Keep More Gains With a Tax-Free Exchange

September 7, 2006

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

Death and taxes might be certain, but that doesn't mean you can't postpone the inevitable. Eating right and getting plenty of exercise can help stave off the former. As for the latter, the Internal Revenue Code (IRC) provides a number of ways to defer the recognition of realized gains. While the rules can be complex, you may find that eliminating or deferring taxes is easier than sticking to that diet and exercise routine. Consider these five strategies to keep the tax collector at bay:

Real estate: Reduce or defer taxable gains

You probably know that when you sell your home, IRC Section 121 allows you to exclude permanently from taxes a big chunk of the gain—$250,000 for singles, $500,000 for couples filing jointly—as long as you (and your spouse, in the case of a joint exclusion) lived there for at least two of the past five years.

But did you know that IRC Section 1031 allows you to defer the entire gain when you exchange certain "like-kind" properties? Both properties must be held either for productive use in a trade or business, or for investment. Beyond that, like-kind is defined pretty broadly. For real estate, it doesn't matter if the properties are developed or not (e.g., you could exchange an apartment building for raw land), as long as the exchange involves property located in the United States.

To make the tax-deferred exchange work, you must identify the replacement property within 45 days of the sale of the old property and complete the exchange within 180 days. And to have a completely tax-deferred exchange, the value of the new property must be equal to or greater than the old property.

Given the complexity, it's a good idea to enlist the help of a specialist in 1031 like-kind exchanges, sometimes referred to as a "Qualified Intermediary," in addition to your real estate broker. Also check with your tax professional to be sure you're following all the rules for reporting, cost-basis adjustment and so on.

Annuities: Lower expenses and more

IRC Section 1035 lets you exchange life insurance contracts or appreciated deferred annuities (either fixed or variable, as long as annuitization hasn't begun) without any current income taxation. And you can even do these "1035 exchanges" between different insurance carriers. Your prime motivation would likely be to lower annual expenses. But there could be other reasons: you're dissatisfied with your sub-account performance; you'd like more investment choices; you're worried about the credit quality of the insurance company; or you'd like more flexibility (e.g., no surrender charges). Before switching, just be sure to review your contracts or annuities for any remaining surrender charges you may be subject to, or existing death benefits or other benefits you may be forgoing.

Stocks: Exercise your options

You can exchange shares of a stock you already own for shares in the same company tax-free, thanks to IRC Section 1036. This provision can come in handy if you have an employee stock option plan at work that allows you to exercise your options via a "stock swap." Not all companies permit this exercise method, so check with your stock option plan administrator.

A stock swap allows you to pay the exercise price with shares of company stock you already own. The main advantage is that you don't need to sell any of your existing stock to raise cash for the exercise price, thus deferring taxation on the swapped shares. An additional benefit can be diversification, since you'll hold fewer shares of your employer's stock post-exercise.

But remember, you'll still owe taxes on any gain resulting from the option exercise itself. You can typically use existing shares to pay the statutory withholding (but no more). However, swapping old stock to pay taxes isn't a tax-free exchange—you'll owe capital gains tax on that portion. Special cost-basis and holding-period rules apply to stock swaps, so talk to your tax professional before exercising.

Exchange funds: Diversify out of big winners

Under IRC Section 721, qualified high-net-worth investors with highly appreciated, concentrated stock positions can diversify without paying taxes by exchanging their stock for shares in a private-placement limited partnership known as an exchange fund. When investors leave, they generally receive pro rata shares of individual stocks, thus further deferring the recognition of gain. Drawbacks can include high fees and lack of liquidity.

Mutual funds: Remove class distinctions

Generally, you can also exchange, tax-free, one share class for another in the same mutual fund. For example, you may have previously purchased Investor Shares of a particular Schwab mutual fund and now have accumulated enough to qualify for the lower-cost Select Shares® class. Making the switch is easy and, when done right, is a non-taxable event.

A word of advice

Keep in mind, sometimes the best course of action is a straightforward sale, where you simply pay your taxes and move on. At other times, however, it pays to be aware of what the law allows. Be sure to get help from a tax professional before entering into any complex transaction that might have serious tax consequences. A Schwab consultant can help.