By Nick Jensen, CPA, CFP®
Are you fortunate enough to own real property that could be sold at a large gain? Real Estate transactions are a topic we discuss with clients frequently as there are a variety of tax related considerations that require thorough and comprehensive planning strategies in order to ensure that the clients’ interests are protected. One option we can help evaluate is the “Tax Deferred Like-Kind Exchange” (1031 Exchange). If done properly, it can defer the tax burden associated with selling a real property with a large gain.
The concept of a Tax Deferred Like-Kind exchange has a long history dating back to the 1920’s. Its most recent significant re-write, codified in IRC Sec. 1031, was in 1954. It was modified further by the 2017 Tax Cuts & Jobs Act to specifically exclude personal property.
This portion of our federal tax law allows for no gain or loss to be recognized if real property held for productive use in trade or business or for investment (for example a rental property) is exchanged solely for different real property of a Like-Kind to be held either for productive use in trade or business or for investment.
There are general “rules” you should keep in mind related to Like-Kind exchange of real estate:
- Generally any kind of real estate is treated as Like-Kind with other real estate.
- The replacement property does not have to exist at the time the exchange property is transferred.
- The same taxpayer that disposes of the relinquished property must acquire the replacement property.
- The definition for Like-Kind is extremely liberal for real estate.
- The exchanged property should not be disposed of immediately after an exchange.
- There is no limit on how many times you can do a 1031 Exchange.
- When cash or unlike property (aka “boot”) is received in addition to the Like-Kind property, gain is recognized to the lesser of the realized gain or the amount of boot received.
In addition to the general considerations we just reviewed, you should also be familiar with the concepts of the Starker Rule, Intermediary, and Reverse Exchange if you are considering a 1031 Exchange.
The Starker v. United States legal case of 1979 codified the non-recognition tax treatment of non-simultaneous, delayed tax-deferred like-kind exchanges. Under this rule the property to be received in an exchange must be identified in a written agreement within 45 days after the transferred property is surrendered. The property in the exchange must be received on or before the earlier of:
- 180 days after the transfer of the property given up, or
- The due date (including extensions) for the tax return year in which the transfer of the property given up occurs. (TIP: Be sure to extend your tax return for the taxable year in which the relinquished property was transferred to allow as much time as possible to complete the exchange.)
In order to accomplish a 1031 delayed exchange under the Starker Rule, a Qualified Intermediary (accommodator) must be used. This is a person or organization separate from the taxpayer who agrees, under the terms of an exchange agreement, to acquire the relinquished property from the taxpayer, transfer the relinquished property to the buyer, acquire the replacement property and transfer the replacement property to the taxpayer. They charge a fee for this service that typically is about $1000 and is often tied to the dollar amount of the transaction. Exchange expenses reduce the amount of consideration received in the exchange and increase the basis of the property received.
Because the Intermediary holds the proceeds of the sale, one must be careful in choosing an Intermediary. There is very little federal regulation of this industry so investors should always evaluate the Qualified Intermediary by examining their:
- longevity under the current ownership/management team
- fidelity bond
- errors and omissions insurance
- experience and expertise
- method of investing funds and what type of account is used
Investors should insist that the proceeds of the sale be held in a dual signature Qualified Trust Account or Qualified Escrow Account. This way their exchange account is unique and separated and it takes two signatures to move money – the client’s and the Intermediary’s. This type of account does not rise to the level of constructive receipt by IRS terms so does not put the 1031 treatment at risk.
A reverse exchange occurs when the taxpayer purchases the replacement property prior to the sale of the relinquished property. This approach makes sense if the investor wishes to assure the acquisition of acceptable replacement property, take advantage of time sensitive investment opportunities, or facilitate a build-to-suit exchange
Consider using 1031 Exchanges in the following situations:
- taxpayer intends to replace with similar property
- to upgrade size and/or quality of investment
- to either consolidate or diversify a real estate portfolio
- to shift property to a state having less of an income and or estate tax burden
- to change non-income producing property (land) to income-producing property (apartment building)
Avoid using 1031 Exchanges in the following situations:
- there is a loss on the sale of the property
- the gain on the sale of the original property could be sheltered by unused or expiring capital loss, charitable contributions, general business credits, or NOL carry forwards
- the sale would generate passive income used to offset passive losses
- there is a wide disparity in capital gains and ordinary tax rates
- paying the tax in the current year is beneficial because of increased future income or rising tax rates
We recommend consulting your Financial Advisor before making major decisions, including real estate transactions, or to examine opportunities such as the 1031 Exchange. Your Advisor should help you gauge the most effective strategies that will ensure that your decisions are in-line with your short and long term goals. If you aren’t currently working with an Advisor who offers comprehensive planning services, feel free to contact us to set up a complimentary planning session to determine how we can help you maximize your strategy and coordinate with your broader financial goals.