Legal Requirements, Recent Tax Law Changes and How They Affect Doctors
IRS section 1031 tax deferred real estate exchanges have been available as a tax deferral method since the 1920’s. However, in the last 15 years the IRS has issued several rulings delineating the exact process that must be followed for different types of exchanges. The rationale that forms the basis for tax deferred exchanges is that the exchange of an asset for a similar asset of equal or greater value represents a continuity of investment which should not be taxed at the time of the exchange. Under Section 1031, a taxpayer may exchange property that is currently held for investment or productive use in a trade or business, for similar or like-kind property. If the exchange is carried out consistent with the provisions of Section 1031, then the taxpayer receives a deferral of all capital gains and depreciation recapture taxes associated with the transfer.
An exchange is rarely a swap between 2 parties. Most exchanges are not simultaneous, and involve 3 parties: the investor (exchanger) who is doing the exchange, the buyer who is purchasing the exchanger’s old (relinquished) property and the seller who is selling the exchanger a new (replacement) property. To create the exchange of assets and to obtain the benefit of the “Safe Harbor” protections of the tax code to prevent actual or constructive receipt of the exchange proceeds, which would disqualify the exchange treatment, most exchangers use the services of a Qualified Intermediary (QI). The QI becomes a fourth party principal in both simultaneous and delayed exchanges. The steps for completing an exchange are relatively simple.
§ The exchanger signs a contract with a QI cooperation clause to sell a relinquished property to the buyer
§ A QI is retained and the exchanger assigns the exchanger’s rights in the sale contract to the QI.
§ At the closing the exchange funds are transferred to the QI, and the QI instructs the settlement officer to transfer the deed directly from the exchanger to the buyer.
§ The exchanger has 45 days from the closing of the relinquished property to identify in writing to the QI possible replacement properties. Certain limitations apply to number and value of properties that may be identified.
§ The exchanger has 180 days (or until the tax filing deadline, plus extensions) to acquire all replacement properties.
§ The exchanger signs a contract with a QI cooperation clause to purchase the replacement property with the seller and the exchanger assigns the exchanger’s rights to the QI.
§ At the closing of the replacement property, the QI transfers the exchange funds to complete the exchange, and instructs the settlement officer to transfer the deed directly from the seller to the exchanger.
There are many different types of properties that have been termed like-kind for purposes of a 1031 exchange, and almost anything that is a deeded property right may be exchanged for another deeded property right. These may include raw land, commercial properties (like veterinary hospitals), Tenants-in-Common properties, investment or rental vacation properties, oil and gas rights, crop rights or payments, water or mineral rights, land or building leases of greater than 30 years, conservation or agricultural easements, and any other type of deeded property right.
The tax liability that is deferred is easily calculated. The adjusted basis for most properties can be easily found on the exchanger’s tax returns. It is simply the sum of the original purchase price plus non-expensed improvements, minus all depreciation taken. This depreciation must be recaptured at a federal 25% tax rate plus varying state rates. The total appreciation of the property is the net sale proceeds minus the original cost and cost of improvements. The appreciation is taxed at the 15% federal capital gain tax rate plus the state capital gain tax rate. The total of these 2 federal tax liabilities and 2 state tax liabilities is the tax than can be deferred through a 1031 exchange. At the time of the exchange, the tax basis from the original property is rolled over into the exchanged property. In order to completely defer all taxes from the exchange transaction, 2 rules must be followed. First, the exchanger must acquire property with at least as much equity as the prior equity in the exchanged property. Second, the exchanger must assume as much debt as the prior debt on the exchanged property.
A veterinary exchange is almost always a process that involves several people, typically a seller, CPA, real estate attorney, Qualified Intermediary, financial planner, and replacement property specialist. Veterinary sales tend to be more complex, as there is almost always a business sale that is occurring at the same time. Sale of the real estate may not be an option, as it may be required with the purchase of the practice. At the sale of a veterinary practice, there are two questions that should be asked. Should you sell the practice property and what to do if you sell. Veterinary hospitals after a practice sale should be treated as any other piece of commercial real estate if ownership is maintained. Veterinary hospitals are usually highly specialized facilities, suitable for only one use. Converting to other commercial uses can be quite costly. It is always advisable to monitor for changes in the area demographics and to the facility, and weigh whether it might be better to diversify into a safer investment. If one does decide to sell, there are two options, 1031 exchange or sell and pay the taxes due (see prior discussion to calculate amount).
