Most people who have heard of Section 1031 of the Internal Revenue Code have heard about it in the context of a like-kind exchange. However, there’s a little more to it, or actually a lot more, but some of it are topics for another time. The basics of a 1031 exchange are covered here.
What is it?
Simply put, the 1031 exchange provides a real estate investor with a way to sell appreciated assets and defer payment of any capital gain taxes by purchasing one or more replacement real estate properties with the sale proceeds. So instead of losing up to 1/3 of your proceeds to taxes, you can spend the money on what you want. However, it’s not that simple. There are some requirements discussed later that have to be met for the 1031 exchange tax treatment to apply.
Utilizing a 1031 exchange is a great method of repositioning, diversifying and consolidating your real estate investment portfolio. It gives you an advantageous tool to use when you sell one property and diversify your real estate portfolio by acquiring multiple like-kind replacement properties or when you sell multiple properties and consolidate your real estate portfolio by acquiring fewer, but larger, like-kind properties with the sales proceeds. These property purchases can also be partial acquisitions.
The most common 1031 exchange structure is a forward, or delayed, 1031 exchange. With this structure, you would sell the first property with the purchase of the replacement property to occur at a later date, but within the required deadlines. You can also take advantage of the improvement 1031 exchange option, where you would use the proceeds from the sale of the relinquished property for improvement or construction on the replacement property.
In order to avoid having to pay capital gain taxes on the sale of real estate using a 1031 exchange, both the sale and the purchase transaction must be structured correctly. First, you must have a qualified intermediary. This person is also referred to as an accommodator, a facilitator and an intermediary. The qualified intermediary cannot be the person or entity selling the relinquished property or acquiring the replacement property, or any taxpayer benefiting from the process. The qualified intermediary acquires the property being sold, transfers the property to the buyer, acquires the replacement property and transfers the replacement property to the taxpayer benefiting from the process. The qualified intermediary should be incorporated into the purchase and sale legal documents for the purchase and sale transactions before they occur. These legal documents include escrow instructions and purchase and sale agreements.
The replacement property or properties purchased with the sales proceeds from the prior property must have a net purchase value which is equal to or greater than the nest sales value of the property sold. In other words, all of the net cash proceeds from the sale must be reinvested. The debt on the replacement property must also replace the debt that was on the relinquished property in an equal amount.
Both the relinquished property and the replacement property must have certain uses to qualify. This is the qualified use requirement. Neither the new nor the relinquished property can be your home or other residence. Both properties must have been held for rental or other investment purposes, or used as part of your trade or business. The issue that mostly comes up here is whether the property or properties were held for investment purposes or sale. A property held for sale would be considered business inventory and would not meet the qualified use requirement. There is also a like-kind requirement, but this doesn’t mean that the properties have to be the exact same type of property (i.e. you don’t have to buy a condo if you sold a condo). As long as both properties meet the qualified use requirement, any real estate property held for investment is generally like-kind to another real estate property held for investment.
The following real estate types apply for the 1031 tax-deferred treatment:
- Commercial Office
- Retail Shopping
- Vacant Land
- Oil and Gas Interests
- Mineral Rights
- Riparian Water Rights
- Tenant in Common Investments
Finally, a valid 1031 tax-deferred transaction requires that certain deadlines are met. Only 45 calendar days are allowed to pass between the closing date on the sale of the relinquished property and the identification of one or more replacement properties. You then have an additional 135 calendar days to close on the replacement property or properties. When you identify the property, the following three rules should be kept in mind because you must comply with at least one of the three: (i) you can identify between one to three properties, but no more than three; (ii) you can identify more than three properties as long as the total fair market value of all the like-kind properties does not exceed 200% of the sales price of the relinquished property or properties; or (iii) you can identify as many like-kind replacement properties as you want, as long as you actually acquire and close on 95% of the total aggregate fair market value’s worth of the properties actually identified.
If you can abide by the rules, utilizing a 1031 exchange is a great way to save on tax expenses from one or more real estate sales. However, it’s not the easiest to validly comply with all of the requirements of a 1031 exchange. There are also many nuances that may come up that are not discussed here. Please contact Dodson Legal Group for a consultation at 844-4DODSON to discuss the best way to structure your real estate investment portfolio.