What you need to know to do a real-estate exchange

Question: I have a second home that I rent out. I now have equity of about $100,000. I would like to sell that house and build a four-plex using a 1031 tax-deferred exchange. Because of the 180-day time limit between the two deals, I am hesitant to do it. If I sold my house and the four-plex was not finished within the 180 days required, is there any way to extend this period until the four-plex is finished? Is there a builder out there who can build me a four-plex if I put my house up for sale and pay him a $100,000 down payment two months before it is finished?

H.M., Mukilteo

Answer: First, a brief explanation for readers unfamiliar with a “1031 exchange”: Internal Revenue Code Section 1031 permits the exchange of one investment property for another investment property without paying capital gains tax on profits from the sale. The capital gains tax can be delayed indefinitely, through a series of exchanges, until the investor eventually cashes out. The investor then pays tax on all profits above the cost of the original property in the exchange chain.

To qualify for a tax-deferred exchange, certain criteria must be met:

The value of the investment property being purchased must be equal to, or greater than the value of the property being sold.

The equity (property value minus loan balance) in the new property must also be equal to, or greater than the equity in the old property. In other words, the loan amount on the new property must be equal to, or greater than, the loan amount on the property being sold.

The replacement property must be must identified within 45 days after closing the sale of the “old” property, and the purchase of the “new” property must be completed within a total of 180 days after closing on the sale of the original investment property.

The investor must not have “constructive receipt” of the sale proceeds at any time during this exchange period or the money becomes taxable income. Typically, this is accomplished by using a professional “exchange facilitator” as a middle man to hold the sale proceeds and execute the exchange documents.

Now, let’s deal with your specific questions. First, there is no way to extend the 180-day time limit. When the IRS says 180 days, it means 180 days. If you close on the 181st day after the sale of your rental house, you will have to pay capital gains tax on your entire profit.

The good news is that you haven’t sold your rental house yet, so you have some flexibility. The key is to find a buyer for your rental house who is willing to delay the closing as long as possible. Remember, the 1031 exchange clock doesn’t start ticking until you close on the sale of your current investment property. You could make the sale of the rental house contingent on a six-month escrow period, or you could give the buyer a lease-option to buy the house at a set price. The buyer could then move into the house and pay rent to you until you were ready to close on the sale.

On the replacement property end of the deal, you might try finding a developer with a project already under way. It’s the permit process that takes forever, not the actual construction time. It’s also a good idea to find a contractor who is used to building “on spec” so that you don’t have to make a large down payment up front. You may be able to enter into a long-term purchase agreement with a builder that would close upon the sale of your rental house and completion of a 1031 exchange.

Also, keep in mind that construction of the four-plex does not have to be completed before you can go do a 1031 exchange, it just has to have a value in excess of the rental house’s value at the time of the exchange. For example, if you were selling a $200,000 house and building a $300,000 four-plex, you could do the exchange as soon as you had more than $200,000 invested in construction of the four-plex. A builder might be more agreeable to working with you if he knows he’ll get a significant payment half way through the project rather than having to wait for all of his money at the end.

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.

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