With this new regulation in place you shouldn't feel that completing an aggressive Form W-4 to avoid unnecessary tax withholdings is sending a warning to the IRS. As a suggestion though, take your higher paycheck and invest it wisely.