An Overview of Several Requirements for Tax Deferral
WHAT IS IRC SECTION 1031?
Section 1031 of the Internal Revenue Code allows an owner of investment property to exchange property and defer paying federal and state capital gain taxes (20%+ applicable state taxes) if they purchase a “like-kind” property following the rules and regulations of the Internal Revenue Code. This allows investors to use all of their proceeds from their sale to leverage into more valuable real estate, increase cash flow, diversify into other properties, reduce management or consolidate into one property.
What is “Like-Kind” Property?
There is some confusion regarding what type of property qualifies for a §1031 tax deferred exchange. The Internal Revenue Code Section 1031 states that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” “Like-Kind” property can include, but is not limited to, any of the following, provided it is held for investment:
- Single Family Rental
- Commercial Property
- Raw Land
For example, a single family rental can be exchanged for raw land, or apartments or a commercial building. In addition, properties can be exchanged anywhere within the United States.
Does an Exchange need to be simultaneous?
No, contrary to what most owners envision, a §1031 tax deferred exchange is rarely a two-party swap. Most exchanges are delayed exchanges, whereby the Exchanger has 180 days between the sale of the relinquished property and the closing of their replacement property. They must identify the potential replacement property(s) within 45 days from closing on their relinquished property.
When is a §1031 Exchange Applicable?
It is applicable whenever a property owner intends to SELL any property that is not their primary residence (and falls under the definition of “like-kind”) and plans to BUY another “like-kind” property within 180 calendar days following the closing of their relinquished property. Paramount to any exchange is a competent and experienced Intermediary. Asset Preservation is the entity which structures, consults, guides and documents the exchange transaction from beginning to end.
An Introduction to §1031 Exchanges
Exchanges are a Powerful Tax Strategy
What does investing in real estate have in common with the game of Monopoly? Winning at both requires acquiring the most valuable real estate by trading less desirable properties for more attractive ones. For real estate investors, it’s easier to finish a winner by understanding the benefits of Internal Revenue Code Section 1031 tax deferred exchanges. By utilizing this powerful tax strategy, property owners no longer need to leave the outcome up to “Chance.”
Tax deferred exchanges have been a part of the tax code since 1921 and are one of the last significant tax advantages remaining for real estate investors. One of the key advantages of a §1031 exchange is the ability to dispose of a property without incurring a capital gain tax liability, thereby allowing the earning power of the deferred taxes to work for the benefit of the investor (Exchanger) instead of the government. In essence, it can be considered an interest-free loan from the IRS.
Basic Tax Deferred Exchange Requirements
Although many investors mistakenly believe an exchange is simply a “swap” of properties, most exchanges completed in the 1990s are variations of what is called a “delayed” exchange. In a delayed exchange under Section 1031, the property currently owned is called the “relinquished” property and must be exchanged for like-kind “replacement” property. The IRS allows up to 180 days between the sale of the relinquished property and the purchase of the replacement property. There are a number of requirements which need to be met to qualify for tax deferral under the tax code:
Requirement #1: Both the “relinquished” and “replacement” properties must be held for investment or used in a business. The IRS uses the term “like-kind” to describe the type of properties that qualify. Any property held for investment can be exchanged for any other “like-kind” property held for investment. This definition covers a vast variety of developed and undeveloped real estate. Properties which are clearly not like-kind are an investor’s primary residence or property “held for sale.” The relinquished and replacement properties need not have identical functions (I.e both be residential rentals or commercial strip centers). For example:
- Stewart owns two residential duplexes in Fort Worth. He can sell them, buy three residential duplexes in Dallas, and not pay tax on the gain from his Fort Worth properties; or
- Stewart owns five acres of undeveloped farmland in Denton County. He can sell it, buy a 12-unit garden apartment building in Houston, and not pay tax on the gain from his Denton County property; or
- Stewart owns three rental homes in California. He can sell them, buy a retail store in Plano, and not pay tax on the gain from his California properties.
Requirement #2: The IRS requires an investor to identify the replacement property(s) within 45 days from closing on the sale of a relinquished property. The 45 Day Identification Period begins on the closing date, and the replacement property(s) must be properly identified in a letter signed by the Exchanger and received by the Qualified Intermediary.
Exchangers have a number of ways to properly identify properties. They may identify up to three target properties without regard to their total fair market value (Three Property Rule). Alternatively, they can identify an unlimited number of replacement properties, if the total fair market value of all properties is not more than twice the value of the property sold (200% Rule). As a final option, an Exchanger can break both of these rules if they acquire 95% of the aggregate fair market value of all identified replacement properties.
