1031 Tax Free Exchanges Explained
What You Need To KNOW
The payment of income or capital gain tax on the sale of property can be voluntary thanks to Section 1031 of the Internal Revenue Code which is one of the most underutilized sections of the tax code. Perhaps the problem lies with calling the procedure an exchange as this creates a lot of misunderstanding and would be better utilized if this was re-labeled as a 1031 rollover because that is precisely what happens. The gain is rolled over to a new property. There are an unlimited number of times an individual can successfully rollover gain and postpone tax. The ultimate goal is to make this tax disappear by one of two ways:
- Sellers may successfully rollover any gain and ultimately move into one of their investment properties and declare it to be their primary residence. Provided they are married and have held the property for five years, reside in the property for a minimum of two years, they can exempt $500,000.00 in taxes upon the ultimate sale.
- Capital gains taxes are eliminated upon the death of the property owner. Heirs receive a step up in basis on the date of death (meaning: when your heirs sell they will only owe tax on the gain above the value on the date they inherited the real estate).
There are actually only seven simple points to master to have a clear understanding of the rules pertaining to 1031 exchanges. With the limited exception of subtle nuances, any realtor can share with customers all they need to know about 1031 exchanges. While the technical terms used to describe properties in an exchange (rollover) are “relinquished properties” and “replacement properties” they simply mean “old property (sold)” and “new property (purchased)”.
1st REQUIREMENT: LIKE-KIND PROPERTY
The first requirement for a 1031 exchange (rollover) is that the old property to be sold and the new property to be bought are like kind. This is frequently one of the most misunderstood concepts involving 1031 exchanges. Like-kind relates to the use of properties. As a result, the old property as well as the new property, must be held for investment or utilized in a trade or business. Vacant land will always qualify for 1031 treatment whether it is leased or not. Furthermore, commercial property may be used to purchase a rental home or a lot may be sold to buy a condo.
Section 1031 expressly states that property strictly held for resale does not qualify for an exchange. This means that investors and developers who strictly “flip” properties do not qualify for exchange treatment because their intent is resale rather than holding for an investment. There are numerous court cases seeking to determine the dividing line between held for resale and investment. Intent appears to be the single most significant factor in determining the difference.
Additional factors to consider:
- Primary residences can never be utilized in an exchange.
- A taxpayer may sell a property to a related party which requires a two-year holding period, a taxpayer may never purchase the replacement (new) property from a related party.
- Properties to an exchange must be within the United States border. Properties located outside the United States may not be involved in the exchange.
Example #1: Thomas owns a food service business, but only leases the building which houses his business. Thomas wants to retire, sell his business and buy a beachfront condominium with the proceeds. Can he do a 1031 exchange?
No. Because Thomas does not own the real estate he cannot do a 1031 by selling his business (which is not real estate) and buy real estate to replace it.
Example #2: Anthony, an attorney, owns an office building that he leases to other attorneys. Can he exchange the building for a vacant waterfront lot on which to build a home?
Yes. Investment property can always be exchanged for vacant land held for investment purposes.
2ND REQUIREMENT: 45 DAY IDENTIFICATION PERIOD
The Internal Revenue Code stipulates that the new property be identified within 45 days of the closing of the sale of the old property.
The 45 days commence the day after closing and are calendar days. If the 45th day falls on a holiday, that day remains the deadline for the identification of the new properties. No extensions are allowed under any circumstances. If you have not entered into a contract by midnight of the 45th a list of properties must be furnished and must be specific. It must show the property address, the legal description or other means of specific identification.
Up to three potential new properties can be identified without regard to cost. If you wish to identify more than three potential replacements, the IRS limits the total value of all the properties that you are identifying to be less than double the value of the property that you sold. This is known as the 200% rule. Accordingly, more than three properties may be identified as replacements however, if the taxpayer exceeds the 200% limit the whole exchange may be disallowed. As a result, the logical rule for investors is to keep the list to three or fewer properties. It is the responsibility of the qualified intermediary to accept the list on behalf of the IRS and document the date it was received; however, no formal filing is required to be made with the IRS.
