Kim Schooley had wearied of managing an apartment building he owned in
Danville, Pa., that produced a sizable flow of income. The building had
appreciated substantially in the 10 years since he bought it, and he feared that
he would have to pay significant taxes on the capital gain if the property were
sold. Schooley solved his problem by trading the building for 60 acres of
woodland in Watsontown, Pa. Through a technique called a property swap, he
managed to defer $20,000 in capital gains taxes. Now, he says, “All I have to do
is write a check twice a year for [property] taxes. The property takes care of
itself.”  Savvy real estate investors like Schooley are employing property
swaps (also known as 1031 property exchanges, after Section 1031 of the tax
code) as an alternative to selling properties for cash and paying the 15 percent
capital gains tax. One of beauties of swaps is that they permit investors to
trade properties repeatedly for others of equal or greater value, as long as the
transactions involve no cash. A wisely executed series of transactions can allow
the owner to speculate in a wide array of properties while postponing the
payment of capital gains taxes throughout his or her lifetime.
Since the IRS
tax law is a national code, real estate can be traded throughout the 50 states.
For example, a shopping mall in Texas can be exchanged for properties anywhere
in the United States—a seaside condo complex in California, an industrial park
in Connecticut, or even a resort with a yacht marina in Florida. Moreover, one
property can be swapped for several: The IRS’s three-property rule states that
investors can exchange one property for up to three others, regardless of their
market value. The 200-percent rule allows investors to swap one property for
unlimited multiple properties, as long as the aggregate fair-market value does
not exceed 200 percent of the fair market value of the property being swapped.
To reap tax-deferral benefits, both the property that is swapped and the one
received in exchange must be used strictly for investment or business purposes.
In addition, the swapped properties must resemble one another. Investors must
also conform to an IRS-mandated timetable: After trading a property, owners must
identify the replacement within 45 days, then close on that replacement property
within 180 days.
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