What Is a 1031 Exchange and How Can it Save Me Money?
What if the government was willing to give you an interest free loan to invest in real estate?
You’d be calling for the application and hurrying to sign up while the going was good.
Well, the government has actually been making that opportunity available for many years in the form of the IRC Section 1031 tax-deferred exchange, one of the most misunderstood and underutilized sections in all of the tax code.
Myths of Tax Deferred Exchanges
Pursuant to IRC Section 1031, a seller of property that is held for productive use in a trade or business, or for investment (homesteads are excluded), can permanently defer the recognition of capital gains upon the sale of their property.
They can then leverage the present value of the resulting tax savings for future investment. In order to do this, the exchanger must direct the proceeds from the sale of their existing property (the “relinquished” property) to a reputable qualified intermediary.
Then, the qualified intermediary uses those proceeds to purchase a “like-kind” property for the exchanger (the “replacement property”) that is of equal or greater value to the one that the exchanger just sold.
As a general rule, you can safely assume that any real property will qualify as like-kind to any other type of real property for 1031 purposes.
Real estate is real estate, whether it is improved or unimproved, residential rental or commercial, and so on.
It is important, however, to keep in mind that both the relinquished and the replacement properties must be held for investment or for productive use in a trade or business on their respective sides of the exchange.
The 1031 exchange is not a dubious tax shelter scheme nor will participation in a properly structured 1031 Exchange trigger an audit.
To the contrary, IRC Section 1031 is an affirmative section of the tax code that is fully sanctioned by the government, provided that the various IRS guidelines are followed.
Initial skepticism is common but there is actually a rational incentive for the government to provide this tax-break. While it may initially seem that the government is foregoing substantial tax-revenue, more revenue is actually derived from other sources when the disincentive from selling low basis property (the capital gain tax), is removed.
For example, allowing the owner of a growing business to move into a newer and larger manufacturing facility, without a debilitating capital gains tax, facilitates the creation of new jobs which, in turn, generates more income and sales taxes. This growth, in turn, creates more opportunities for that company’s suppliers and its providers of employee benefits and services.
It also generates more title premiums; creates more opportunities for realtor’s commissions; increases transfer tax revenue; and so on and so forth.
This phenomenon is commonly called the “velocity of money.”
Motives for Doing an Exchange
Keep in mind that a tax-deferred exchange is not a reason to sell property. Rather, it is a means by which another goal or purpose can be achieved for a particular investor or business property owner.
Some common motives for doing a 1031 exchange include upgrading into a larger facility for an expanding business; consolidating many smaller properties into one larger facility with less management burdens; diversifying one’s holdings from a single, large facility to a group of smaller ones in different regions; moving investments to a location closer to where the investor lives (or is relocating to); or simply reinvesting into a hotter market.
Every property owner has their own unique perspective and, therefore, the motive for exchanging can be as varied as the property owners themselves.
Whatever the motive, though, a 1031 exchange is considered an essential tax tool to accomplish the desired goal.
The Timing Requirements
The most widely known requirements of the 1031 exchange, even among those with just a cursory knowledge of the code section, are the 45 and 180 day rules.
What these rules refer to are the strict timeframes under which the taxpayer, also known as the “exchanger”, must “identify” potential replacement properties and acquire at least one of the identified properties.
These seemingly simple rules, however, are fraught with pitfalls that can easily jeopardize an exchange.
In a typical delayed exchange, where the exchanger begins by relinquishing property that they already own, the 45 day period to identify replacement property begins running from the date of the closing of title on the exchanger’s relinquished property.
That day is day zero and the next day is day one for both the 45 and 180 day time periods (which run concurrently).
During this 45 day period, the exchanger must specifically identify, in writing, the property or properties that they intend to purchase with the proceeds of their relinquished property.
Furthermore, the identification must be in writing, signed by the exchanger, and delivered to an undisqualified party (usually the qualified intermediary).
If the exchanger fails to identify any properties as “replacement” properties during the 45 day period, the exchange is over and the proceeds of the relinquished property are taxable to the extent that they represent capital gain (Such gains are taxable at the Federal Capital Gains rate plus any applicable State capital gains tax, depending on the location of the “relinquished” property).
Assuming, however, that the exchanger does successfully locate a replacement property or properties, and properly identifies them, the exchanger then has 180 days from the date of the relinquished property closing to close title on the replacement property or properties.
Remember, however, that the 45 and 180 day rules refer to “calendar” days, not “business” days. Therefore, even if the 180th day falls on a national holiday, or if the exchanger is incapacitated or unavailable for some reason, there will be no extensions granted by the IRS.
None. Don’t even ask.
If the closing of title on the replacement property does not occur within 180 days, the exchange is over and, again, the relinquished property proceeds are taxable to the extent that they represent capital gain.
Furthermore, a common pitfall of the 180 day rule is the mistaken assumption by many taxpayers that the 180 day rule is absolute. It is not. In reality, the rule requires that the closing of title on the replacement property must be completed within 180 days OR before the exchanger’s tax return is due or filed (including any extensions.)
This means, for example, that an individual exchanger who commences an exchange on December 1st, in a non-leap-year, would have only 135 days to complete their exchange, instead of the full 180 days.
Worse yet, if the taxpayer were to file their tax return before they closed on their replacement property, the exchange would terminate immediately upon the filing of that return.
The aforementioned tax-deadline predicament is easily resolved by the filing of a request for an automatic extension of time to file a tax return but it’s crucial that the exchanger be aware of the problem and actually does so.
The exchanger should also be aware that there are different tax deadlines for different types of taxpayers.
For example, C and S corporations are generally required to file their tax returns on or before March 15 and will have to consider the implications for the 45 and 180 day rules with respect to that earlier filing date.
A common error in attempting a 1031 exchange is for an exchanger’s attorney to close on their client’s relinquished property, place the proceeds of that sale in their attorney’s escrow account and then contact a qualified intermediary to facilitate the exchange.
Unfortunately, though, under this scenario, the exchange is blown before it’s even begun.
The exchange agreement between the taxpayer and the qualified intermediary must be in place prior to the closing of title on the relinquished property and, if it is not, then no tax deferral is realized.
An even worse scenario would be where the client’s attorney actually facilitates the exchange from start to finish, essentially acting as their client’s intermediary.
It’s easy to see that this is an unacceptable scenario for a tax-deferred exchange since Section 1031 expressly disqualifies the exchanger’s own attorney or CPA, among others, from acting as their intermediary and performing this type of service.
For now, the Qualified Intermediary industry is unregulated. It is, therefore, imperative that the prudent exchanger chooses a reputable, experienced intermediary whose documents and services have routinely withstood IRS scrutiny.
Perhaps even more importantly, though, is that you choose an intermediary that you can be sure is going to be there with your funds when you need them.
Many of the so-called independent intermediaries will provide a guaranty that your funds will be returned but just remember that a guaranty is only as good as the assets that are backing it.
What if that company goes bankrupt while your exchange is in progress or, worse yet, what if the intermediary simply disappears with your seven or eight figure proceeds?
Be aware that this is not an uncommon occurrence so make sure to use an intermediary that is affiliated with a major financial institution
. If a qualified intermediary’s name isn’t one that you readily associate with a reputable and financially stable company then you shouldn’t be using them.