Mastering and Understanding the 1031 Exchange
By Aileen Torrens, Real Estate Closings, Transactions, & Litigation Attorney.
Many prospective investors/exchangers shy away from the 1031 Exchange, simply due to the lack of understanding of the confusing terms and conditions for entering into the exchange. However, the 1031 Exchange is certainly one of the most valuable and under-utilized tax breaks currently out there for investors. By understanding the following basic concepts and utilizing a team of professionals to guide you along the way, you may find yourself entering into the 1031 Exchange world.
1. General Concept & Benefits: The 1031 Exchange was created with the intent that no gain or loss should occur if a property is exchanged for the purpose of productive use in a trade or business or for investment when the exchange is “like in kind” and is exchanged for the same purpose. The 1031 Exchange shelters and allows the investor/exchanger to defer the capital gain tax when the profit from a sale of investment property is used immediately and within certain set time frames for re-investment with the same intended use of investment or for business. Below are the basic guidelines and rules so that you can begin to grasp the concepts of a 1031 Exchange.
2. Like in Kind: This term is probably one of the most confused terms when first learning about a 1031 exchange. The common misconception is that the property must be similar in the type of property (i.e. lot, condominium, duplex, commercial, and rental single family home). However, like in kind, instead means similar use of the property. Therefore, the property being exchanged and the new property being obtained must both be utilized for similar purposes and with the same intent. Like in Kind refers to utilization for business or investment.
This means that a lot may be sold and the profits used to purchase a rental home. That home can later be sold and the profits used to purchase a condominium property. The following two kinds of properties cannot be used for an exchange: (1) a primary residence or homestead residence. The reason, being that the intended use is to reside primarily in the home and not for investment or business. (2) flip properties. The reason being that when a property is immediately flipped this is regarded as only intended to be held for re-sale and not to be held for investments.
Therefore, like in kind really means same intended use, which must be for investment intentions.
3. Time Frames: The 1031 Exchange does have strict time lines that must be followed to avoid losing the tax benefit. These time frames both are run using calendar days. This means that all days including weekends and holidays do count for the total amount of days. The following are two main time frames that run simultaneously:
a) The 45 day identification period to identify replacement property: The 45 day identification period requires that within 45 days from the date of the closing on the sale of the relinquished property, a new property (replacement property) for the purchase or exchange must be identified. For purposes of identification this means that you must clearly identify the property by address, legal description, parcel identification or any other standard clear identification for the property. It is best to use all these descriptions for identification purposes. If a contract is not entered by 12am of the 45th day, the 1031 classification is lost. The 1031 allows up to 3 properties to be identified without taking into account the values of the 3 properties. However, if more than 3 properties are identified, then the IRS requires that the value of the properties being purchased be less than 2 times the amount of the property being sold.
b) The 180 closing on the replacement property: The 180 day closing requirement period begins to toll on the day of closing the sale of the replacement property. This requires that closing take place before or on the 180th day. This time line is a strict one, which does not allow for extensions for any reason, including lender delays. Therefore, today in light of the new Closing Disclosure Requirements, it is highly advised that the property set to close with sufficient time to avoid loss of classification under the 1031, which will occur should the 180 days lapse.
These two periods run simultaneously and the closing of the new property before or on the 180th day must be identified in the 45 day identification requirement.
4. Arms Length and Exact Title Exchange: The transaction must be Arms Length. The transaction must also have the exact title names on both the relinquished property as Seller and the replacement property as a Buyer. This means that the deed must be taken with the same person’s name that sold the first property. Therefore, if husband and wife own an investment condo and sell under a 1031, the new property for 1031 exchange should be purchased by both husband and wife. The same will occur if a corporation or trust enters into a 1031 sale wherein they will need to purchase as that same corporation or trust name.
5. Values & Calculations: There are two main requirements for values of the 1031 Exchange:
(1) The replacement property must have equal or greater fair market value as the relinquished one. Therefore, the investment value should either stay the same or should increase if your goal is to have 100% of the gain deferred.
(2) No cash profits may be pocketed. The amount of cash to the Seller on the Settlement Statement after closing costs and fees are deducted, cannot be pocketed by the Seller. This must be set aside and held by a Qualified Intermediary for reinvestment. Any amount of cash profits pocketed will be taxed.
Allowed Cost deductions: All closing costs and payoffs on mortgages will be reduced from profits of the sale. Additionally, Capital Improvements may be deducted from the Net Profits only if done 180 days prior to the transaction. For example, if a 1031 Seller has completed a second floor to an investment property, within 180 days prior to the 1031 Sale, then he may use this as a deductable cost on the exchange. Also, 15% of purchase costs against Personal Property may also be deducted from profit.
6. The team of Professionals: Intermediaries, Attorneys, and CPAs:
The IRS requires the investor/exchanger to use a middle man to hold the monies pending next investment to occur within the time lines above. This middle man is known as a Qualified Intermediary. That intermediary’s job is to hold the monies in escrow (interest to be kept by investor and taxed as personal income) and prepare necessary IRS documents, including an Exchange Agreement.
Attorneys can assist by reviewing the Agreements and Exchange Documents to review for accuracy. Not properly preparing these documents will lead to loss of the deferment and 1031 classification. Attorneys may also act as Qualified Intermediaries and may prepare all title closings to ensure that the closing take place within the required time frames. Also, an attorney is recommended to prepare the closing deeds and ensure that the names are proper.
CPA advice is highly recommended. There are many additional facts that should be reviewed to your personal situation prior to doing a 1031 Exchange.
7. Contract Language: Contract language must provide for assignability under the Purchase and Sale Agreement. This way a Qualified Intermediary may be assigned as the Seller/Buyer with the final deed being under the Investor/Exchanger’s name. A disclosure is needed in the Purchase and Sale Agreement, as well as notifying the other party of your intentions to use a 1031 Exchange.
8. Excluded property: The following property is excluded from the 1031 Treatment: Stocks, bonds, notes, stock in trade, partnership interests, trust certificates, contract assignments, flip intention properties, and primary home.
However, a 1031 may be converted from an investment property to a primary home after 5 years and so long as the investor has lived there for at least 2 non consecutive years.
9. Benefits: 1031 Exchange taxes are deferred to the future to be only taxed when that investor/exchanger sells the property with the intention and end result of keeping the cash profits. Capital Gains Tax is eliminated at the time of death. There is a step-up basis for heirs upon death of the investor/exchanger. It also allows an investor to change course of investments with market changes and to diversify their portfolio. This allows for making better suited investments and deferring tax liability on these investments for a period as long as a person’s life.