Deferred Capital Gains Taxes
1031 EXCHANGE INFO
6 Very Important 1031 Exchange Rules
If you are planning to complete a Section 1031 like-kind exchange, you need to be sure that you know and understand the rules. While there is no substitute for professional advice, this information will get you moving on your way to completing your exchange and steering clear of the ire of the IRS.
Before we begin, it is prudent to lay out just exactly what a “1031 exchange” is. This process gets its name form Section 1031 of the Internal Revenue Code. There are two sets of rules in this code: one deal’s with real property (land, buildings, and other structures) and the other deals with personal property (boats, aircraft, cattle, etc.). This article relates only to real property.
As it relates to real property, IRS Section 1031 allows holders of business or investment property to delay paying capital gains on the disposition of their property so long as the rules are followed. This is a powerful tax and investment strategy as well as estate planning tool. Theoretically, an investor could continue deferring capital gains on property until their death thereby avoiding capital gains altogether (although estate taxes may have to be paid).
Now, on to the rules:
Rule #1 › Both the “old property” and the “new property” must be held for investment or business use
In the early days of like-kind exchanges, getting past the “similar use” rule was difficult. If you had a two-story brick apartment building that you wanted to exchange, you had to find another person with a two-story brick apartment building to “swap” with. The two of you would get together and simultaneously “swap” titles.
In the late 70s and early 80s, T.J. Starker changed all that with a series of court cases that went all the way to the Supreme Court. These cases cleared the way for Congress to rewrite code section 1031 in 1991. The resulting code allowed property owners to exchange any property held for investment or business use for any other property held for business or investment use.
Now, that two story brick office building can be exchanged for raw land, a warehouse, or even partial ownership of a larger office building. The only requirement is that the property be for investment or business use. Section 1031 does make a distinction between investment property and property held for resale. Generally, “fix and flip” properties do not qualify for tax-deferred exchanges. Intent is an important component of qualifying your property for favorable exchange treatment. As such, most industry professionals agree that a holding period of one year and one day would satisfy the IRS that the property was an investment. The underlying idea is that by holding the property for this period, you would not be converting short term capital gains into long-term capital gains by completing the exchange. (The IRS really frowns on attempting to convert short-term gains into long-term gains in these situations.)
Rule #2 › 45-day identification time limits
From the day that you close on the sale of your old property, you have 45 calendar days to identify your replacement property. Being calendar days, the limit includes holidays, weekends, and vacations. This time period is not negotiable and the IRS will not make exceptions to this rule. Be sure that your Qualified Intermediary (QI) is available when you are ready to identify if you are getting close to the end of your 45-day identification.
If you go beyond the 45-day limit for your identification and continue with the exchange, your whole exchange will be disqualified and penalties and taxes are sure to ensue. If you change your identified property list after 45 days, you (and likely your QI) will go to prison. The list that you develop during this period of time has some stipulations associated with it as well. For starters, if you identify three properties or less, there is no limit on the total value of property that you can identify. For example, if John sells a building for $450,000 he can identify $25,000,000 or more in replacement property so long as there are not more than three properties included in this total dollar value. There is no limit on the dollar value.
However, if John identifies more than three properties, he is subject to the 200% rule. This rule states that John cannot identify more than $900,000 ($450,000 X 200%). If he goes over that limit, the exchange will be disqualified. For obvious reasons, it is best to keep the list to three or fewer properties in most cases.
Your list is given to your QI whose job it is to receive the list on behalf of the IRS. The properties on the list must be identified in such a way that an IRS agent could request the list and drive to each of the listed properties. It is recommended that you give the complete physical (not mailing) address of each property to be identified. Be sure that you verify the address before turning in your list.
Rule #3: 180-day purchase time limit
From the date that you close on your property sale, you have 180 days to close on your replacement property. Take note that the identification period and closing period run concurrently. When your identification period is up, you will only have another 135 days left to close. The day of closing is when title is officially passed to you. Like the identification time limit, there are no extensions and no exceptions.
Rule #4 › Use of a Qualified Intermediary
Law requires that you not touch the money between the sale of your old property and the purchase of your new property. To accomplish this, you must use an uninterested third party called a Qualified Intermediary (QI). These people are also sometimes referred to as facilitators or straw men.
