1031 Exchange
Overview:
Investments are made expressly for the purpose of making a profit. The ultimate goal is that at some point you will sell the asset for more money than you’ve invested. Real estate investing, no matter how large or small, affords several avenues to take your profit out of the deal. The tax consequence of each approach is quite different.
You could simply sell the property and pay tax on the gains. This is the most straightforward method of taking your profits, but is typically the most expensive.
Currently the Federal Capital Gains rate is 15%. If the property has been held for less than 12 months the rate is your ordinary income tax rate, which can be as high as 36%. In the case of depreciable property (such as rental or industrial property) there are additional taxes due. Over the period you have owned the property, you have taken a depreciation deduction each year against your ordinary income. Now that you are selling the property the Federal Government will be recapturing the revenue they didn’t receive from you over the years you had the property in service. This recapture is taxed basically at your ordinary income tax rate. In addition to what you will owe the Federal Government you will also have New York State income taxes to pay.
Depending how long you’ve held the property and the dollar amount of the improvements that have been added to your cost base, you could have a substantial exposure to capital gains tax. Obviously, the first thing that’s done when addressing the issue of taking your profit out of the deal is to have a long talk with your accountant. You should have an idea of your tax bill before considering selling the property.
If you feel this property is still a good investment but need money for other purposes, refinancing the property becomes a viable option. If you’ve owned the property for some time, you probably can net out the same amount of cash through refinancing as you could through selling it. You can safely refinance the property for 70% to 75% of the value of the property, take the proceeds, pay no capital gains tax since you didn’t sell it and still have the property in your portfolio. This is a sensible way of going if your are happy with the investment you’ve made in this property and see it increasing in value going forward. If you’re not happy with the property or have become negative to the prospects of continued appreciation, then refinancing would not be the best course of action.
There is a third option. If you plan on making another real estate investment and don’t want to hold on to this particular piece, you can execute a 1031 tax-deferred exchange. Section 1031 of the Internal Revenue Code allows property owners to exchange their property for other like-kind property. This makes it possible to transfer the financial gain that is realized from the sale of a property into another property.
There are strict rules that need to be followed in order for the exchange to qualify for this preferential tax treatment. Before considering this approach you should continue your discussion with your accountant. If he agrees that this is the way to go, then work closely with him and your attorney to be sure your execution is properly done.
For a property to qualify for the exchange it first needs to show that it was being held for the productive use in a trade of business or was being held for investment. It can’t be your primary residence or your vacation home. The property you are trading off is called the relinquished property.
Your goal is to take the relinquished property and trade it for the replacement property or properties. The replacement property must be of like kind. All this means is that it must be a property that you will be using for business or investment purposes. You can exchange a residential property for a commercial property, a hotel for a shopping center, etc.
The sale must be executed through the use of a Qualified Intermediary, establishing special trusts or special security and guarantee arrangements. At no point during the transaction can any of the proceeds of sale get into the investor’s hands. The Qualified Intermediary can serve in no other capacity and must be completely independent from you. In other words, a family member would not be eligible to function in this capacity.
Section 1031 requires an actual exchange of properties. If you simply sell your property and reinvest the money in another property, you will not qualify for exchange treatment, even if it is a simultaneous close. This type of transaction will result in “Constructive Receipt”.
Constructive receipt occurs when you have the funds in a position in which you may draw on them, direct their usage, or give notice of intention to withdraw. In other words, you must not have control of the funds. If you have any type of control on the funds or control over the person holding the funds, you will be considered to have constructive receipt. When the Qualified Intermediary is holding your funds you are not in constructive receipt because control over this money is subject to a substantial limitation or restriction. You are in constructive receipt at the time such limitations or restrictions lapse, expire, or are waived. The Qualified Intermediary is an independent organization whose only contract with you is to prepare the exchange documents and hold the cash proceeds from the sale
of the relinquished property, nothing else. It cannot serve as your attorney, accountant or any other agent of yours.
The proper procedure you need to follow is this. You find a buyer for your property. You then close on the sale, but the proceeds of sale are given to the Qualified Intermediary not to you. You then have 45 days to identify the replacement property to the Intermediary. The Intermediary has 180 days from closing on the relinquished property to close on the replacement property unless the tax return is due for the investor first. Then that date becomes the deadline.
The replacement property must be of equal or greater value than the relinquished property. There can be more than one replacement property. You can:
· identify up to 3 properties up to any value
· identify any number of properties as long as the value doesn’t exceed twice the sale price of the relinquished property. (Remember we are talking about the identifying stage; the sale price or prices have not been negotiated yet.)
· identify any number of properties as long as you close and take title to 95% of the value of such properties.
All the proceeds of sale from the relinquished property need to be invested in the replacement property. Remember you are not being relieved of your tax bill, you are just deffering it. When the time comes and you finally sell the replacement property, without doing another 1031 exchange, the capital gains tax is calculated the same as in any other sale. You need to establish the cost basis on the new property at the time of sale.
The basis on the new property starts with the basis transferred from the old property. That is the original purchase price, plus the transaction costs at the time of purchase, plus the cost of any improvements, less any depreciation that was taken over the years. We then add in the difference between the sale price of the old relinquished property and the new replacement property, minus the deprecation on the new replacement property. It is on this number that the capital gains tax is calculated.