Example #1: Raymond sells his old property for $500,000.00 on March 15th. He may identify up to three new properties of any value within forty-five days of closing.
Example #2: Raymond wants to identify four new replacement lots each selling for $300,000.00. Will this work?
No. This is not acceptable as the four properties total $1,200,000.00 and therefore exceed 200% of the property being sold.
3RD REQUIREMENT: THE 180 DAY PURCHASE PERIOD
This rule is simple and straight forward. Section 1031 requires that the purchase and closing of one or more of the new properties occur by the 180th day of the closing of the old property. The property being purchased must be one or more of the properties listed on the 45 day identification list. A new property may not be introduced after 45 days. These time frames run concurrently, therefore when the 45 days are up the taxpayer only has 135 days remaining to close. Again there are no extensions due to title defects or otherwise. Closed means title is required to pass before the 180th day.
Example #1: Mary identified a condominium under construction within 45 days of her sale. The developer now informs Mary it will not be completed and ready to close with title passing within the 180 day period. Mary, through no fault of her own is prohibited to close within 180 days, accordingly, her exchange will fail.
4TH REQUIREMENT: USE OF A QUALIFIED INTERMEDIARY
Sellers cannot touch the money in between the sale of their old property and the purchase of their new property. By law the taxpayer must use an independent third party commonly known as an exchange partner and/or intermediary to handle the change. The party who serves in this role cannot be someone with whom the taxpayer has had a family relationship or alternatively a business relationship during the preceding two years. The function of the exchange partner/intermediary is to prepare the documents required by the IRS at the time of the sale of the old property and at the time of the purchase of the new property. The intermediary must hold the proceeds of the sale in a separate account until the purchase of the new property is completed. The taxpayer is entitled to the interest of these funds and must treat the interest as ordinary income during the period of escrow.
If 1031 documents are prepared incorrectly, the IRS will disallow the exchange. No state or the federal government, regulates qualified intermediaries. The majority of companies performing this function are not bonded as there are no licensing requirements. (Be Careful)
Example #1: Arthur copies 1031 forms he received and sets up a special account at his bank for the sale proceeds to go into following closing. He never touches the funds and had his bank wire all of the proceeds to the title company for his new purchase property. Will this suffice?
No. By failing to have a qualified intermediary, Arthur exercised dominion and control over the funds and therefore the exchange will be disqualified.
5TH REQUIREMENT: TITLE MUST BE MIRROR IMAGE
Section 1031 requires that the taxpayer listed on the old property be the same taxpayer listed on the new property. If you and your wife are married and sell the old property than you and your wife must also be on the title to the new property. If a trust or corporation is in title to the old property that same trust or corporation must be on title to the new property.
If only the husband is on the old property, but his wife is required to be on title to the new property to help qualify for the loan, one solution to avoid this problem prior to the sale would be for the husband to Quit Claim his interest to himself and his wife. Similarly, if shareholders of a corporation or partners in a partnership or members of a LLC are desirous of selling their respective corporate interest, this is prohibited. What qualifies for 1031 treatment is real estate and not partnership interests. To accomplish this objective the entity must be liquidated and deeds must be issued to provide the respective partners with a “tenants in common interest” in lieu of a partnership or related interest.
Example #1: Mark owns a warehouse building in his own name but wants to buy a condominium in the name of a new limited liability company he wants to set up. Can he do this?
No. The new property must be acquired in his own name to successfully complete the exchange.
Example #2: Jimmy is married to MaryEllen and owned a condominium prior to his marriage that is titled in his sole name. Can he take title to the new lot purchase in both his name and Betty’s name?
No. Jimmy must first complete his exchange in his own name. Afterwards he may Quit Claim his interest to himself and MaryEllen as husband and wife after the exchange is complete.
