Tax-free (deferred) like-kind exchange
In the following article, Peter A. Karl, III explains in detail The Section 1031 exchange. Also know as the tax-free (deferred) like-kind exchange, the law provides tax payers an opportunity to choose not to pay taxes when disposing of property. The taxes can essentially be deferred when exchanged with investment and rental property than an individual owns. Karl defines how the exchange works, identifies time limits involved, specifiies replacement formalities, qualifying properties and the keys to avoiding taxes through the 1031 exchange.
Section 1031 Exchanges in a Nutshell* By Peter A. Karl, III
*An article published in the August 2002
issue of the Tax Reduction Letter published by
Bradford & Company (1-877-829-9673)
The payment of income taxes on the disposition of real estate is completely voluntary!
The Section 1031 exchange is the most underutilized part of the tax law. That's truly sad as it offers the most significant savings. It could be a name problem-calling it an "exchange." People think exchange during the holidays when they stand in line to return and replace to return and replace the sweater than did not fit. The tax law "exchange" might get a lot more attention if lawmakers called it a "rollover" because that's what you accomplish with Section 1031. You rollover the gain to the new property.
You can continue the rollover of gain and postponement of tax with successive exchanges (stemming from the original property you relinquished), provided a one year holding period exists with the replacement property. The postponement of taxes turns into the cancellation of taxes to the extent that the property get a set-up in basis at date of death.[i]
For example, you buy land for $50,000. It grows in value. You exchange it for land worth $130,000. At the date of your death, the land has grown in value to $300,000. It transfer to your heirs at $300,000 (its stepped-up basis). The increase in value from the original $50,000 through the $130,000 exchange and including the increase to $300,000 its not subject to income taxes under the stepped up basis concept.
How the exchange really works
The Section 1031 exchange is really a sale and then a subsequent reinvestment. The deferred exchange is the most popular form of exchange. It involves four parties:
You as the owner (actually, seller) of the property being relinquished.
The buyer for your property.
The seller of the property you want to acquire.
A qualified intermediary.
The qualified intermediary is an individual or entity with whom you have not had a business relationship of any sort within the last two years.[ii] Therefore, your accountant, lawyer, or real estate sales professional will not qualify as an intermediary.
The intermediary makes the exchange work. Think of exchange money as "radioactive." You may not touch it. Your buddies (like your accountant or lawyer) may not touch it. If you or your buddies touch it, you destroy the exchange and trigger taxes.
The qualified intermediary handles the money and holds the sales proceeds from your property in interest bearing accounts. Then, the intermediary distributes the money as needed to purchase the replacement property.
Strict time limits
Observe the exchange time-limit rules. These dates are set in stone. They are not suggestions. Start date. The strict time limits for the Section 1031 exchange starts with the "initial transfer date." This is the date you close the sale on the property you are selling (the relinquished property).
Forty-five (45) days from the initial date you must formally identify your possible choices of replacement property.[iii]
One hundred eighty (180) days from the initial transfer date, you must have the previously identified replacement property titles in your name. [iv]
Tax law shortens the 180-day period when you tax return is due during the 180-day period. If the exchange occurs after October 17, you need to file an extension to receive the full 180 days.
For example, if your initial transfer date is December 1, you need to file for the automatic extension on or before April 15 to have the benefit of the full 180 day replacement period until May 30.
Planning tip. Postpone the initial transfer date with a lease. For example, you could allow the buyer to occupy the property under a triple net lease until you exercise your option to close the sale.[v]
The replacement formalities
Ideally, within forty-five days, the qualified intermediary uses part of the funds from the relinquished property sale for an earnest money deposit on the replacement property. This provides positive identification. Alternatively, within forty-five days, you can designate the replacement property in a signed document that you hand deliver, mail, fax, or otherwise send to the qualified intermediary.[vi]
The regulations permit you to identify more than one possible replacement property.[vii]
The maximum number of replacement properties that you may identify under the two main rules is three properties of any fair market value, or any number of properties, if the fair market value of properties identified does not exceed 200% of the agregate fair market value of properties relinquished. Look at the beauty of this! When you sell your property, you can be absolutely clueless about where to reinvest. Further, you have complete flexibility as to the type of realty you accept as replacement property. It can be investment or rental property, vacant land, or realty used in a trade or business. About the only types of property that do not qualify are personal use and foreign realty.[viii]
Keys to not pay taxes
You pay no taxes under Section 1031 when you receive no cash, and obtain no debt relief.