History:
The origins of tax-deferred exchanges go back to The Revenue Act of 1918. This was the first income tax code and it did not specifically allow for any type of tax deferring exchange. To accommodate the needs of farmers, exceptions began to be granted so they could swap parcels of land among themselves to make their farms more productive. The Revenue Act of 1921 was the first time tax-deferred exchanges were formally authorized by the government. This was a much more liberal tax code than we have today. It allowed for exchanges of like-kind as well as non-like-kind assets. Even securities could be exchanged.
The exchange rules were cleaned up with the adoption of the Revenue Act of 1924. This act limited the use of tax-deferred exchanges to like-kind properties. In 1954 the tax code was amended moving the requirements for tax-deferred exchanges to Section 1031 and adopted the framework of our present day structure.
The Deficit Reduction Act of 1984 codified the rules governing a tax-deferred exchange adopting the 45 and 180 calendar day rules. The next significant revision to this section occurred in 1989. The Revenue Reconciliation Act of 1989 made 2 major revisions. First, it eliminated the ability to use a tax-deferred exchange between domestic and foreign properties. Second, it created a 2-year holding period requirement for 1031 exchanges involving related parties.
Major Guidelines:
The property that the owner is selling must qualify as business or investment property. Dealer property or property considered as inventory is not applicable. A property that is being “flipped” would not qualify for a 1031 exchange. Neither would a primary residence or a vacation home meet the requirement.
Only the gain on the net proceeds of sale needs to be reinvested in the replacement property. The net proceeds is defined as the sales price of the property less all transactional expenses paid by the seller at closing. If the replacement property is not of the same or greater value tax will be due on the shortfall. The IRS calls this “boot”.
The mortgage on the replacement property must be equal to or greater than the mortgage that was on the relinquished property at the time of the sale. If the mortgage taken out on the replacement property is greater than the existing mortgage that was on the relinquished property the difference is considered boot and taxes will be owed on that difference. If you are looking to take cash out of the transaction, the way to do it is to place a mortgage on the property after title is transferred from the Intermediary to you.
The same ownership entity that sold the relinquished property must become the owner of the replacement property. Whatever taxpayer id number was used for IRS filings on the relinquished property must be the same id number that is associated with the replacement property. This is why a tax-deferred exchange cannot be used when a partnership is breaking up. In order to take advantage of a 1031 exchange, a partnership would need to convert to a Tenancy in Common form of ownership, wait 2 years to conform with the holding period requirement of related parties, and then execute the 1031 exchange. Tenancy in Common is defined as an undivided fractional ownership of real estate. Each owner has his own deed and therefore an owner can pass through the exchange since he can now use the same tax id number.
Exchanges can be executed either through a forward exchange or a reverse exchange. Until now we have been addressing forward exchanges, where the relinquished property is sold prior to the purchase of the replacement property. It is possible to acquire the replacement property first. This is called a reverse exchange. In 2000 the IRS published Revenue Procedure 2000-37 in which they set the guidelines to properly execute a reverse exchange. This procedure details the requirements of a “Parking Arrangement”. That is a mechanism by which the Qualified Intermediary acquires the replacement property holding or “parking” it while waiting for the relinquished property transaction to close.
The procedure works like this. First, the Qualified Intermediary either creates an “Accommodation Titleholder” or takes title in its own name. This entity then takes title to the property. Second, a “qualified exchange accommodation agreement” must be entered into within 5 days. This agreement commits the Accommodation Titleholder to report to the IRS that it is the owner of the property and files tax returns reflecting all income and expenses related to the property. It specifies that the property be parked for the purpose of completing a 1031 exchange within 180 days of taking title. Third, the relinquished property must be identified to the Qualified Intermediary within 45 days of the Accommodation Titleholder taking ownership of the replacement property.
The Accommodation Titleholder is an independent entity of the principal in the transaction. This means that the principal can lend money to the Titleholder in order to purchase and or renovate the replacement property. He can lease the property from the Titleholder. He can be paid a management fee for managing the property for the Accommodation Titleholder. He can build on or renovate the property. Whatever the principal does, he needs to make sure that property is transferred to him within the 180 day window or he will not qualify for the exchange.
Construction Exchange:
A 1031 exchange can also be used to construct or substantially rehabilitate a property. The biggest obstacle however is that you need to comply with the 180 day timeframe. The procedure here is similar to the reverse exchange. The property is parked during the construction phase. Proceeds of the sale or the relinquished property is held by the Intermediary and released to the Titleholder to pay the contractors. Once all the proceeds of sale are spent, the property can now be transferred from the Titleholder to the principal completing the exchange.
The 1031 tax-deferred exchange allows the real estate investor the flexibility to modify his real estate holding to best suite his investment objectives without exposing himself to capital gains tax. It also has the effect of keeping real estate values strong. An investor has little incentive to sell off real estate holdings. If he does, he is obligated to share a substantial share of his profits with the IRS. This limits the number of properties that actually come to market. In addition there is another effect. When an investor starts the exchange process in motion, he is forced to move quickly. If he doesn’t complete the transaction within 180 days he loses all the benefits of the exchange. This forces him to be less aggressive in negotiating the purchase price on the replacement property. He will choose to pay a higher price in order to control the timing of the purchase
transaction. He’s got too much to loose if he closes on the 181st day.
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