6TH REQUIREMENT: REINVEST EQUAL OR GREATER AMOUNT
In order to defer 100% of the tax on the gain of the sale of old property, the new property must be of equal or greater value. There are actually two requirements within this rule. First, the new property must be of greater or equal value of the one which is sold. Secondly, all of the cash profits must be reinvested. You may however, deduct closing expenses and commissions from the sale of the property being sold. If the property is being sold for $1,900,000.00 and the actual net amount after closing expenses is $1,832,000.00 all that is required to be spent for the replacement property is a total of $1,832,000.00. Closing expenses associated with the purchase may be added into the purchase, as well as capital improvements completed within 180 days together with furnishings. In fact, a taxpayer may make an unlimited number of capital improvements as well as spend up to 15% of the acquisition cost on personal property.
A party who elects to do an exchange and take cash out may do so, however, any cash received will be taxed at the corresponding rate of ordinary income if held for less than one year or at the current capital gains tax rate if held for more than one year.
Example #1: Mike owns a property he paid $1,350,000.00 for and is now selling for $1,850,000.00. He has a $950,000.00 mortgage against the property and wants to buy a smaller condo for $900,000.00 with the cash. Does this qualify for tax deferral treatment?
No. Steve is buying down from $1.850,000.00 to $900,000.00. Accordingly, tax is owed on the amount of the buy down, which is $950,000.00.
Example #2: Mike decides to buy a replacement property for $2,500,000.00 and obtains a $2,000,000.00 loan using $500,000.00 of the $900,000.00 cash that the qualified intermediary is holding. Is his exchange fully deferred?
No. Despite buying up, Mike did not use all of the cash and will be taxed on $400,000.00.
7TH REQUIREMENT: REVERSE EXCHANGES – TITLE TO BOTH PROPERTIES CANNOT BE IN SAME NAME AT SAME TIME
All previous requirements are applicable…..and then some. A reverse may come in handy when a seller does not yet have a buyer for the property that he wishes to sell and is afraid of losing the new property he wishes to acquire. In the fall of 2000, the IRS issued a revenue procedure that established the concept of an exchange accommodation title holder (which is actually another name for a qualified intermediary). Simply put, a taxpayer may not have both the old as well as the new property titled in their name at the same time and still qualify for a reverse exchange.
The IRS has set up guidelines which allow the taxpayer to acquire the new property before the old property is sold provided title is taken in the name of the exchange accommodation title holder (typically a limited liability company which is created). Under this scenario an entity, other than the taxpayer, will hold legal title in what is commonly referred to as a qualified parking arrangement until such time as the old property is sold. The old property must be sold and closed within 180 days of first acquiring title to the new property. As soon as the old property is sold the proceeds are then directed to the exchange accommodation title holder at which time the property may be deeded out of the parking arrangement directly to the taxpayer. This procedure is actually quite simple provided cash is utilized to fund the new purchase. The vast majority of lenders simply will not lend funds to a third party entity and only to the taxpayer.
If financing the new property cannot be avoided then title must be conveyed out of the taxpayers name to a straw person prior to acquiring the new property. This will avoid having title to the old property and title to the new property being in the taxpayer’s name at the same time which is a prohibited transaction. Although this is an acceptable procedure to the IRS the conveyance to the straw person must be reported as an arm’s length transaction the straw person will then convey title to the ultimate purchase. This is an expensive proposition in some states from a tax perspective. Consult a qualified 1031 attorney in your state.
In conclusion, there are countless scenarios involving 1031 exchanges with each and every one being unique with its own set of facts and circumstances. If you understand the seven technical requirements set forth above, you clearly understand 95% of all aspects of Section 1031 of the Internal Revenue Code. If you have questions, or have facts or circumstances which you are uncertain of, I would greatly encourage you to consult a CPA or an attorney who has experience and is knowledgeable with 1031 tax deferred exchanges.
Tomorrow – Delaware Statutory Trust Securitized 1031’s (Getting Rid of the Tenants, Toilets & Trash)!
Next Week - How to Turn Your Primary Residence Into a 1031-able Property