Exchanges Growing Popular Among Hotel Sellers, Buyers

Reprinted from Hotel & Motel Management Magazine

Our property-owning clients are now computing potential income-tax levels on their real-estate sales - and they're blanching.

Today, there are fewer incentives to sell outright. Because of the 40 percent increase in the rate charged on resale profit and the market resistance to "retail pricing" of hotels, many owners will utilize exchanges rather than sales in order to maximize their equity.

There is no immediate transaction tax on the income of those who exchange. The new tax law leaves untouched all of the rules relative to exchanging, keeping this tax-deferral option as wide open as it's been for many years.

Seller, Buyers Benefit

The pure economics of higher taxes on more moderate gains will surely induce sellers to require buyers to participate in more exchange transactions. Buyers will agree because they'll receive the benefit of better terms. After all, the seller, looking at no immediate hefty tax on his profit, will tend to pass along a portion of this tax deferral to the buyer - thus lowering the buyer's property-cost level.

Many people believe that an exchange requires two parties to accept each other's assets in a straight trade. Not true. For example, I can agree to give you my property by asking you to buy a third property, then exchanging that property for mine at a closing. Instead of directly giving me your cash and taking my property, I'm asking you to give that equity to the owner of a property I want. He contracts to sell it to you, and you exchange it for mine.

It seems complicated, but it's really quite simple.

Trade-Up Opportunity

Deferring taxes through a like-kind exchange gives owners an opportunity to trade up for more valuable property. In a like-kind exchange, the original property must be one that is held either for use in business or for investment purposes. Therefore, lodging properties absolutely qualify for those who wish to benefit from a current tax-free rollover of gains from the sale of one property that can be used to acquire another.

To demonstrate the benefits of an exchange, let's say you own a hotel that originally cost $2 million, has since depreciated to a book-value of $1, and is now worth $3 million. If you sold the property, you'd have to pay anywhere from 21 percent to 40 percent tax on the difference between the depreciated book value and the sales price.

But if you arrange an exchange, you'll have $400,000 to $800,000 in additional equity purchasing-power by virtue of the tax deferral. Normal leveraging means you can buy real estate worth $3 million to $6 million more today by sheltering the gain from current taxation.

The key to understanding the tax benefits of a like-kind exchange lies in the tax concept of "basis." Your basis in an asset is your cost, with certain adjustments. Basis increases by the cost of permanent improvements that you make to your property and is reduced by depreciation deductions that you claim over the years.

The Deferral Continues

When you eventually sell the replacement property, you'll then pay tax on the entire profit, including profit made on the original sale. But the tax deferral can go on until you choose to stop trading properties. In effect, a tax deferral (though it must be paid eventually) is like an interest-free loan from the IRS.

There are, of course, rules to follow in order to qualify for exchange treatment - they appear in Section 1031 of the Federal Tax Code. Have your accountant and lawyer outline them for you.

If you're interested in additional information regarding exchanges, I'd be happy to hear from you.

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