PRESENT ISSUES IN
FORESTRY AND TIMBER LAW

Tax Free Exchanges

By: David J. Colligan, Attorney At Law

While attending the fall meeting of the New York Forest Owners' Association, I was asked to write an article about those hardworking commercial property owners who have, through the sweat of their brows, created a "sweat equity" in their commercial real estate and now are faced with the difficult prospect of how to dispose of it without paying an enormous tax burden. Many of these people have been woken up in the middle of the night by tenants who have minor complaints, have been climbing on icy roofs in the middle of winter to break up ice dams, and have otherwise spent a lifetime fixing, patching, repairing, and creating equity in commercial real estate.

Now, as they look back at an asset that has been greatly depreciated, they are wondering how they can continue their real estate investment without the high intensity maintenance and management that goes into commercial and residential investments. Most commercial real estate owners would look kindly at a nice, quiet forestry investment in productive timberland. Most timber owners have not experienced trees phoning them in the middle of the night or trees failing to send the rent in on a timely basis. In fact, just the opposite happens, as trees provide income without complaints.

The good news is that the Internal Revenue Code § 1031 permits a tax free exchange of "like kind property." The catch is that the property must be held for investment purposes and must be of a similar nature to what you are transferring. While all like kind and forced conversion transactions (§ 1041 of the IRC) is beyond the scope of this article, a discussion of what constitutes like kind property for a tax free swap of commercial property into forest property will be the focus of this article.

The first thing to remember is that an apartment building full of residential tenants is like kind with a forested tract populated by trees that may or may not have value for timber purposes. This is because the Internal Revenue Service has deemed all real estate to be of a like kind. Trees, while standing, are considered real property and therefore would be no different than having a building located on a commercial property. This designation of like kind property has been utilized by many successful real estate entrepreneurs to transfer appreciated wealth from one investment into another. Think of the buying power if you had 25% more cash available to purchase land! At a federal rate of 20% and a state rate of approximately 7%, you can buy 27% more land with tax free exchanges than you could otherwise afford.

While the tax free exchange concept appears very generous, the IRS has made the rules of compliance very exacting and strictly enforced. Typically, anyone who wants to participate in a tax free exchange would identify a property they wish to sell, find out the approximate value of that property, and then proceed to identify properties they wish to purchase or "swap into" so that the transaction can proceed within the time frames allowed. As a general rule, "swapping down" has too many negative tax implications to be useful. Therefore, transferring property and "swapping up" to a more expensive property is the usual transaction seen in tax free exchanges. Once the properties have been identified, the exchanger must decide whether they want to proceed with a two-sided or a three-sided transaction.

A two-sided transaction would usually involve the investor finding a buyer for the commercial property, and then going out and finding the replacement property (whether tree farm or other commercial property) and asking the seller of the replacement property to exchange deeds to the two properties, together with whatever other consideration is necessary to close the more expensive transaction. Thereafter, the seller of the replacement property would sell the investor's original property, taking whatever gain on the entire transaction as a taxable realization of income. Meanwhile, the original investor now owns the replacement property and has not realized income for income tax purposes!

A three-sided transaction is similar to a two-sided transaction, however, a third-party "facilitator" is used to hold property essentially in trust until replacement property has been located and acquired. The rules on locating replacement property require that the replacement property be identified within 45 days and be closed within 180 days of the sale to the facilitator. Furthermore, facilitators require a fee for their services which usually starts at 10%, but is negotiable. If the original investor cannot identify potential replacement property within 45 days and close on one of those replacement properties within 180 days, the tax free exchange is treated as a taxable exchange and income tax returns must be filed, and taxes paid.

As with all tax-advantaged transactions, there are certain negatives that must be evaluated prior to entering into the transaction. A major negative of a tax free exchange is that the tax basis does not get "stepped up" to the new purchase price, but remains the historic tax basis of the original property, plus whatever additional consideration is paid for the replacement property. Since some portion of every timber sale is a return of tax basis and therefore non-taxable, future timber sales may not be deductible at the same level they would have been if an outright purchase was made. Another negative is that the transaction must be properly reported to the IRS on a form with the income tax return for the year in which the transaction occurred. If the timber tax form is not filed with the current year tax return, the entire transaction's tax free treatment would be in jeopardy. Furthermore, the tax free exchange rules may not be that beneficial if a large amount of "boot" is transferred as part of the exchange, as "boot" is considered taxable even in a tax free exchange. "Boot" is usually mortgages that are paid off as part of the transaction and other indirect or direct consideration received by the transferring investor which is not reinvested in the replacement property. Therefore, anytime there is a mortgage on the property to be exchanged, careful review of the transaction must be done by a competent tax expert to explain exactly what the tax benefits are prior to entering into the transaction. Even though there are some negative aspects to using a tax free exchange, the benefits almost always outweigh the negatives in a properly structured transaction.

Much like brain surgery, it is not recommended that you do this alone, but only with the help of a competent professional who specializes in these transactions.

David J. Colligan can be reached at (716) 852-3540 and he was assisted in this article by Roy H. Cunningham, an associate attorney in his office who received his L.L.M. (Masters in Taxation) from the University of Denver School of Law).

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Report Added: September 15, 1998