The QI has several important roles. As indicated above, the QI is responsible for handling the identification documents and closing of the transaction. The QI will facilitate the transfer of funds and title. They will prepare all of the required paperwork. They also hold the funds between the sale of the old property and the purchase of the new property.
As you can see, the QI plays a very important role in your 1031 exchange. Any glitch along the way, whether with identification or closing documents, could disallow your exchange. For this reason, it is important to be sure that you are dealing with a professional in this field. No government body regulates Qualified Intermediaries. Therefore, it is important that your QI be bonded. The fact that the QI is bonded does not guarantee that your exchange will not be challenged but it does show that the QI has committed the time, energy, and resources to put some “meat” behind their credentials.
It is also very important to know who cannot serve as your Qualified Intermediary. This list includes your CPA, attorney, realtor, relative, employee, or business associate. You must use a completely independent third party.
Rule #5 › Titles must match
The ownership of the old property must match the ownership of the new property. For example, David Jones owns an apartment building that he wishes to exchange into a Tenant in Common fractional ownership of an office building. The title document of the old property shows the owner as “David P. Jones”. David is married and he would like to share ownership of the TIC property with his wife, Rebecca, with whom he files a joint tax return. If David adds his wife Rebecca to the title of the new property, the IRS will deem this transaction to be a sale and subsequent purchase thereby disallowing the exchange.
However, if David and Rebecca are cousins who own the property together and file separate tax returns, one or the other could complete an exchange with their portion of the sale proceeds. The IRS will look to the tax records to identify proper title.
This title requirement can be a bit of a hurdle for estate planning. For this reason, it is important to speak with an estate attorney regarding your desires for your property dispositions. Many property owners will seek to turn a business property (such as an apartment building that they have owned for many years) into an income producing property with no management duties (such as a TIC triple net investment) in their later years to produce worry free retirement income. This transaction generally requires some thought toward estate planning and proper title.
Another important issue to consider is whether or not a trust, partnership, or LLC owns the property. If one of these entities owns the title of the old property, it must also own the title to the new property in order for the exchange to be allowed. If only one participant in the LLC, partnership, or trust decides not to continue with the exchange process, no one will be allowed to exchange their portion of the proceeds. Once again, ownership must match and you must reinvest all of the sale proceeds (see Rule #6).
Rule #6 › Reinvestment of sales proceeds
To defer all of the capital gains taxes, you must: 1) purchase a property of equal or greater value and 2) reinvest all of the cash proceeds from the sale. Forget what you have heard about taking on as much or more debt in the new property. Let’s take a look at a couple of examples to clarify this point.
Example #1: David decides to sell a piece of property that he has owned for several years. The property has the following capital structure:
Sales price: $300,000
Mortgage Debt: $100,000
Cash to Intermediary $200,000
David buys a new property for $425,000 using all of the $200,000 cash from the QI and adding mortgage debt of $225,000. David has met the reinvestment rules for this property.
Example #2: Using the same sales figures from above, David buys a new property for $225,000. David reinvests all of the cash from the QI and adds mortgage debt of $25,000 to the property. David has violated part of the reinvestment rule by buying a less expensive property than that which was sold. The taxable gain (called “boot”) in this case is $75,000 ($300,000-$225,000), the difference in the sales price of the old property and the purchase price of the new property.
Likewise, if David purchases a new building for $350,000 but only uses $175,000 of the cash from the QI, the excess cash ($25,000) is taxable as boot.
Notice that neither of these cases causes the entire exchange to be disqualified. David simply does not maximize the tax deferral on his transaction.
This list, while not comprehensive, should be enough to get you started on the right path towards your 1031 like-kind exchange. The information provided herein is for information purposes only. Every situation is different, and I recommend you seek professional advice from a real estate attorney or tax accountant if you have any further questions.
Carlos R. Alvarez
Hablo Tu Idioma
Llama Hoy Mismo
Author: Carlos Alvarez
April 6th 2018
About Carlos: Carlos Alvarez has 20 years of real estate experience. He began his real estate career in Californi...