SECTION §1031 TAX-DEFERRED EXCHANGE
The IRS Section §1031 Tax-Deferred Exchange is an established method of 1) selling one’s investment property and then 2) proceeding with an acquisition of another investment property within a specified time frame. And as long as some basic Internal Revenue Code timetables and rules are followed, these transactions together will qualify as a “Section 1031 Exchange.”
The result? Recognition of capital gains on the sale of the “sold property” will be deferred. And 100% of the tax-deferred sales proceeds will, therefore, be available to invest in the new property, thus preserving capital and allowing a full impact of investing the entire net proceeds into purchasing an even larger and more productive property than would have been possible if the sales proceeds of the “sold” or “relinquished” property had been reduced by capital gains taxes.
In an exchange, the mechanics, logistics, and overall process of selling a property and then buying another property are essentially identical to any standardized sale and buying situation. But a "1031 exchange" is unique because the entire transaction is therefore treated as an exchange and not just treated as a simple sale. It is this difference between "exchanging" and not simply buying and selling which, in the end, allows the taxpayer to qualify for a deferred gain treatment. So, expressed simply, the IRS views sales as taxable and 1031 Exchanges as tax-deferred!
1031 Rules and “Like-Kind” Property
The 1031 Exchange allows real estate investors to “exchange” property held for (1) the productive use of business or trade or (2) for investment purposes, into another investment property or properties while deferring the recognition of capital gains.
To qualify for a Tax Deferred Exchange, the “Exchangor“ must exchange the original investment property for a "like-kind" replacement property or properties.
And the question arises: “What is “like-kind?” When the tax code talks about "like-kind" property, here is the meaning: An investor can trade ANY type of investment property or property held for trade or business for any other type of investment property or property held for trade or business.
“Like-kind” properties, therefore, include apartment buildings, shopping centers, single-tenant retail, single-family home investment rentals, office or industrial buildings, medical office buildings, marinas, single-family rental homes or condominiums, warehouses, office buildings, industrial parks, agricultural land, raw or unimproved land, leasehold interests, 30-year ground leases, undivided fractional interests, Tenant In Common (TIC) interests, mineral rights, oil fields, air rights, and development rights.
Properties not qualifying as “like-kind” include personal residences, Real Estate Investment Trust (REIT) shares, partnership interests, or any properties located outside of the United States.
This means that an investor can complete a qualifying 1031 exchange by trading an apartment building for a commercial building, or an office building for a working farm, or a storage facility for a retail shopping center, etc.
Investors Currently In Partnerships
Some of our clients are or have been investors in real estate investment partnerships. Partnership interests do not qualify for 1031 tax-deferred exchange treatment as “like-kind” property. Tenant-In-Common interests do qualify. Therefore, we advise our clients anticipating sale of their partnership investment to work with the partnership management and legal and tax counsel to convert the partnership legal structure into a “tenant-in-common” legal entity. This way, upon sale of the investment, individual investors will be able to exchange their separate tenant-in-common interests into individual triple net leased investments (or other types of property) via the mechanism of the 1031 Tax Deferred Exchange.
A personal residence is not considered “like-kind” per Section 1031, however, if the personal residence is first converted to rental property it would then be considered “like-kind” property. Tax advisors typically suggest that the conversion to rental property be done in a separate tax year from the actual sale and exchange.
Types of 1031 Exchanges
A. Delayed Exchange
(THE MOST COMMON EXCHANGE) Because of the inherent problems associated with trying to accomplish simultaneous closings (described in “B” Below) and because of the dangers of violating the rules of Internal Revenue Code Section 1031, most real estate investors use the Delayed Exchange (also known as "Starker Exchange") as the method of choice for completing tax-deferred exchanges. (Starker is the name of a landmark Oregon judicial decision. The Delayed Exchange was later formally enacted into federal tax law in 1984.)
Rules for Delayed Exchange
So because the 1031 exchange represents an IRS-recognized approach to the deferral of capital gain taxes, it is crucial to understand the rules and timetables specified by the IRS over the years under the Section 1031 statute.
1. The exchangor has a total of 45 days from the closing of the property that is being sold or disposed of to identify up to three potential replacement properties.
2. Or, the exchangor can identify any number of properties, so long as their combined fair market value does not exceed 200% of the value of the property being sold or disposed of.
3. The 95% exception rule states: neither of the first two rules apply if 95% of the value of all of the properties identified are actually acquired.
4. The exchangor has a total of 180 days from the close of the property that was sold (relinquished) to close on the replacement property. Remember that the rule is not six months, but 180 days.
