Avoiding Capital Gains Tax on Investment Property: Don’t Be Duped

As anyone with experience in business or investments can tell you, the hefty federal tax bill that comes with capital gains on the sale of investment property is simply unavoidable. Fortunately though, every savvy investor knows that “inevitable” doesn’t necessarily have to mean “soon.” For the past 12 or so years, since enactment of IRS Regulation 1031, many real estate investors have become well acquainted with the so-called “1031 like kind exchange” process. Many have dubbed the process a “tax free exchange.” If only that were true! The fact is, however, that capital gains taxes are truly inevitable. Thankfully though, the inevitable can be postponed - nearly indefinitely.





Real estate, like so many other investment properties, is purchased with the expectation that it will appreciate in time. That appreciated value, for the business investor, becomes taxable profit subject to up to 20% capital gains tax. Unlike real estate that is purchased as the primary residence of the owner, there are no exclusions or exemptions on the appreciated value of investment real estate. Likewise, there are no roll-over periods for which an investor can sell one property and buy another without facing the “inevitable.” Even if you sell one investment property and – just one minute later, buy a replacement property, Uncle Sam want his due.





Enter the 1031 Exchange Process. The Internal Revenue Service, in keeping with their usual sympathetic devotion to the taxpayer, have devised the like kind exchange process for the sale of one investment property and the purchase of the second – all while “deferring” the tax until the time of the replacement property sale. If the investor uses the same process the next time, and the next, and the next, he creates a “near tax free” process.





A typical “forward exchange” (selling one property before purchasing another) incorporates the use of a qualified intermediary, or “QI.” The QI provides service to the property owner by acting as a seller’s agent, a purchaser’s agent, and an escrow agent. Sound confusing? Many QI’s would like you to believe so. While it is true that there can be many specific tax questions relating to any given exchange of investment property, so many who use the process repeatedly will find it surprisingly simple. The reason, -- it is a simple process.





As an attorney, I have provided transactional legal work over the years for many of my clients, exchanging a wide array of investment property - from real estate to multi-million dollar aircraft. Because I served as their attorney, I was considered “disqualified” from also serving as their intermediary, thus requiring my client to seek the services of an independent QI. As one who takes great care to keep client costs within reason, I became increasingly frustrated in seeing my client subjected to the costs of the unreasonable fees of QI services. It was not unusual to see QI fees in excess of $10,000, $20,000 or more for a single transaction. So much for my client’s preservation of capital!





The enactment of the 1031 regulation created a boon for countless entrepreneurs seeking to establish themselves as QI’s. Seeing the tremendous fees that it can attract, it’s no wonder so many became ready and willing to provide what they proclaim as “complex” and “technical” services. The truth is that nearly all of them defer the technical legal and tax matters to the investors own professional advisor, totally exculpating themselves from liability. Why then, are they charging the investor such outrageous fees? The answer, in my opinion, is because they can get away with it. “Everybody’s doing it, therefore, it must be justified” is the expected reaction.





I hope, in the course of the coming weeks to share a bit more insight into why I believe the 1031 exchange is a very simple process, why exorbitant fees should be avoided, and how they can be.