Section 1031 exchanges: a wealth-building tool

Friday, June 18, 2010 By Dan Scanlon

Nothing in life is really free, but for real estate investors the next best thing is being able to defer paying taxes due on the sale of real estate.

For almost 100 years, the Internal Revenue Code has included a provision called Section 1031 that allows investors to exchange their investment in one asset for another one, while deferring the payment of taxes until the ultimate disposition of the replacement asset. This process can be repeated as many times as the taxpayer wants. In many cases, taxpayers hold replacement property until they die, allowing their heirs to inherit the property without having to pay any capital gains taxes.

There are other reasons for a taxpayer to exchange investment property rather than sell outright:

• The taxpayer can move from one investment directly into another without having to liquidate other interests in order to pay taxes.

• The exchange can provide investment diversification or consolidation.

• The exchange can allow the taxpayer to get out of obsolete property.

• The replacement property can provide greater appreciation or cash flow.

• An exchange can enable a taxpayer to relocate from one area to another.

• The replacement property can eliminate management problems.

• The exchange can be part of retirement or estate planning.Basic rules

Let’s first be clear about the type of real estate that qualifies for this deferral, and the type of taxes that apply.

Section 1031 allows taxpayers to exchange property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of “like kind.” The taxes that are sought to be deferred are federal capital gains (currently 15 percent) and cost recovery recapture (currently 25 percent), and any applicable state taxes, such as the new Hampshire business profits tax, which is 8.5 percent of the capital gain.

The definition of “like kind” is far more expansive than many people think. with real estate, the options are virtually unlimited. a taxpayer owning a duplex rental property can acquire a retail strip center, raw land can be exchanged for an office building, one property can be exchanged for many, an industrial building can be exchanged for a Tenant in Common (TIC) interest, a multifamily property can be exchanged for a single-tenant asset, etc.

The property must be in the United States, which includes the 50 states and all U.S. possessions. The benefits of Section 1031 are not available to dealers of real estate, such as a developer who creates a subdivision for the purpose of selling off lots to builders, and stocks, bonds, notes, partnership interests and beneficial interests in trusts do not qualify as “like kind.”

The basic rules for obtaining tax deferral are that the taxpayer must acquire replacement property (the new property) having equal or greater debt and equity as the relinquished property (the old property), all of the proceeds from the sale of the old property must be reinvested into the new property acquisition and the taxpayer must receive nothing in the exchange except like-kind property.

If the taxpayer acquires any debt relief that is not offset by a contribution to the new property, or cash, those items are considered “boot,” triggering a taxable event.

For many years, there was an assumption that the exchange of properties was simultaneous. In 1979, the Starker case allowed exchanges to be delayed, so that the taxpayer could sell the old property, have the sales proceeds held in escrow, and then acquire the new property later on. In 1984, the Starker provisions were codified, and time frames were established for the process. Today, delayed exchanges are by far the most common type.Strict time frame

The Internal Revenue Code also sets forth so-called “safe harbor” rules that, if followed, will ensure that the delayed transaction qualifies for tax-deferral. These rules call for the use of a qualified intermediary (QI) to hold the funds, use of a qualified trust, use of a security arrangement to secure the exchange proceeds and the payment of interest on the exchange proceeds.

The code does not specifically define the term “qualified intermediary,” but rather defines disqualified parties, including some family members as well as the taxpayer’s lawyer, accountant, employee or broker.

The time limits for completing the delayed exchange are hard and fast. The taxpayer has 45 days from the date of the sale of the old property to identify the replacement property. Failure to do so is the biggest reason 1031 exchanges aren’t completed, especially when there’s a lack of available replacement properties in the market, as is the case today.

The taxpayer also has 180 days from the date of the sale of the old property to complete the exchange by closing on the replacement property. If the taxpayer’s federal tax return for the year in which the old property was sold is due before the 180 days, the replacement property must be acquired by that date, unless the taxpayer files for an extension.

There are additional rules relating to the identification of replacement properties, but the key steps for identifying replacement property is that the identification must be in writing, it must clearly identify the property, it must be signed and dated by the taxpayer, it must be received or postmarked by the midnight of the 45th day, and it must be delivered to the QI or a party related to the exchange who is not a disqualified person.

In some cases, the taxpayer may want or need to acquire or even construct the replacement property before selling the old property. a “reverse exchange” is permissible under additional “safe harbor” rules that lay out time frames similar to the 45- and 180-day rules for delayed exchanges.

There are several other rules and nuances involved in Section 1031 transactions, and this column is not intended to offer legal or tax advice. But Section 1031 is clearly a tool that allows any taxpayer to continually “trade up” to better quality investments while being able to defer capital gains taxes.

Dan Scanlon, JD, CCIM, is an adviser with Grubb & Ellis|Coldstream Real Estate Advisors Inc., Bedford. he can be reached at 603-206-9605 or dscanlon@coldstreamre.com.

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