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.
Unfortunately,
the 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.