Say you use Section 1031 to dispose of your $200,000 building with a $100,000 mortgage for a $250,000 building with a $150,000 mortgage. No taxes here. You exchange your $100,000 equity in the $200,000 building for the same equity in the $250,000 building. You receive no cash. You received no debt relief. In fact, your debt increased from $100,000 to $150,000 because you now own more building and more depreciation deductions.
You can tax advantage of Section 1031 even if you have liability over basis problem that precludes you from giving the property to a relative or charity without recognizing gain. In these cases, you recognize no gain if the replacement cost is equal or greater than the sales proceeds from disposition of the old property.
Impounded funds used to pay closing costs do not count as cash receipts to you. The regulations state that use of money held by a qualified intermediary to pay specified transactional items will not result in actual or constructive receipt by the exchangor of the remaining funds. This rule apples to
Costs that relate to the disposition of the relinquished property or to the acquisition of the replacement property; and
Expenses listed as the responsibility of a buyer or seller in the typical closing statement under local standards.
Examples of these expenditures include commissions, recording or transfer taxes, and title company fees. Also, the selling price of the property relinquished does not include reimbursements to you to cover monies you received, like advance rents, or expenses you already paid, like property taxes.
More property flexibility than you think
There is no requirement that the exchange be a "one for one" transaction. In other words, you can divest yourself of one property and replace it with two properties or vice versa.
In fact, you might want to consider a "build to suit" (a/k/a construction exchange) where you identify replacement vacant land along with the details of a structure you want built during the 180-day reinvestment period. The qualified intermediary disburses impounded funds to the contractor(s) on a "pay as completed" basis.
Alternatively, you might buy a "fixer-upper" and have the qualified intermediary rehab it using impounded funds. The result: You improve your replacement property using pre-tax dollars. Similarly, you can identify less expensive property that needs some capital improvements (like a new roof) to gobble proceeds from the property relinquished.
This is not an "all or nothing" proposition. To the extent the qualified intermediary has money remaining at the end of the exchange period, the law taxes it as "boot" (cash received by you). That's the bad news.
The good news is that the law taxes you only on the boot received part. The receipt of boot does not ruin the entire exchange.[ix] It simply triggers taxes on the amount you receive as boot.
Owner takebacks in a 1031 exchange
Most of the normal options for selling your property apply to an exchange. For example, you (actually, your intermediary) could finance the sale of your property with an owner takeback (purchase money mortgage). With the owner takeback, you:[x]
reduce the total contract price by the like-kind property received, and
reduce the gross profit by that part that applies to the exchange.
Alternatively, you may want to avoid taxes altogether on the owner takeback. Your qualified intermediary may accomplish this for you by:
discounting the takeback mortgage to cash and then using the net proceeds for the replacement property, or
assigning the takeback mortgage in the acquistion of the replacement property.
With the assignment, the seller accepts the takeback at its face value. The seller likes this deal because he secures the takeback mortgage with two properties:
the property you sold (relinquished) in the exchange, and
the property you bought from the seller (target property).
Reverse exchanges
Section 1031 is flexible. Recently, the IRS established a safe harbor for "reverse exchanges." [xi] You have to love these. The "reverse" comes in handy when you do not yet have a buyer for the property you want to relinquish and you are afraid of losing the property you wish to acquire.
To help with reverse exchanges, the IRS issued a recent Revenue Procedure that established the notion of an Exchange Accommodation Title-holder (EAT) (really, another name for a qualified intermediary). The EAT buys the replacement property using money that you advanced. He then "parks" the property for you. You have the 180-day replacement period to "get your act together" and find a buyer for the property that you wish to relinquish.
