Overview of 1031 IRC Tax Deferred Exchanges

By: David W. Hotes, Esquire and David T. Wagner, Esquire

The IRS permits the deferral of tax assessed against the gain on the sale of investment property if that investment property is “exchanged” for other investment property (a “Like-Kind Exchange”). Such Like-Kind Exchanges are allowed pursuant to Section 1031 of the Internal Revenue Code and the regulations promulgated thereunder. It is important to note that this technique, which may be referred to as a 1031 exchange, a deferred-tax exchange or a like-kind exchange, allows only for the deferral of such underlying tax and not the exclusion thereof. However, successive exchanges are allowed, such that tax on gain will not be levied until liquidation of the investment.

The rationale for a deferral of taxation is that the exchange constitutes a continuation of the taxpayer’s investment. Therefore, the intent and motivation of the transaction must be consistent with a continuation.

A Like-Kind Exchange may be used by individuals or entities (each, a “Taxpayer”) when selling investment real estate or other assets which are held for productive use in a trade or business but not inventory. The term “1031” is commonly used, but many aspects and implications of utilizing this tax deferral strategy are not always thoroughly understood. We do not attempt to cover all of the bases in this primer and advise that any Taxpayers contemplating a Like-Kind Exchange seek the counsel of their attorney and/or accountant prior to engaging in this type of transaction. Though there is a great deal of flexibility in the structuring of these transactions, certain hard and fast rules do exist, so caution and prudence in planning and implementing a Like-Kind Exchange is warranted.

To begin with, a Taxpayer should calculate the amount of gain on the investment property targeted to be sold (the “Relinquished Property”) that is subject to tax. Generally, that “Gain” will be equal to the “Adjusted Sales Price” less the “Basis” in the property. The Adjusted Sales Price is equal to the gross sales price less allowable closing costs and commissions, and the Basis is equal to the historical price the Taxpayer paid for the property, plus allowable closing costs and capital improvements made to the property, less all allowable depreciation (whether deducted or not). This Gain will be comprised of two components: (i) prior depreciation, which will be “recaptured” and taxed as ordinary income; and (ii) the remainder, which will be taxed at the preferential long-term capital gains rate of 15% (provided the Relinquished Property was held for greater than one year). Note that the amount of the Taxpayer’s mortgage or any other loan secured by the Relinquished Property, whether it is a purchase-money mortgage or a refinance mortgage, has no bearing on the calculation of Gain.

Currently, the tax rate on long term capital gains is at a historic low. Therefore, the determination of whether or not to enter into a Like-Kind Exchange should include a detailed analysis of the Taxpayer’s future plans with respect to real estate investing and a calculation of the actual tax consequences of a regular sale of the Relinquished Property. While the Taxpayer may be “saving” money now by simply not paying tax, in the event that the capital gain tax rates are increased by subsequent legislation (which is all but guaranteed), the Taxpayer may ultimately have increased its overall tax burden, even after factoring in time value of money concepts.

The IRS has established guidelines which, if followed, will qualify the transaction for tax-deferred treatment without excess scrutiny. Below are the general guidelines for a basic, forward-looking Like-Kind Exchange which must be followed to fit within the “Safe Harbor” established by the IRS:

• A. Use of Relinquished Property. The Relinquished Property must have been used for business or investment purposes and not inventory;
  
• B. Funds Directly Into Escrow. The proceeds from the sale (the “Exchange Funds”) must be deposited directly with a Qualified Intermediary (“QI”) by the title company. The Taxpayer is not permitted access to or control over the proceeds. Generally, this means that the Taxpayer’s attorney, accountant or any other related party cannot act as the QI.
  
• C. Identification Within 45 Days. The Taxpayer must identify, in writing, potential “Replacement Property(ies)” within 45 days of the date of sale of the Relinquished Property (the “Identification Period”). The discussion below will go into more detail about the identification process, the number of properties which can be identified and the necessary characteristics of the Replacement Property(ies).

• The Replacement Property(ies) must be of “like kind.” Fortunately, this term is quite liberal, and encompasses exchanges of most forms of realty for other forms of realty (e.g. a warehouse, an apartment, raw land and a rental property are all of “like kind”).
  
  **Excluded Assets:
  
  • Partnership Interests
    
  • Personal Residences
    
  • Second/Vacation Homes (where personal use exceeds the greater of 14 days or 10% of the number of days actually rented)
    
  • Dealer Property
    
  • Property Outside the U.S.
• Three Property Rule – The most popular safe harbor rule for identification, this rule allows the Taxpayer to identify up to three potential Replacement Properties without regard to their value.
  
