Question: I would like to know if it’s possible to sell my rental property (out of town, 20 acres with a house) and divide the profit and reinvest in two rental houses near my home in Lynnwood without paying capital gains.

G.D., Lynnwood

Answer: Yes, you can use a tax-deferred exchange to accomplish the rollover, but you must be very careful to the follow the tax rules to the letter.

Section 1031 of the Internal Revenue Code allows you to roll the profits from property held for investment or used in a trade or business into what’s called like-kind replacement property. Like-kind simply means that the replacement property must also be held for investment or used in a trade or business. Contrary to popular belief, you do not have to go from one rental house into another rental house, or from a commercial building into another commercial building.

You can exchange from raw land into a rental house, from a rental house into an apartment building, from an apartment building into several rental houses, etc. The only exception is that you can’t roll the proceeds from the sale of a rental house into the purchase of a personal residence because your home is not an “investment” property.

However, setting up a tax-deferred exchange involving multiple properties is much easier said than done. The time deadlines are very strict. The IRS gives you only 45 days to locate a replacement investment property and 180 days to close on the purchase of that property. It’s even tougher when you have to find two replacement properties instead of one. But it can be done if you plan your strategy well in advance.

Start looking for replacement properties now. Don’t wait until you sell your existing property. That gives you more time to make an intelligent decision. The 45-day clock starts ticking the day you close on the sale of your current property. Many real estate agents tell stories about frantic investors desperately scrambling to find an acceptable rental property to buy as their 45-day time deadline ticks down to the last few days.

Sometimes these investors end up with a less-than-ideal property that they would never have purchased under normal circumstances. Don’t put yourself in that kind of stressful position.

Once you get a purchase offer on the property you’re selling, try to delay the closing for as long as possible. The buyer may be able to close the deal within 30 days, but if you extend the closing date to 60 or 90 days out, you can add a month or two to your exchange deadline.

To qualify for a tax-deferred exchange, the purchase price of the replacement property must be equal to or greater than the sales price of your current investment property. For example, if you sold your 20 acres and house for $400,000, you could purchase two rental houses that cost $200,000 each.

The $400,000 combined value of the rental houses would equal the sales price of the property you are selling. This can be done in any combination, such as a $150,000 rental condo and a $250,000 rental house, as long as the combined purchase price of the two investment properties equals, or exceeds, the value of the property you’re selling.

The mortgage balance on the new property must also be equal to, or greater than, the total mortgage balance on your old properties.

To complete a tax-deferred exchange, you must use an intermediary known as an exchange facilitator. You cannot have any contact with the cash proceeds from the sale of your investment property at any time during the exchange period or it becomes a taxable gain.

An exchange facilitator is similar to an escrow company in that it holds the money from the sale of your investment property. But unlike an escrow company, the exchange facilitator actually participates in the transaction as a buyer and seller rather than a neutral third party.

Therefore, you must be certain that you’re dealing with a reputable firm, because as I said above, you may not have any contact with the funds during the exchange period. That means the exchange facilitator has total control over your money during that time, and if they run off with it, you are just plain out of luck.

A Section 1031 exchange is an excellent way to keep the value of your real estate portfolio growing without giving up a chunk of your profits in capital gains tax every time you sell. Just be sure to follow the exchange rules to the letter. There are no time extensions allowed. If you miss a deadline, your entire gain becomes taxable.

Mail your real estate questions to Steve Tytler, The Herald, P.O. Box, Everett, WA 98206. Fax questions to Tytler at 425-339-3435 or e-mail him at economy@heraldnet.com.