With recent appreciation in real estate, we are seeing more clients interested in 1031 exchanges. These exchanges (often called “like kind” exchanges) can be complex. But as long as you follow the rules, it is a great way to defer capital gains on real estate with substantial appreciation.
First of all, most real estate investors understand that a big tax bill can follow the sale of appreciated real estate held for investment purposes. When appreciated real property is sold, the profits from this sale—termed capital gain—are taxed as ordinary income (a tax rate of up to 39.6%) if the property is held for less than one year, or taxed at a more favorable rate of 15% (subject to certain exclusions) if held for a period of time longer than a year. However, Section 1031 of the Internal Revenue Code (“IRC”) allows for the deferral of capital gains tax if the proceeds of the sale are used to acquire a new property (or properties).
There are certain criteria that must be met in order for the taxes to be deferred:
- The investor must obtain a “like-kind” replacement property. The definition of “like-kind” property provided by the IRC is very broad. Essentially all real property is like-kind (when applied to investment and exchange), allowing for the exchange of land with a commercial building, apartment buildings being exchanged with a single rental property, etc. The key is that they are held for investment purposes. This includes all real property within the United States; any purchase of property outside of the U.S. is not considered “like-kind”.
- The investor must not receive cash. Any cash received by the investor will be considered taxable boot. In addition, anything received in exchange for the property that is not considered “like-kind” is labeled boot. This includes private use property including cash, securities, debt relief, notes, etc.
It is important to note that if the real estate investor receives a debt reduction, this amount will be considered “boot” and will be taxable to the investor. In order to avoid any taxable event, the investor must buy a replacement property that is of equal or greater value than the relinquished property. They also must invest all of the net proceeds from the sale of the original property and obtain debt that is equal or greater on the new investment property.
Qualified Intermediary or Accomodator
Before going into descriptions of the types of exchanges, there is an important term that should be understood in the exchange process. A Qualified Intermediary is often used in the process of these exchanges and acts as sort of a “middle man.” The real estate investor typically will enter into a 1031 exchange agreement with the qualified intermediary.
During the sales process, the intermediary will basically acquire the property from the investor (or seller) and transfer it to the new buyer. The proceeds from the disposition of the relinquished property will go directly to the qualified intermediary and not the seller. The real estate investor will then identify the replacement property and the qualified intermediary will acquire the property and transfer it to the investor. This is the standard role of the qualified intermediary.
Types of Exchanges
There are various types of exchanges: delayed exchange (the most common), simultaneous exchange, and reverse exchange (the most complicated of the exchange methods, and least common). Let’s take a closer look at the types:
- Delayed Exchange. In a Delayed Exchange, a qualified intermediary is used to transfer the investor’s properties and proceeds. An Exchange Agreement is made between the investor and qualified intermediary, and the investor’s rights in a sales contract are transferred to the intermediary. The intermediary effectively becomes the seller and transfers the relinquished property to the buyer. The intermediary retains the proceeds from the sale and uses these funds to purchase the investor’s new replacement property. The new property is then transferred to the investor and the exchange is complete. We will discuss the specifics below.
- Simultaneous Exchange. This type of exchange occurs when the relinquished property and the replacement property are transferred at the same type (simultaneously). It is typically recommended that a qualified intermediary be used to make sure that the transaction is consummated correctly.
- Reverse Exchange. This type of exchange occurs infrequently. They typically utilize a “holding” company that is an entity established by a qualified intermediary. The real estate investor utilizes the holding company to “hold” the relinquished or the replacement property. Because of the complexity, you should ensure that you work closely with an experienced exchange professional.
Considering the delayed exchange is the most common type, it deserves a closer look. It is imperative that the rules for the exchange are meticulously followed. The property investor has just 45 days from the close of escrow on the relinquished property to identify potential replacement properties. After the replacement properties have been identified, the real estate investor has 180 days to close escrow on the replacement property (or properties). Again, the qualified intermediary acquires the replacement property with the proceeds from the sale of the relinquished property and transfers the replacement property to the investor.
An important point to note is that the real estate seller must put a clause in the real estate contracts that stipulates that all applicable parties to the contracts must cooperated in the 1031 exchange process. Once the investor has entered into an agreement with a buyer to purchase the property it will be placed into escrow. The investor will then typically enter into an exchange agreement with the qualified intermediary that will allow for the intermediary to become the “substitute seller.”
The 45-Day Rule
Let’s take a closer look at the first timing issue for a delayed exchange. The investor must close escrow on a replacement property or identify potential replacement properties within 45 days from the date of transfer of the exchanged property. The rule is satisfied if the replacement property is received before the 45 day expiration period.
If the replacement property is not acquired within 45 days, the properties identified must be documented by a written document that is signed by the seller and delivered to the qualified intermediary. This notification must include a description of the replacement property, which will typically include the legal description and street address.
However, there are limitations on the number of potential replacement properties. The investor can identify more than one property, but needs to consider the following restrictions:
- Three-Property Rule. This rule allows the investor to identify any three properties regardless of their values;
- 200% Rule. The investor can identify any quantity of properties so long as the combined aggregate market value of the properties does not exceed 200% of the combined aggregate market value of all of the exchanged properties; and
- 95% Rule. This allows for any number of replacement properties so long as the fair value of the properties received by the end of the exchange period is at least 95% of the combined aggregate fair value of all potential replacement properties identified.
Please realize that the IRS just requires written notification within the 45 day window. However, in practice the investor may want to have a sales contract in place by the end of the 45 day period. After expiration of the 45 day window, the investor can no longer acquire any other property that was not previously identified. In addition, failure to submit the identification letter will cause any exchange agreement to otherwise terminate and the qualified intermediary will remit any unused funds to the investor. This will trigger capital gains tax.
The 180-Day Rule
As discussed previously, the investor has 180 days to close on a replacement property. The replacement property must be closed and the exchange completed no later than the earlier of: (1) 180 days after the transfer of the exchanged property; or (2) the tax return due date (including extensions) for the tax year in which the relinquished property was transferred. No provision or rule exists for the extension of the 180 day rule for hardship or any other situations.
The rules for 1031 exchanges can be complex, so make sure that you utilize a competent qualified intermediary. In addition, a knowledgeable CPA and attorney can help you navigate all the rules and requirements. Considering the benefits of the tax deferred exchange, it can be a wonderful tax planning tool.