Real estate investors have long utilized the 1031 Tax Deferred Exchange as a means to build wealth with pre-tax dollars. This section of the Internal Revenue Code allows investors to dispose of an investment property and acquire another investment property without paying tax on the realized gain – so long as all of the rules are followed. The primary advantage of an exchange is the ability to use the entire equity to acquire a single or a number of replacement properties. Investors have the freedom to move their equity into properties that better fit their objectives. My clients have exchanged into more lucrative properties, properties in more tax favorable states and properties that are less management intensive – all without having to pay tax upon the disposition of the investment they sold.
Here are the top ten issues to address when structuring your exchange:
1. Use a Qualified Intermediary
In a non-simultaneous exchange, an intermediary is necessary. The Treasury Regulations enumerate who can act as your intermediary. A person is disqualified from acting as an intermediary, for instance, when the intermediary has acted as the investor’s attorney, accountant, agent, investment banker or bears specified business relationship (e.g. company partially owned by the investor) or familial relationship. Professional intermediaries exist, but are largely unregulated. Due diligence is important here.
2. Count the Days
An investor is allowed 45 days to identify his replacement property and 180 days to acquire his replacement property. These time periods are not subject to extension. The first audit I defended as a tax attorney included the examination of a tax deferred exchange. During the exam, the examiner pulled out a calendar and counted the days to ensure the identification period and acquisition period were both satisfied. Retain documentation to substantiate the timing of the exchange.
3. Be Mindful of Mortgaging Property
One of the fundamental rules of the tax deferred exchange is that any money received in the exchange is treated as “boot” and taxed. In order to circumvent this rule, some investors have refinanced their relinquished property prior to their exchange to convert their equity to tax-free cash. The IRS has ruled that, in many cases, cash proceeds of a refinancing immediately prior to closing of an exchange transaction constitute taxable income to the taxpayer. To reduce this risk, many investors will increase the debt on their relinquished property before listing the property for sale. Refinancing of a replacement property after the exchange is less risky, but there remains a degree of risk under some circumstances.
4. Related Party Transactions
Special rules apply to exchanges involving a related party. Examples of related parties are:
- family members;
- grantor and fiduciary of the same trust;
- a corporation and partnership if there is specified common ownership;
- a host of other business relationships.
In the event an exchange takes place between related parties, the investor and the other parties to the transaction must hold the property acquired for a period of at least two years. There are some narrowly applied exceptions to this rule.
5. Seller Financing
An exchange consists of a disposition of one or more relinquished properties and acquisition of one or more like-kind replacement properties. If a seller finances the buyer’s purchase, he will receive a promissory note. A note is not considered like kind with real estate. Therefore, absent some specific techniques, the tax benefits of an exchange can be greatly diminished when seller financing is involved.
6. Offshore Property
Under the provisions of the code, real property located in the United States and real property located outside of the United States are not property of a like kind and do not qualify under Section 1031. Properties in foreign countries, however, are like kind with properties in any other foreign country.
Partnerships participate in exchanges every day without any problems. However, issues arise when the partners want to go their separate ways. Section 1031 prohibits exchanges of partnership interests. Therefore, if a partnership exchanges out of a property, the partners are not allowed to use their portion of the proceeds to acquire their own replacement property. This has led to what is known in the industry as a “drop and swap.” In a drop and swap the partnership distributes proportionate fee simple interests to the individual partners. The partners then either cash out or perform an exchange with their fractional interest in the property into a replacement property. The IRS and state taxing authorities have started to scrutinize these transactions based upon a legal theory the courts apply in order to disregard the “drop” portion of the transaction. This results in the transaction being treated as an exchange of partnership interests and is therefore taxable. I recently defended an 18 property exchange which was professionally structured to reduce the risk of an adverse tax ruling. We prevailed, largely due to the manner in which the transaction was structured. It is critical for any investor who is considering such a transaction to obtain professional advice well in advance of the transaction.
8. This Applies to Losses as Well
Over the years I have had occasion to assist investors with property swaps. Most exchanges involve third party buyers or sellers, but property swaps occur when two parties directly exchange properties. Typically an intermediary is not necessary with property swaps, but it should be noted that application of Section 1031 is mandatory. If an investor swaps property that would produce a loss if sold outright, his loss will be deferred and not currently recognized.
9. There are Alternatives
Exchanging is a proven method to build wealth. However, depending upon the tax posture of the investor and other circumstances, an alternative to a tax deferred exchange may be more appropriate. Alternatives to an exchange include:
- Continuing to hold the property;
- Sale of property, payment of taxes and reinvestment in real property or another type of property;
- Seller financing of the property to spread the tax recognition pro-rata over the term of repayment;
- Refinance of the property to obtain funds for additional investment in other real property or other type of property.
10. Proper Planning Prevents Poor Performance.
Section 1031 is a powerful investment tool. In order to work properly, a number of factors must be considered and the rules must be followed diligently. Never undertake a 1031 exchange without obtaining professional guidance that takes into account your tax posture and investment objectives.
Rob Platt, CCIM is a licensed sales associate with CRE Consultants who specializes in investment properties. He is also a licensed California tax lawyer and real estate broker. Mr. Platt has participated in over 1,000 tax deferred exchanges and is a court recognized expert in 1031 exchanges. For further information or assistance, he can be reached at 239-659-1447 or Rob.Platt@CREconsultants.com