If one decides to exchange, the range of options is very great. Most practitioners that I have worked with have desired to roll over their practice investment into an income producing property. There are several options here:
§ Owner managed properties-Usually rental houses or small apartment/retail complexes. Likely will produce the highest return (10-12% per year) but also entail the most hands-on management.
§ Professionally managed or Triple Net Leased properties- Typically commercial properties with management by a real estate company or by the tenant. Medium rate of return (9-11%), with some management. Very difficult to find in today’s real estate environment within 45 days.
§ Tenants-in-Common properties- Very large office buildings with US government or Fortune 500 tenants, larger shopping malls. Typical returns 7.5-9.0%, depending on lease length. Longer term leases with escalations and higher quality tenants. Leveraged some through non-recourse loans to provide greater depreciation (typically 40-60% of income tax free due to depreciation deduction) and increased share of appreciation. Properties more available and easily identified. No management responsibilities to exchanger.
The key to a successful exchange is a replacement property specialist, as the exchanger has only 45 days after the sale of his original property to identify the properties to be exchanged into.
Numerous situations have come into play with the sale of veterinary properties. Following is a list of some of the circumstances that I have come across, and the results.
§ Simple delayed exchange- 2 parties and properties identified and purchased.
§ Real estate partnerships- Have been harder unless all partners want to exchange into same thing. IRS rules specify that selling entity and purchasing entity must be exactly the same. Typically must unwind partnership and transfer the assets to the individual partners. Individuals may then exchange by themselves. Be careful, as IRS regulations require property to be held for productive use. What time frame constitutes held? If dissolve partnership and then exchange same day, IRS will likely disallow exchange as was done solely for the tax saving benefits. Consult tax attorney.
§ Corporation owned real estate and practice-No one likes these, as have additional liability issues while practicing and additional accounting issues at sale. Typically must separate corporation into two corporations, one with the practice and one with the real estate. After 1-2 years of separate tax filings, corporation may then do an exchange or possibly dissolved and assets distributed. Consult tax attorney and CPA, as may take years to accrue tax benefits of changes.
§ Partial real estate sales- Typically when an associate buys into the practice. Can do a 1031 exchange on a partial sale. Be careful what real estate entity is formed after the associate buys in (partnership, LLC), as may then create a situation that is harder to unwind (see above) and guarantee the seller a tax bill. Time frame of when original owner is going to sell the rest of the real estate and whether an exchange is likely should help guide plan.
§ Sale of old building and construction of new- Definitely should consider exchange rather than outright sale of old building and taxes due.
§ Practices where real estate too valuable for veterinary practice location- Real estate is typically sold for commercial use and practice acquires another site or leasehold. These practices are not as salable unless original owner moves practice, as is more risk to the buyer if he has to move the practice.
§ Practice real estate sale with original owner holding note- Hard to do an exchange as owner must invest equity equal to equity in sold property. If all he gets is a note, he must come up with that money out of pocket. Lots of notes I have seen have an option to pay off at any time or a balloon in 3-5 years. This guarantees the seller a large tax bill at the time the note is paid off, with no option of exchanging, as the sale was 3 years ago.
§ Practice seller co-sign real estate note with bank- This is a much better option than owner financing, as seller gets funds at closing and can do an exchange. Seller is contractually released from note when note has 80% loan/value ratio, which is typically in 3-5 years, (which is when he would likely be released if he financed with a balloon).
§ Clinic and house on same property- Residence can be split off from clinic property and sold with the $250,000/$500,000 residential capital gain exclusion for single/married people. The rest of the property may then be exchanged.
§ Practice real estate owned by spouse- Spouse must also be the acquirer of the replacement property. Be careful as banks may require other spouse to be on the note if dependent on his/her income, which would void the exchange as the selling party would not be the same as the acquiring parties.
§ Can exchange into multiple properties if helps with diversification or estate planning
§ 1031 exchanges are exempt from California’s 3.33% real estate withholding tax.
§ Can exchange from a single owner to a single owner LLC for liability purposes, or a living trust for estate planning purposes.
Dr. Gary Ackerman is a former practicing veterinarian and multiple clinic owner from Richmond, Virginia. He is now the owner of Atlantic Veterinary Services, specializing in practice sale transitions and IRS Section 1031 real estate exchanges. In this capacity he is a licensed commercial real estate agent for Whittle and Roper Realtors in the Coldwell Banker national Realtor referral network, specializing in 1031 real estate exchange replacement property. He is also a registered representative for the United Securities Alliance securities firm, specializing in 1031 real estate exchanges into private placements in Tenants-in-Common properties and other real estate investments.
Presented July 20, 2003 to the American Veterinary Medical Law Association by Dr. Gary L. Ackerman.