Trading Spaces: 1031 Exchanges

The ins and outs:

As defined by Section 1031 of the Revenue Code, an investor may exchange an asset, such as land or a building and reinvest the proceeds in a similar, or “like-kind,” asset without paying capital gains taxes. As a result, the investor can put every dollar from the sale back to work in the market – generating a significantly higher return.

Many investors who are selling would prefer to buy a replacement property, even if it doesn’t have a great return, than to pay a substantial capital gains tax. That way you are not giving away the principal from your investment.

To simplify a highly complex process, the owner of an investment property, defined as virtually anything that isn’t a primary residence, can defer paying income or capital gains taxes on the profit by “exchanging” the property for a “like-kind” investment at a higher price. The term “like-kind” refers to the nature of he property, not its quality or market value.

The effect of a 1031 exchange is not to eliminate the owner’s taxable gain, but to postpone the taxation by transferring the gain into the replacement property.

Example: For many investors, a 1031 exchange can offer significant financial benefits with relatively little risk. Let’s say that a couple who bought a vacation condominium for $100,000 in 1995 have paid off the mortgage and now want to sell their unit at the market price of $300,000. Under most circumstances, they would face a 15 percent capital gains tax on the $200,000 profit and would have to write a $30,000 check to Uncle Sam.

In addition, the IRS would recapture any depreciation of the property. Even if you didn’t take depreciation on your annual returns, the IRS will still compute the implied depreciation. As a result, the real tax bite is a lot more ugly – usually 20 percent or more.

But, if the owners of that condominium were to purchase another qualifying investment property valued at $300,000 or more, or perhaps two units at $150,000 each, and follow a very specific list of instructions, the capital gains tax could be deferred indefinitely. That way, they could put all of the $200,000 back to work in the real estate market, with an opportunity to leverage their investment and benefit from future appreciation. And, even if the owners were to purchase a less expensive property, there would still be tax benefits from a 1031 exchange.

Once the transaction closes (or transactions close), the clock starts ticking. The investor has to identify one or more “like-kind” investment properties in writing within 45 days of that closing. Then, the investor must select one or more properties from that written list and close the purchase(s) within 180 days of the sale closing(s). The owner must take title to the new property or properties in the same way that title was held on the previous property.

The definition of a “like-kind” investment property is really broad. If the owner is selling a condo, for instance, he doesn’t have to buy another condo. It could be a single-family home or shopping center. The property doesn’t even have to be rented out in order to qualify; the key is that you are purchasing for investment.

It’s also possible for an owner to enter into a 1031 exchange with a “related party”, provided neither party sells the property within two years following the closing.

Find an Expert: You will need an attorney, CPA or qualified intermediary service. Make sure the mechanics of both transactions are handled correctly without triggering an unexpected tax bill. These responsibilities must be assumed by your legal and tax advisors. Fees typically range from $400 to $1,000 or more, depending on the scope of services. And, there are different rules with foreign nationals.

A Real Estate Professional can provide suitable properties for their clients to buy and can help in making sure that the second transaction closes on time. It’s important to understand your own specific desires, short-term and long-term objectives, and your feelings about risk. Are you looking for a long-term hold on vacant land, or maybe you want to be a landlord.

Sometimes a replacement investment is found before even listing the first property. In some cases, you could even close on the second property first, then sell the initial holding in a “reverse 1031 exchange”. While this is a more complicated and expensive process, sometimes you need to close on the second one first due to market conditions. Be aware that this is a viable option.

While 1031 exchanges may be complex – and there are potential pitfalls along the way – they offer clear benefits to many investors. The required 1031 process itself is straightforward and relatively simple. But the devil is in the details. A clear legal process is required, and the documentation can be lengthy. All purchase contracts are assigned to the intermediary, and proceeds from the exchanger’s sale are escrowed in the intermediary’s trust account during the exchange period.

Most Real Estate exchanges involve relinquishment of one to three investment properties. An exchange may not exceed three replacement properties without meeting the criteria of another test – the replacement aggregate fair market value may not exceed 200 percent of the relinquished fair market value.

How a Real Estate Professional can assist you:

1) Enter a sales contract with a buyer for the relinquished property.

2) Recommending a qualified intermediary. The exchange agreement will be between you and the intermediary. The intermediary will normally prepare all documents, make all assignments of property and notifications, hold all funds in trust, provide detailed instructions for closing officers and disburse all funds.

3) Will help you identify the property to be acquired as replacement property within 45 days of the relinquished property’s closing.

4) Will help you replace the property by entering into a contract to buy the replacement property an d close on the new property within 180 days of the closing of the relinquished property. Your deadline for filing your tax return must be extended until the exchange is complete.

Some exchanges can be very complicated. When the order of the transactions is reversed and construction or renovation is required to meet value; the process becomes complicated and even tedious. But, most can be done.  The process itself is straightforward but precise. If every requirement is not met, the exchange may be damaged, allowing the IRS to declare that a sale and a purchase have taken place. Hence, focus on a qualified intermediary who will guide you through the process.

Section 1031 exchanges, while challenging, you will find that they are worth the time and effort.

Source for this article: Florida Realtor May 2006.