The "paper-trail" for the reverse exchange should begin immediately with the original agreements. You could include a clause like this:
The seller reversed the option to convert the subject transaction to qualify under Section 1031 of the Internal Revenue Code with the purchaser agreeing to cooperate in the execution of any of the required documentation (including, but not limited to a Four-Party Deferred Exchange Agreement and a Qualified Intermediary Agreement) provided purchaser shall incur no addition cost or liability.
Properties that qualify
The tax-deferred exchange rules of Section 1031 apply to business and investment real estate. The rules do not apply to your personal home. Also, you may not use the favorable exchange rules for vacation homes that have substantial personal use.[xii]
Planning tips. You may use the favorable exchange rules if you convert you home to a bonafide rental property for a minimum of one year, the long term capital gain holding period.[xiii]
If you have an operating business, Section 1031 applies separately to both the realty and personal property (a "mixed property exchange"). The personal property parts, like computers, desks, and vehicles are more difficult to configure. IRS regulations that apply to Section 1031 define like-kind personal property with terms such as "like class" and "like use."[xiv]
The terms "like class" and "like use" deny exchanges of office equipment for cars. Similarly, the rules deny exchanges of an operating business intangible personalty, like goodwill, even if similar in nature (e.g. two restaurants).
Planning tips. The rules make it easy for you to use Section 1031 to defer taxes on real estate. Stay with the "easy" (real estate) for maximum return on minimum effort.
Avoiding taxes without 1031 exchange
What happens if you want to stop investing in real estate? Is there anything you can do? Yes! In an upcoming issue, we will examine tax avoidance alternatives if you are no longer interested in reinvesting in real property. We will look at property owned by a multi-member partnership or limited liability company where some want to cash out and the others want to reinvest under Section 1031.
Summary
Remember, the law gives you a choice to pay or not pay taxes when you dispose of property. You can defer taxes when you exchange investment and rental real estate that you own individually. Also, your trust or closely-held corporation may use the exchange rules to defer taxes on its investment and rental realty.
So, choose not to pay taxes! Do this with the "rollover" benefits of Section 1031 that allow you to defer the tax on property you sell by rolling the profits into replacement property. To make this happen, you need only an intermediary to sell your property and buy the replacement. What could be easier?
Section 1031 Exchanges in a Nutshell* By Peter A. Karl, III
*An article published in the August 2002
issue of the Tax Reduction Letter published by
Bradford & Company (1-877-829-9673)
The payment of income taxes on the disposition of real estate is completely voluntary!
The Section 1031 exchange is the most underutilized part of the tax law. That's truly sad as it offers the most significant savings. It could be a name problem-calling it an "exchange." People think exchange during the holidays when they stand in line to return and replace to return and replace the sweater than did not fit. The tax law "exchange" might get a lot more attention if lawmakers called it a "rollover" because that's what you accomplish with Section 1031. You rollover the gain to the new property.
You can continue the rollover of gain and postponement of tax with successive exchanges (stemming from the original property you relinquished), provided a one year holding period exists with the replacement property. The postponement of taxes turns into the cancellation of taxes to the extent that the property get a set-up in basis at date of death.[i]
For example, you buy land for $50,000. It grows in value. You exchange it for land worth $130,000. At the date of your death, the land has grown in value to $300,000. It transfer to your heirs at $300,000 (its stepped-up basis). The increase in value from the original $50,000 through the $130,000 exchange and including the increase to $300,000 its not subject to income taxes under the stepped up basis concept.
How the exchange really works
The Section 1031 exchange is really a sale and then a subsequent reinvestment. The deferred exchange is the most popular form of exchange. It involves four parties:
You as the owner (actually, seller) of the property being relinquished.
The buyer for your property.
The seller of the property you want to acquire.
A qualified intermediary.
The qualified intermediary is an individual or entity with whom you have not had a business relationship of any sort within the last two years.[ii] Therefore, your accountant, lawyer, or real estate sales professional will not qualify as an intermediary.