• Effect of Loans Secured by the Property – The amount of any loan secured by the Relinquished Property will necessarily impact the equity calculation. For example, if a Relinquished Property having a Basis of $50,000 is sold for $200,000, with the net proceeds (or Exchange Funds) being $100,000, the Taxpayer must close on one or more Replacement Properties which have a value equal to or greater than $200,000 and use all of the $100,000 to acquire the Replacement Property(ies).
• Closing Within 180 Days. The Taxpayer must close on the acquisition of the Replacement Property(ies) within the earlier of: (i) the due date of the tax return (including extensions) for the tax year during which the transfer of the Relinquished Property occurs; or (ii) 180 days from the date of the sale of the Relinquished Property (the “Closing Deadline”). Note that the 45 day time limit and the 180 day time limit run concurrently.
  
• Mirror Image Ownership. The tax identification number of the person or entity purchasing the Replacement Property(ies) must be identical to that of the tax identification number of the person or entity previously holding title to the Relinquished Property (though insertion of a revocable trust or a single member limited liability company is allowed, and we recommend that all real estate investment property be held in a limited liability entity).
  
• Full Deferral Requires Use of All Exchange Funds. All Exchange Funds must be used in the acquisition of the Replacement Property(ies). To the extent any funds are not used in the acquisition, those funds constitute “boot” to the Taxpayer and are subject to tax.
  

Another potential pitfall for a Taxpayer is having his or her Relinquished Property characterized as inventory. This is a pitfall because Gain from the sale of inventory held by a “Dealer” may not be the subject of a Like-Kind Exchange. This area is complex, and is necessarily based on the unique facts and circumstances of each case. However, certain general guidelines have been developed. These include: (i) avoiding multiple or successive sales by the same Taxpayer; (ii) retaining a given piece of real estate for as long as possible before selling; and (iii) avoiding making physical changes to the real estate. For example, assume that the Taxpayer holds one parcel of property for investment and has entered into a contract to sell that property to a real estate developer. If the contract to sell property requires the Taxpayer to undertake certain subdivision activities in preparation for the sale, which many often do, the IRS may classify the Taxpayer as a Dealer, the property as inventory and disallow the exchange.

If the Taxpayer is unable to acquire any of the identified Replacement Properties, any other property acquired by the Taxpayer will be “other property” and the gain on the initial sale will be taxable. Alternatively, using the example above, if the Taxpayer identifies two $100,000 Replacement Properties but is only able to close on one, the Taxpayer will only qualify for a partial tax deferral and will be subject to tax on one-half of the underlying Gain.

The agreement with the QI will govern when and under what circumstances the Taxpayer is permitted access to the Exchange Funds for the entire 180 day exchange period. Generally, and except for certain limited uses which include posting an earnest money deposit on the Replacement Properties, the Taxpayer is not entitled to the use or benefit of the Exchange Funds regardless of whether any Replacement Properties are acquired. That is, once the funds are in escrow, whether or not any Replacement Properties are identified, the funds are locked away until the earlier of closing on the Replacement Properties or the Closing Deadline.

A Like-Kind Exchange, when properly consummated, is a powerful tax deferral strategy that can defer tax on Gain indefinitely and can be a great engine for building wealth and avoiding the “Tax Man.”

A wealth of complexity and flexibility exists to Like-Kind Exchanges, including the use of a reverse exchange, “Starker” exchange or an investment in a “TIC” pool. Strict adherence to the rules and regulations is required to remain within a given Safe Harbor. The failure to comply with what seems to be an unimportant rule could subject the Like-Kind Exchange to increased scrutiny and possible disallowance. A thorough understanding of this body of law, as well as the potential ramifications based on your particular facts and circumstances, will allow you to make an informed decision with respect to any contemplated Like-Kind Exchange.

The inherent complexity of the exchange process requires the sober analysis of the benefits and potential pitfalls of an exchange before taking action This article is not meant to be a definitive or exhaustive guide to this topic, but as a brief overview. If you are considering the sale of an investment property, we welcome the opportunity to discuss with you the opportunities, challenges, options, upsides and downsides of your situation.

David W. Hotes 240.778.2329

IRS CIRCULAR 230 DISCLOSURE

To ensure compliance with requirements imposed by the U.S. Internal Revenue Service, we inform you that any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding tax-related penalties under the U.S. Internal Revenue Code or (2) promoting, marketing, or recommending to another party any tax-related matters addressed herein.