Swapping is a time-honored tradition for marbles, baseball cards and your sister`s sweaters.
In baseball, there was the best-forgotten Cub-Cardinal trade of Lou Brock for Ernie Broglio. In real estate, there was the more palatable trade of the Ray-Vogue College of Design property at 750 N. Michigan Ave. and First National Bank of Chicago`s property at 664 N. Michigan Ave.
Swapping, or in more business-like terms ”exchanging,” has become a standard tool in the real estate broker`s bag of tricks since the late 1920s, when Congress granted special tax dispensation on exchanges of ”like-kind”
properties, such as apartment buildings for shopping centers, or undeveloped farmland for already built factories.
As long as these exchanges are for commercial or industrial property, they are exempt from capital gains taxes under Section 1031 of the Internal Revenue Code, but the property exchanges are exempt only until the property is sold outright, at which time the taxes are due.
”A real estate exchange is a way to defer the tax on a profitable real estate trade,” Robert Bruss wrote in ”The Smart Investor`s Guide to Real Estate.” ”This tax postponement, however, can last forever because it is possible to make a continuous chain of trades, never paying profit tax, as the investor goes from a small property to a multimillion-dollar one.”
That is the lure of the ”tax-deferred exchange.”
However, there are also disadvantages, according to Mark Lee Levine, a lawyer, author and professor at the University of Colorado. The advantage of the capital gains deferment has to be measured against the disadvantage of not being able to depreciate the property as if it were an outright purchase.
”Computer studies show . . . that it is not always true that you come out with more wealth by exchanging,” Levine said.
Mark Goode, vice president of the corporate real estate firm, Goode and Associates, Des Plaines, has begun to use the tax-deferred exchange in his business only recently but anticipates using it regularly in the future.
”It`s a lot like the old barter system, where someone has something someone else wants and they simply exchange it,” he said.
His firm closed three exchange deals, worth about $11 million total, last year.
A $3.75 million, three-way exchange was the most unusual. It involved Elk Grove Partners, which owned a $2.2 million, 80,000-square-foot property in Elk Grove Village, unleased; Wented Co., which owned a $1.1 million, 46,000-square-foot property in Schil-ler Park, leased by Niagara Envelope Co.; and Kelfran Associates, which owned a $425,000, 15,000-square-foot property in Chicago, leased by Scientific Supply Co.
The first part of the exchange involved Elk Grove Partners and Wented. Elk Grove Partners had $1.1 million in equity and a $1.1 million mortgage for its property, and Wented owned its building outright. When the two companies exchanged, their equities were equal, and Wented assumed Elk Grove Partners`
mortgage.
In the second part of the exchange between Elk Grove Partners and Kelfran Associates, Elk Grove Partners exchanged its new $1.1 million building for Kelfran`s $425,000 building, which it also owned outright. Then to balance the equities, Elk Grove Partners provided Kelfran with a $675,000 mortgage for its new, more expensive property.
Because Elk Grove Partners was trading ”down,” it had to pay capital gains taxes, but there were other incentives for the company to exchange its property, Goode said.
The company had been trying to sell its empty building for a year, during which time it had to pay $25,000 in monthly costs. In the two exchanges it was able to reduce those monthly expenses first to $12,000, and then to $2,500. In addition, it was able to reduce what Goode calls the ”risk level of value,” which simply means that it is usually easier to sell a smaller, less valuable property.
Wented and Kelfran both deferred payment of capital gains taxes in the transaction, an estimated $160,000 and $60,000, respectively. For them, too, there were other advantages in the exchange, Goode said.
”They are in the business of making widgets; their business was not real estate,” Goode said. ”By exchanging their properties, they were able to go on with business and not be concerned about the sale of their original properties. As soon as the exchange took place, they were operating out of their new buildings, making widgets and distributing them.”
The popularity of the tax-deferred exchange has swung up and down through the years with general economic conditions and changes in the tax code such as how depreciation is allowed on commercial real estate.
However, because exchanges are often not reported on tax returns, there are no accurate figures regarding their use. Some people feel that exchanging real estate was more popular a decade or so ago, before real estate values began their astronomical appreciation. Others, think that taxpayers have become more aggressive in recent years, increasing the exchange activity.
Today, because the depreciation period has been shortened, and because the capital gains law is at its lowest level in years, people are more apt to sell than swap, said Peter Levy, a real estate lawyer with Rudnick & Wolfe.
If tax reform becomes a reality in the next few years, and other tax breaks disappear, exchanges may once again gain in popularity, according to some in the real estate industry.
Others expect less exchange activity. ”As the tax rate falls, there`s less concern with taxes,” Levine said.
The original congressional intent for the tax-deferred exchange is
”muddy,” Levine said.
”There is an argument that it is good public policy to encourage people to transfer property,” he said. ”It encourages activity in the marketplace, which otherwise might be discouraged if the taxes had to be paid.”