The intermediary makes the exchange work. Think of exchange money as "radioactive." You may not touch it. Your buddies (like your accountant or lawyer) may not touch it. If you or your buddies touch it, you destroy the exchange and trigger taxes.
The qualified intermediary handles the money and holds the sales proceeds from your property in interest bearing accounts. Then, the intermediary distributes the money as needed to purchase the replacement property.
Strict time limits
Observe the exchange time-limit rules. These dates are set in stone. They are not suggestions. Start date. The strict time limits for the Section 1031 exchange starts with the "initial transfer date." This is the date you close the sale on the property you are selling (the relinquished property).
Forty-five (45) days from the initial date you must formally identify your possible choices of replacement property.[iii]
One hundred eighty (180) days from the initial transfer date, you must have the previously identified replacement property titles in your name. [iv]
Tax law shortens the 180-day period when you tax return is due during the 180-day period. If the exchange occurs after October 17, you need to file an extension to receive the full 180 days.
For example, if your initial transfer date is December 1, you need to file for the automatic extension on or before April 15 to have the benefit of the full 180 day replacement period until May 30.
Planning tip. Postpone the initial transfer date with a lease. For example, you could allow the buyer to occupy the property under a triple net lease until you exercise your option to close the sale.[v]
The replacement formalities
Ideally, within forty-five days, the qualified intermediary uses part of the funds from the relinquished property sale for an earnest money deposit on the replacement property. This provides positive identification. Alternatively, within forty-five days, you can designate the replacement property in a signed document that you hand deliver, mail, fax, or otherwise send to the qualified intermediary.[vi]
The regulations permit you to identify more than one possible replacement property.[vii]
The maximum number of replacement properties that you may identify under the two main rules is three properties of any fair market value, or any number of properties, if the fair market value of properties identified does not exceed 200% of the agregate fair market value of properties relinquished. Look at the beauty of this! When you sell your property, you can be absolutely clueless about where to reinvest. Further, you have complete flexibility as to the type of realty you accept as replacement property. It can be investment or rental property, vacant land, or realty used in a trade or business. About the only types of property that do not qualify are personal use and foreign realty.[viii]
Keys to not pay taxes
You pay no taxes under Section 1031 when you receive no cash, and obtain no debt relief.
Say you use Section 1031 to dispose of your $200,000 building with a $100,000 mortgage for a $250,000 building with a $150,000 mortgage. No taxes here. You exchange your $100,000 equity in the $200,000 building for the same equity in the $250,000 building. You receive no cash. You received no debt relief. In fact, your debt increased from $100,000 to $150,000 because you now own more building and more depreciation deductions.
You can tax advantage of Section 1031 even if you have liability over basis problem that precludes you from giving the property to a relative or charity without recognizing gain. In these cases, you recognize no gain if the replacement cost is equal or greater than the sales proceeds from disposition of the old property.
Impounded funds used to pay closing costs do not count as cash receipts to you. The regulations state that use of money held by a qualified intermediary to pay specified transactional items will not result in actual or constructive receipt by the exchangor of the remaining funds. This rule apples to
Costs that relate to the disposition of the relinquished property or to the acquisition of the replacement property; and
Expenses listed as the responsibility of a buyer or seller in the typical closing statement under local standards.
Examples of these expenditures include commissions, recording or transfer taxes, and title company fees. Also, the selling price of the property relinquished does not include reimbursements to you to cover monies you received, like advance rents, or expenses you already paid, like property taxes.
More property flexibility than you think
There is no requirement that the exchange be a "one for one" transaction. In other words, you can divest yourself of one property and replace it with two properties or vice versa.
In fact, you might want to consider a "build to suit" (a/k/a construction exchange) where you identify replacement vacant land along with the details of a structure you want built during the 180-day reinvestment period. The qualified intermediary disburses impounded funds to the contractor(s) on a "pay as completed" basis.
Alternatively, you might buy a "fixer-upper" and have the qualified intermediary rehab it using impounded funds. The result: You improve your replacement property using pre-tax dollars. Similarly, you can identify less expensive property that needs some capital improvements (like a new roof) to gobble proceeds from the property relinquished.
