An Overview by Thomas J. Raub CCIM
The tax consequences of the sale of a commercial or investment property may have a significant impact on one's ability to obtain a different property for their business. or investment portfolio. A tax deferred exchange may reduce this impact.
In 1921 a regulation was put in place to establish a method to tax transactions where no dollars were transferred. This regulation is identified by tax code 1031 and is referred to as a 1031 exchange. With the significant tax revisions of 1986 and subsequent follow on tax revisions, this regulation has seen increased use by investors. The potential benefits and restrictions should be considered in all sales of commercial and investment property.
The 1031 exchange is often referred to as a "tax free" exchange. This is a misnomer. For qualifying properties, the 1031 exchange allows a mechanism for deferring taxes due as a result of gain realized on the sale of commercial or investment properties. The amount of taxes deferred is dependent on the value of properties exchanged. If a higher value property is exchanged for one of lesser value and therefore cash (or personal property) is included to compensate for this difference in value, capital gains tax would be due at closing for that portion that was not real property.
As an example, a person has a property valued at $500,000 that has $400,000 of equity and wishes to downsize to a smaller property that is valued at $350,000. Since the properties are not of equal value the transaction includes $150,000 in cash in addition to the $350,000 property. Gain realized on the sale is $400,000, all of which would be taxable in year of sale in normal sale transactions. With a 1031 exchange, taxes would be due in the year of the transaction on the $150,000 cash (referred to as boot) and the taxes on the $250,000 portion of the gain would be deferred until the new property was sold, or further deferred if another 1031 exchange was done at that time.
While the intent of this article is to "simplify" the details of a 1031 exchange, requirements and tax consequences, it is not meant to imply that this is a simple subject or transaction. Prior to electing this method, counsel with a commercial real estate agent, attorney, and accountant familiar with the specifics of a 1031 transaction is highly recommended. There are steps and a sequence of events, that if not followed, will require the transaction to be considered an outright sale rather than a 1031 exchange. These steps, once taken, cannot be rescinded.
To qualify for an exchange, several conditions must be met:
· Properties are exchanged.
· Both properties are of "like kind." This does not mean apartment house for apartment house, land for land, but rather real property for real property. Securities and similar items are excluded from 1031 transactions.
· Relinquished property held for productive use in a trade, or business, or for investment.
· Replacement property will also be held for productive use in a trade or business or investment.
Based on the above exchange qualifications, many situations warrant consideration of "exchanging" properties rather than sale or merely retaining existing property. They include:
· Current property has large equity and therefore large capital gain if sold
· Desire to gain more leverage from equity
· Need to diversify investments
· Geographical move
· Need to have asset with better borrowing power (from raw land to improved property)
· Acquire a larger property than possible if previously owned property has been sold, taxes paid, then remaining cash used to purchase new property
The ideal 1031 transaction is when two properties of equal value are exchanged, between two interested parties, with no cash, personal property or other considerations (all referred to as "boot") involved. Value inthis case does not necessarily refer to market value of the property, but rather value to the parties involved in the exchange. If properties are exchanged with no boot, they may considered to be of equal value by the IRS for purposes of establishing Basis (cost of property) used for future capital gain calculations. In this ideal scenario, the closing is similar to a conventional closing with the exception of appropriate wording in the documentation that a 1031 transaction is being executed.
A more likely scenario is a three party (or more) transaction, referred to as "Starker" exchange, where the investor (person wanting to do an exchange) has a buyer for his property that does not have a property desired by the investor or may not have a property at all, only cash. In this situation , a third party has the property desired by the investor and so is made part of this exchange. In this exchange, the process must proceed in a very specific manner to insure that all IRS conditions for the exchange are satisfied. This exchange may either be simultaneous or delayed.
Most three party exchanges and all delayed exchanges involve the use of another party to the exchange typically referred to as: Qualified Intermediary, Facilitator or Accommodator. The intermediary acts to facilitate a deferred exchange by entering into an agreement with the investor for the exchange of properties. The intermediary must be a disinterested party to the transaction, complying with strict IRS guidelines regarding associations with the parties involved.
In a delayed exchange, there are time limits that apply. These limits must be followed to the letter with no grace periods for weekends, holidays, etc. Once the investor property has been relinquished, two clocks start.
The first is a 45 day identification period that the investor has to identify the property to be obtained in the exchange. The investor may identify more than one property (if more than 3, the aggregate value must not be more than 200% of the fair market value of the relinquished property).
The second is a 180 day period. The investor must receive the identified replacement property within the earlier of 180 days from the closing on the relinquished property or the due date for the investor's tax return (including extensions).
During the above time periods, funds received from the relinquished property are held by the intermediary. There can be no actual receipt, construed receipt, or control of these funds by the investor. Such action would cause the original transaction to be considered a sale with appropriate capital gains taxes due and no ability to do a 1031 exchange involving that property:
In summary, 1031 exchanges are another technique available to the investor. The more equity you have in the property to be relinquished, the more potential there is for the 1031 to be a viable alternative to a normal sale transaction. The 1031 exchange is more complex, will incorporate more administrative costs and must ensure that very specific documentation and procedures are followed. The value of obtaining skilled advice, as mentioned earlier in this article, cannot be overemphasized.
The intent of the above article is to provide a conceptual overview of 1031 exchanges and how you might benefit from them. Space does not permit a more detailed account and therefore all requirements and specifics for a 1031 exchange have not been included.
This information is provided for reference purposes only. You may want to consult with legal counsel on current Vermont State laws.