Requirement #3: Close on the replacement property by the earliest of either: 180 calendar days after closing on the sale of the relinquished property or the due date for filing the tax return for the year in which the relinquished property was sold (unless an automatic filing-extension has been obtained). Example: If an Exchanger closes on the relinquished property on December 27, the 180 day period will end after April 15 (Tax Day). In this case, they would have to close on the replacement property (or request an extension of time to file their taxes) by April 15. Exchangers may choose to close both transactions within a shorter period of time, thereby avoiding the potential hardship of the 45/180 day time limits.
Requirement #4: The most common exchange format, the delayed exchange, requires investors to work with an IRS-approved middleman called a “Qualified Intermediary.” The Qualified Intermediary actually documents the exchange by preparing the necessary paperwork (Exchange Agreements), holding proceeds on behalf of the Exchanger, and structuring the sale of the relinquished property and purchase of the replacement property.
Note: To defer all capital gains taxes, an Exchanger must buy a property or properties of equal or greater value (net of closing costs), reinvesting all net proceeds from the sale of the relinquished property. Any funds not reinvested, or any reduction in debt liabilities not made up for with additional cash from the Exchanger, is considered “boot” and is taxable. Example: Stewart sells his duplex, which he held for investment, for $160,000. A hundred days later he closes on a different duplex, which he will hold for investment, for $110,000. Stewart banks the $50,000 in excess funds for his child’s education. Stewart must pay capital gain taxes on $50,000. (In this example, Stewart chose to take some money out of his exchange and pay the tax.)
When Are Capital Gain Taxes Paid?
Maybe never. Many investors mistakenly believe they will “have to pay the taxes sometime” so they might as well just sell. Quite often, this is a bad decision. The tax on an exchange is deferred into the future and is only recognized when an investor actually sells the property for cash instead of performing an exchange. Investors can continue to exchange properties as often and for as long as they wish, thus moving up to better investments and putting off the taxes for many years. The extra purchasing power generated by deferring the taxes will produce increased income and a larger investment holdings.
Unlike those playing Monopoly, real estate investors don’t have to depend upon a “roll of the dice” to pass GO and collect more money. Property owners should utilize tax deferred exchanges to acquire the desirable “Boardwalk” and “Park Place” properties and win the investment game!
What Language Should be Added to the Contract in An Exchange?
Although many Exchangers include language in their Purchase and Sale Agreement establishing their intent to perform on exchange, it is not required by the Internal Revenue Code.
Contracts SHOULD be Assignable
It is important, however, that the Purchase and Sale Agreements for both properties be assignable. In order to structure a typical exchange transaction, Asset Preservation must be assigned in as the Seller of the relinquished property and also as the Buyer of the replacement property.
An Exchanger should review the contract to confirm they are not prohibited from assigning their position as either a “Seller” or “Buyer” to a Qualified Intermediary. When a typical exchange is initiated by Asset Preservation, we are shown as the Seller on the Settlement Statement instead of the Exchanger being reflected as the Seller.
The verbiage below is satisfactory in establishing the Exchanger’s intent to perform a tax deferred exchange and releases the other parties from costs or liabilities as a result the exchange:
Sale of Relinquished Property
“Buyer is aware that Seller intends to perform an IRC Section 1031 tax deferred exchange. Seller requests Buyer’s cooperation in such an exchange and agrees to hold Buyer harmless from any and all claims, costs, liabilities, or delays in time resulting from such an exchange. Buyer agrees to an assignment of this contract by the Seller.”
Purchase of Replacement Property
“Seller is aware that Buyer intends to perform an IRC Section 1031 tax deferred exchange. Buyer requests Seller’s cooperation in such an exchange and agrees to hold Seller harmless from any and all claims, costs, liabilities, or delays in time resulting from such an exchange. Seller agrees to an assignment of this contract by the Buyer.”
Many Exchangers and real estate agents add exchange language to the contract for two reasons:
It establishes their intent to perform a 1031 tax deferred exchange;
To notify the other party in advance of the need to assign the contract to an Intermediary.
“LAST MINUTE” EXCHANGES ARE POSSIBLE!
Even if no language was included, many real estate investors contact our office just minutes before closing on their transaction and successfully convert a sale into an exchange. In most situations, a successful exchange can be accomplished as long as Asset Preservation is contacted prior to closing.
This information is not intended to replace qualified legal and/or tax advisors. Every taxpayer should review their specific transaction with their own legal and/or tax counsel. © 2000 Asset Preservation, Inc.