Broker Check

1031

A transaction, properly structured under IRC Section 1031, allows a taxpayer to sell a property, reinvest the proceeds in a new property, and defer all the capital gains taxes. Moreover, it may be possible to never have to pay taxes on the gain.

The IRC States:

“No gain or loss shall be recognized on the exchange of property held for productive use in 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 or trade or business or for investment.” IRC Section 1031 (a)(1).

THE 1031 PROCESS

  • As soon as the exchanger has opened escrow to sell his/her property, you should establish a
    relationship with a Qualified Intermediary (QI) The QI is a necessary party who will facilitate the
    preparation and processing of documents and perform other duties.
  • Notify your real estate agent or attorney to include an “Exchange Cooperation Clause” in the
    purchase and sale agreement.
  • Begin to search for suitable Replacement Property so that you can satisfy the 45-day
    identification requirement. That is, the exchanger has 45 days from the transfer (closing date for
    sale) of the Relinquished Property to identify Replacement Property (or Properties).
  • The “Exchange Period” requirement is that the Replacement Property must be received by the
    exchanger within the earlier of 1)180 calendar days after the sale of the Relinquished Property
    or 2) the due date, including extensions, of the tax return for the Exchanger for the tax year
    when the Relinquished Property was sold.


IDENTIFICATION REQUIREMENTS

The Qualified Intermediary can provide a Form for identifying Replacement Property and provide
guidance on specific information required. Before the end of the identification period (45 days), a
previously submitted Form can be revoked by sending a signed notice to the QI. The following three
identification methods are available:

  • Three Property Rule. The exchanger can identify up to three Replacement Properties without
    any consideration of market value.
  • 200% Rule. The exchanger can identify any number of potential Replacement Properties,
    provided the aggregate fair market value of all of the identified properties does not exceed
    200% of the aggregate fair market value of the Relinquished Property.
  • 95% Rule. An exchanger can identify more than what the 3-property rule or the 200% rule allow
    provided that by the end of the Exchange Period, at least 95% of the aggregate fair market value
    of all the identified properties is acquired. In most case this rule should be avoided because of
    the risk of failure to satisfy the 95% threshold.


VESTING (SAME PERSON OR ENTITY)

  • The general vesting rule is that the taxpayer who is the seller of Relinquished Property must be
    the same taxpayer that buys the Replacement Property.
  • For this purpose, the Exchanger’s revocable living trust or other grantor trust may acquire
    Replacement Property in the name of the Exchanger individually, provided the Trust is a
    disregarded entity for Federal tax purposes.
  • Similarly, the Exchanger may sell property held individually and acquire property in a single
    member LLC, provided the LLC is a disregarded entity for Federal income tax purposes.
  • A husband and wife in a community property state may sell property held individually as
    community property and title Replacement Property in a two-member LLC which is itself
    community property, and provided the LLC is a disregarded entity for Federal tax purposes.
  • There are other vesting issues which may arise. This is particularly true if there are vesting
    changes that may be contemplated at some time before or after the exchange. Tax and legal
    counsel should be consulted.

“LIKE KIND PROPERTY” THAT QUALIFIES FOR REPLACEMENT PROPERTY

  • Virtually any kind of real estate can be exchanged for any other kind of real estate. It could be
    raw land or farmland for an office building, an apartment building for industrial property, retail
    property for oil & gas royalties, etc.
  • Delaware Statutory Trusts (DSTs) qualify for replacement property and make it easy to diversify
    into more than one Replacement Property. We are generally able to offer DSTs which own
    multifamily properties (single property or portfolio), NNN properties leased to major credit
    tenants such as Walgreens, CVS, Dollar Tree), medical buildings (single or portfolio), royalties.
    DSTs make it easier for the exchanger to complete the exchange process:

1. Due diligence has already been performed at different levels by the DST sponsor,
broker-dealer, and third parties who report on the sponsor and the individual
properties.
2. Debt, if any is non-recourse. The DST is obligated; the investors are not.
3. The loan is already in place and can be used as basis for depreciation purposes.
4. Professional management is in place. Investors are relieved from the burdens of
management.
5. Investor can put in any amount over the minimum (usually $100,000 cash). This makes it
possible to invest the exact amount needed to complete the exchange (avoid having to
put in too much or too little cash).
6. Easier to diversify within the time limits into more than one Replacement Property.
7. With completed due diligence, loan in place and management in place, the risk of failure
to identify and acquire replacement property within the time constraints is significantly
reduced.

REPLACEMENT PROPERTY MUST BE OF EQUAL OR GREATER VALUE THAN RELINQUISHED PROPERTY

  • In order to avoid any taxable income from the sale of Relinquished Property, the Replacement
    Property needs to be equal or greater in value than the Relinquished Property.
  • In addition, any debt on the Relinquished Property that is paid off during the exchange, must be
    replaced by debt on the Replacement Property. If the new debt is lower than the debt retired,
    then the Exchanger will have taxable “boot” equal to the amount of debt not replaced.
  • Any cash taken out of the Relinquished Property sales proceeds will be taxable.
  • ZERO. We generally can offer clients a special kind of DST called a “Zero”. This is for Exchangers
    who have a high loan to value on Relinquished property.

NEVER PAY THE DEFERRED TAX
Many clients continue to complete a 1031 exchange over a long period of time in order to continue to
defer taxes and maintain an income producing passive real estate investment. If a 1031 Replacement
Property is held until death, then heirs will receive a step up in cost basis and avoid capital gains taxes.

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