Since the 1920s, property owners could trade investment property on a tax-free basis. The only catch was that you had to find someone to trade properties with you simultaneously. Mr. Starker had investment property he wanted to trade, but no one to trade with, so being resourceful, he sold his investment property and immediately used all of the proceeds to buy another, claiming that he had really traded the property, that his investment was converted to tangible funds for only a short period of time, and that should not be counted against him for tax purposes.
IRS did not agree, and they
demanded he pay the profits on his sale.
This result was challenged by Starker and he eventually won,
successfully deferring his profits from his sale.
In order to address this result, Congress approved a revision to the Tax Code to authorize “Tax Free Exchanges” for certain types of real and personal property. This code section created a labyrinth of regulation, requirements, issues and strict timelines that must be complied with for a successful tax-free exchange.
The most common 1031 exchange is the sale of real estate with all the proceeds used to buy new investment property. For example, Mr. Jones owns a building in Scranton that he bought for $100,000. Assuming no depreciation or capital improvements, his purchase price is his basis in the property which he wants to sell, which is often referred to as the “relinquished property.”
In 2019 Mr. Jones’ building is now worth 1.6 million dollars. If he sells and pockets the money, he will owe almost $225-300k in capital gains taxes. However, if Mr. Jones uses the proceeds from the sale to buy a building in Florida, he can defer all the tax due.
Note this is not tax avoidance, because the new apartment in Florida, called the “replacement property” will also have a basis of $100,000. When it is sold in the future, the gain will be recaptured.
In order to effectuate a 1031 exchange, a seller of relinquished property must enter into an exchange agreement with an independent third party prior to closing, called a Qualified Intermediary. Once the relinquished property is sold, the net proceeds must be directly delivered to the QI. In no case can the money go to the Seller or his agents, as the fiction of “no control” over the sale proceeds is required to protect the tax-free exchange.
Within 45 days of the sale of the relinquished property, the Seller must identify the replacement property by written notice to the QI. Up to 3 properties can be identified without special consequences.
The seller has 180 days to close on the identified property(ies), with the monies held in escrow by the QI transferred directly to the seller of the replacement property. If the closing is not timely completed the exchange fails, and the tax becomes due. Please note that if the 180-day window overlaps April 15, you must file for an extension, or your window will be terminate on April 15.
When originally promulgated, 1031 exchanges required deeding of the relinquished and replacement properties to the QI, resulting in extra costs and potential title issues. However, the
IRS now allows direct deeding, which eliminates this
step. However, the QI should still be
listed as the seller or buyer on your closing statement, to reflect the
exchange status of the transaction.
While 1031 exchanges are limited to investment property, it does not mean that you can not invest in residential real estate. For example, if you are selling investment property with a large gain, it is permissible to complete and exchange that property for a residence in Florida, so long as your initial intent is to use same as an investment property. While there are no promulgated time periods for establishing investment intent, the property should be rented for at least two or more years in a true, arms length fashion, to avoid an
IRS challenge before you take personal residency of
the replacement property.
1031 exchanges are not limited to equal swaps of value. You can make a partial deferment by buying a lesser value property, with the taxes prorated on the percentage difference in value between the relinquished and the replacement property. 1031 exchange proceeds can be used to leverage more than one replacement property and can be used to acquire a slice of a much more expensive property, in the form of tenants in common purchase.
One key element of 1031 exchanges are the strict timelines relating to the time frames. These are strictly applied and exchanges outside these periods will be rejected. Reverse exchanges are also permitted, allowing the acquisition of the replacement property up to 180 days before the sale of the relinquished property.
As exchanges are complicated, the cost of completing an exchange may make the benefit of deferral of taxes less enticing. Our firm charges approximately $1,000.00 for a simple exchange, plus costs. In addition, there are extra accounting charges for exchanges, and your sale proceeds will be tied up at least 180 days, usually without interest, during the exchange period. Therefore, a well thought out exchange strategy, including a thorough tax analysis, should be made prior to proceeding with an exchange.