By Jodi Summers

An Ocean Park senior citizen was startled when a real estate agent brought an unsolicited offer for the corner storefronts he’d owned for decades. Now he was torn. He didn’t really want to sell because he enjoyed the monthly income, but if he sold, it would free him from responsibility. But then there was the issue of capital gains. He talked to his accountant about it. His accountant suggested a 1031 exchange.

“It used to be that on a scale of one to 10 in importance in estate plans, real estate was about a five. Now it’s at eight,” notes attorney Yaron Hassid. “Real estate values have been going up so rapidly that it’s now seen as a safe investment. Five years ago, the stock market was perceived to be safe with 10 percent returns.”

If you own (or want to own) an investment property, a 1031 exchange can become the basis for increasing your real estate wealth by making periodic trades up for larger properties.

Suppose you purchased a triplex north of Wilshire during the real estate dip of in the early ’90s. These days, the property is valued more than $1 million, but thanks to rent control, you’re bringing in about $40,000 per year in revenues. As authorized by Internal Revenue Code 1031, you can exchange that property for something more desirable — say a three-unit shopping center with a billboard bringing in $168,000 per year in revenues.

Internal Revenue Code 1031 has allowed tax-deferred exchanges of investment and business properties since 1921. To qualify for tax-deferral when selling a property, an individual is required to trade an income-generating property used for investment or business for a “like kind” property (or properties) equal to or greater than the equity of the one they are selling.

A qualified tax-deferred trade up is viewed, tax wise, as one continuous investment. So, if you exchange your property, you avoid paying taxes.

There is no limit to the number of times or the frequency you can use IRC 1031 to escalate your real estate wealth without paying capital gains taxes. Buy a fixer on Tuesday, sell it Thursday, by a bigger fixer next Tuesday. As long as it’s an investment property and not a primary residence, you’re good to go.

Noted real estate columnist Bob Bruss cites at least 10 reasons for exchanging real estate:

1. Pyramid your investment equity without tax erosion of your sale profit.

2. Minimize or eliminate the need for new mortgage financing on the property acquired.

3. Get rid of an undesirable property that is difficult to sell and acquire a better property.

4. Increase the investor’s depreciable basis.

5. Acquire a property that better meets the investor’s needs, such as more cash flow or easier management.

6. Partially defer profit tax by trading down to a smaller property that suits the owner’s needs.

7. Avoidance of depreciation recapture tax when selling a property.

8. Refinance either before or after the trade to take out tax-free cash.

9. Accept an unexpected purchase offer to sell a currently owned property without owing tax.

10. Completely avoid capital gains tax by still owning the last property in a chain of tax-deferred trades when you die.

Commonly known as a Starker Exchange, Internal Revenue Code 1031(a)(3) allows an investor to sell property and have the sales proceeds held by a qualified third party while they purchase their replacement property or properties. IRS time limits give the investor 45 days to choose the next properties, and 180 to complete the tax-deferred transaction.

“If you don’t have everything lined up, you can miss those deadlines,” says Margaret McDonnell, president of 1031 Corp. “It sounds like a long time, especially the fact that you have 180 days to close on a new place, but it’s really very short.”

Another option is a reverse exchange. As of late 2000, IRS Revenue Procedure 2000-37 has allowed the replacement property to be acquired by the third-party accommodator and held until the old property is sold.

Death is the ultimate tax shelter. Any capital gains tax you would have owed if you sold your real property (and other assets) is forgiven upon your death, and your property heirs receive a new “stepped-up tax basis.”

For details, consult your accountant.

(Jodi Summers is director of the investment division at Boardwalk Realty Santa Monica. For your real estate needs, e-mail her at jodis@boardwalkrealty.com, or call 310-309-4219.)