B. Simultaneous Exchange
The relinquished property and the property to be acquired have escrows that are closed simultaneously. For practical purposes, the logistics of accomplishing a simultaneous closing are quite difficult and this type of exchange is rare. Anyone who has been through an escrow closing on a commercial property is aware of this. Because of the difficulty of predicting with certainty exactly when a transaction will close, the “Starker” Delayed Exchange (see “A” above) has become the preferred exchange method of real estate investors.
C. Reverse Exchange
The Internal Revenue Service has recently issued Revenue Procedure 2000-37, which allows an Exchangor to complete a Reverse Exchange. A Reverse Exchange allows the Exchangor to acquire property before the Exchangor has sold the property that he would like to relinquish in the Exchange. This gives the Exchangor the possibility of making sure that the up-leg property definitely fits his requirements before selling his old property.
D. The “No Equity” Exchange
What if you are in the unique situation where "zero equity" is left or available in your investment property? This can happen during times of economic recession and in certain real estate markets in certain regions of the country. The property's market value may have dropped to a level below the outstanding debt on the property, which in turn eliminates any available equity.
If a straight sale takes place, there are still depreciation recapture and capital gain taxes to be concerned about. The solution: arrange and complete a 1031 exchange even on property with no equity. This allows you to defer the payment of your depreciation recapture and capital gain taxes into replacement property even though you have no equity.
The “Qualified Exchange Intermediary” (“QI”)
When putting together a delayed exchange, it is critical that a competent “Qualified Exchange Intermediary” (“QI”) be used. The Exchange Intermediary will hold the proceeds of the relinquished property in trust for the exchanger and upon the instruction of the exchanger, will acquire one or more of the named properties and assist in the closing of the replacement property.
The use of a Qualified Intermediary significantly reduces the stress of the transaction by assuring the proper execution of required documentation. Qualified Intermediaries provide a large array of options so that investors have access to the full power of exchanges.
Some Functions Of The Qualified Intermediary:
-Confers with each Exchanger's attorney and/or tax advisor and forwards legal documentation, as requested, so that the IRC §1031 rules and regulations are thoroughly understood
-Prepares the necessary documentation - Exchange Agreement, Assignment(s), Notice of Assignment(s), Qualified Exchange Account Form, Security of Funds Instruments and Instructions to each Closer/Escrow Officer - and oversees each closing to assist in proper §1031 procedures
-Throughout the proper exchange documentation, consummates the sale of the relinquished property and the purchase of the replacement property
-Holds and protects the exchange proceeds on behalf of the Exchanger until funds are needed to purchase the replacement property
-Provides guidance, information and critical timelines through-out the entire exchange
Many investors are surprised to discover that the Qualified Intermediary industry is not nationally regulated. However, there was consumer protection legislation passed in 2008 in California which improved the standards of the QI industry through required disclosures, segregation of exchange funds, required bonding, and prohibition of certain actions. In all cases, the careful selection of the Qualified Intermediary is essential to ensure the highest levels of expertise and security of funds.
We prefer to use an intermediary who segregates the funds of each exchange in a separate account with a bank, and who offers a Letter of Credit backed up by the assets of a financial institution to guarantee the safety of the funds held during the course of the exchange. Here is a more detailed discussion of the role of the Qualified Intermediary.
Public Policy Reasons For 1031 Exchanges
There are strong “public policy” reasons for exchanges. America’s commercial and multifamily residential investment real estate industry could become stagnant without the availability of exchanges. 1031 Exchanges encourage upgrading and improvement of real estate investments throughout the society. Exchanges encourage more frequent transactions as appreciated real estate is exchanged for higher valued real estate. Neighborhoods get upgraded. And as the real estate assets are upgraded and bought and sold, direct and indirect jobs are created. Higher quality working spaces and living spaces result. Increased current rental income from the improved spaces, result. Some of this income gets taxable at ordinary income rates. Higher property taxes result and government services and roads and schools are better funded.
Alternatively, if gains were to be recognized immediately at sale without allowing an exchange option, owners might not have the incentive to upgrade and would not sell their properties as frequently because of the burden of transaction costs including currently due taxes. Some investors might squeeze their investment properties for every dollar without improving them in a “race to the bottom.” Again, in conclusion, the Country’s commercial and multifamily residential investment real estate industry could become stagnant without the availability of exchanges.
We have also included a Glossary Of 1031 Exchange Terms on this website.
Derek Morris, MBA
The Derek Morris Company
Santa Barbara, California
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COPYRIGHT (C) 2021 DEREK MORRIS
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COPYRIGHT (C) 2021 DEREK MORRIS
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