This is not an "all or nothing" proposition. To the extent the qualified intermediary has money remaining at the end of the exchange period, the law taxes it as "boot" (cash received by you). That's the bad news.
The good news is that the law taxes you only on the boot received part. The receipt of boot does not ruin the entire exchange.[ix] It simply triggers taxes on the amount you receive as boot.
Owner takebacks in a 1031 exchange
Most of the normal options for selling your property apply to an exchange. For example, you (actually, your intermediary) could finance the sale of your property with an owner takeback (purchase money mortgage). With the owner takeback, you:[x]
reduce the total contract price by the like-kind property received, and
reduce the gross profit by that part that applies to the exchange.
Alternatively, you may want to avoid taxes altogether on the owner takeback. Your qualified intermediary may accomplish this for you by:
discounting the takeback mortgage to cash and then using the net proceeds for the replacement property, or
assigning the takeback mortgage in the acquistion of the replacement property.
With the assignment, the seller accepts the takeback at its face value. The seller likes this deal because he secures the takeback mortgage with two properties:
the property you sold (relinquished) in the exchange, and
the property you bought from the seller (target property).
Reverse exchanges
Section 1031 is flexible. Recently, the IRS established a safe harbor for "reverse exchanges." [xi] You have to love these. The "reverse" comes in handy when you do not yet have a buyer for the property you want to relinquish and you are afraid of losing the property you wish to acquire.
To help with reverse exchanges, the IRS issued a recent Revenue Procedure that established the notion of an Exchange Accommodation Title-holder (EAT) (really, another name for a qualified intermediary). The EAT buys the replacement property using money that you advanced. He then "parks" the property for you. You have the 180-day replacement period to "get your act together" and find a buyer for the property that you wish to relinquish.
The "paper-trail" for the reverse exchange should begin immediately with the original agreements. You could include a clause like this:
The seller reversed the option to convert the subject transaction to qualify under Section 1031 of the Internal Revenue Code with the purchaser agreeing to cooperate in the execution of any of the required documentation (including, but not limited to a Four-Party Deferred Exchange Agreement and a Qualified Intermediary Agreement) provided purchaser shall incur no addition cost or liability.
Properties that qualify
The tax-deferred exchange rules of Section 1031 apply to business and investment real estate. The rules do not apply to your personal home. Also, you may not use the favorable exchange rules for vacation homes that have substantial personal use.[xii]
Planning tips. You may use the favorable exchange rules if you convert you home to a bonafide rental property for a minimum of one year, the long term capital gain holding period.[xiii]
If you have an operating business, Section 1031 applies separately to both the realty and personal property (a "mixed property exchange"). The personal property parts, like computers, desks, and vehicles are more difficult to configure. IRS regulations that apply to Section 1031 define like-kind personal property with terms such as "like class" and "like use."[xiv]
The terms "like class" and "like use" deny exchanges of office equipment for cars. Similarly, the rules deny exchanges of an operating business intangible personalty, like goodwill, even if similar in nature (e.g. two restaurants).
Planning tips. The rules make it easy for you to use Section 1031 to defer taxes on real estate. Stay with the "easy" (real estate) for maximum return on minimum effort.
Avoiding taxes without 1031 exchange
What happens if you want to stop investing in real estate? Is there anything you can do? Yes! In an upcoming issue, we will examine tax avoidance alternatives if you are no longer interested in reinvesting in real property. We will look at property owned by a multi-member partnership or limited liability company where some want to cash out and the others want to reinvest under Section 1031.
Summary
Remember, the law gives you a choice to pay or not pay taxes when you dispose of property. You can defer taxes when you exchange investment and rental real estate that you own individually. Also, your trust or closely-held corporation may use the exchange rules to defer taxes on its investment and rental realty.
So, choose not to pay taxes! Do this with the "rollover" benefits of Section 1031 that allow you to defer the tax on property you sell by rolling the profits into replacement property. To make this happen, you need only an intermediary to sell your property and buy the replacement. What could be easier?
posted by Russell T. Nolting at
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