1031 Tax Exchange
So, What To Do With My $$$ Now? Considered A 1031 Tax Deferred Exchange? Wee, What is a 1031 Exchange? Well.....Let's SEE
- Much has been written over the years to explain tax deferred exchanges,
however, it has been my experience that most explanations are lengthy
and much too technical. Being a well known real estate attorney with an
emphasis in tax deferred exchanges, as well as an author on this
subject, it has been brought to my attention that a simple to read guide explaining tax-deferred exchanges has been in high demand for quite a long time. I hope this guide will be useful to you.
- To begin with, I am often asked, "Why should I consider a tax-deferred exchange?" Well, there are various reasons why one would do a tax-deferred exchange, the following are a few examples:
1 __
You may have some non-income producing real estate investments, such as raw land, which are not giving you any cash flow. You could exchange this for property that is income producing, such as a duplex or a rental home. Not only could you start realizing a cash flow, but you can also get income tax deductions such as depreciation, which you did not have with your raw land.
2 __
Often people find that they have been holding properties long after their appreciation has topped out. You can start rebuilding your equity by disposing of those properties and acquiring new ones.
3 __
The area your rental properties are located in has become economically depressed or is deteriorating. Why not trade those properties for others in a better location or neighborhood?
4 __
If you have rental properties with problem tenants or they are in need of expensive maintenance or repairs, sell the properties and acquire other rentals with fewer problems. This may also give you an increase in appreciation.
5 __
Many people think about selling and reinvesting into more income or investment property. One would be foolish not to do a tax-deferred exchange! If you sell and reinvest, you will pay income taxes on the realized gain. However, if you call it an exchange, you will pay no taxes. This means that more money is available as leverage for acquiring your next properties. Look at it as a free loan from the government!
6 __
With proper estate planning you can keep exchanging properties throughout your lifetime. Neither you nor your heirs will ever pay income taxes on the gains.
7 __
By doing a tax-deferred exchange, you can conserve your equity by not having to pay taxes on your net profits.
- When you sell real estate which has been held for investment or for business, we all know that a large amount of income taxes will need to be paid. Even if you reinvest all of the money from your sale into more real estate, you will still pay nearly the same amount in income taxes.
EXCHANGES
- In most of our minds the question lies, "what do the big boys do?? If all of the tax loop holes are for the rich, well, what can the average taxpayer do??" OK,
here is the answer we've all been looking for! If you arrange for the
sale of your business or investment properties as an "Exchange", such
as "trade" properties so to speak, and then reinvest all of the money
from your sale into buying more business or investment properties, you
will pay NO INCOME TAXES! Yes, its true!
- Also, your income taxes are actually deferred (postponed) until the day you decide to outright sell your property and pocket the sales proceeds. You can even avoid "ever" having to pay the income taxes at all by continuing to exchange properties throughout your entire lifetime! Then, with proper estate planning, you can pass it all to your heirs completely TAX-FREE!!
DISADVANTAGES
- There are only two possible disadvantages worth noting. One of them being that you will have a slightly lower depreciation schedule when
you acquire your new properties. This is because the IRS will look at
your new tax basis as being the same as your previous one; less your
deferred gain.
- The other disadvantage is that losses on your income tax return cannot be deducted if you exchange property rather than sell it. So, if you want to take a loss, just call it a sale, not an exchange
- Tax-deferred real estate exchanges are legal and ethical. Internal Revenue Code Section 1031 has been in existence since 1928. The IRS has even established "recent" guidelines for accomplishing tax-deferred exchanges! The purpose for this law has been to encourage real estate sales nationwide which, in turn, supports our entire economy.
- In
this area confusion often sets in. Put very simply, any type of real
estate used for business, trade or investment purposes will qualify.
Examples are: apartments, office buildings, multiplexes, single family
or condo rentals, raw land, farms, ranches, commercial, and industrial.
All of these will qualify! A lot adjoining a primary residence can also qualify if it is considered investment property.
- MIX & MATCH: You are not limited to exchanging for property similar or exactly like your present property. The law and the IRS allows you to trade raw land for an apartment building or a commercial mall, or a condo rental as long as you structure it as an exchange. As long as you are selling (wanting to exchange) real property used for business, trade or investment purposes; you can buy (exchange it for) any other type of business, trade or investment properties. For example, you can sell your self-operated gas station (trade property) and buy an apartment building (business property) and pay no taxes!
- Now it is time to talk about IRC Section 1034. This law is in regards to your "personal" residence. The home you live in will not qualify for
an exchange because you cannot mix IRC Sections 1031 with 1034. In
other words, you cannot sell your home and use the proceeds to buy
business or investment property. Nor can you sell business or
investment property and buy a primary residence that you intend to live
in shortly after acquiring it. Exceptions and loopholes do exist, and will be discussed later.
- But for now, remember, that all of the properties you sell and buy in an exchange must be trade, business or investment related.
- You do not have to buy property at the same time you are selling. The law allows for what is called a "Delayed Exchange".
This lets you sell now and buy your "replacement" property at a later
time. However, the law does set up some strict timing requirements
which will be explained later.
- There are some
interesting ways you can plan your exchange. For instance, you can sell
your property to one party and buy your replacement property from
another. You can sell one property and buy two, three or more
replacements! Here is a good example: if you sell a $450,000 waterfront
lot you can buy a $50,000 condo rental, a $100,000 parcel of raw land
as an investment, a $150,000 duplex, and a $200,000 commercial
building, and PAY NO TAXES!
- Also, you can sell several properties and buy only one property with the sales proceeds. In this instance, you may sell a triplex, a rental single family home and acreage for $400,000 and buy an office building for $500,000 and still pay no income taxes!
- First of all, let's address the question, what exactly is meant by a "dealer"?
- A
"dealer" is a person, corporation, or entity that acquires property for
a fast resale only. They are similar to "used car dealers" who buy cars
to quickly repair, clean and polish them for resale. Congress limited
exchanges to those properties "held for productive use in a trade or business or for investment". The IRS
interpreted those words to exclude properties "held primarily for
sale". Therefore, if a dealer or anyone else tries to exchange property
held primarily for sale, they cannot exchange.
- However, if a dealer decides to rent the property or to hold onto the property long enough to be considered investment property, then the property can be exchanged. Read my book for more details.
HOW TO HAVE A TOTALLY TAX FREE EXCHANGE
- For
you folks who like rules and formulas, this section is for you! For
those of us that don't, we will keep it simple. So, here it goes...
when you sell your property(s), the replacement property(s) must equal or be greater than the
VALUE (sale price) and existing DEBT of the property(s) being sold
(exchanged), and all of your EQUITY from the property you are selling
(exchanging) must go into acquiring the replacement property(s).
- The formula is: The replacement property(s) must be equal or greater in VALUE & DEBT than the property(s) being sold (exchanged).
- Sometimes
you may have a PARTIAL TAX-DEFERRED EXCHANGE. This may happen in a
number of ways. Such as pocketing some cash from the sale, or receiving
"nonlike-kind" property in the exchange. This "non-like-kind" property
could be personal property or any other kind of property different from
real estate. Another way to have a partial tax-deferred exchange would
be for your replacement property to not be equal to or greater than
either the VALUE or DEBT of the property you sold. This means that you will pay some income taxes.
- Any
one of the above situations is known as a "PARTIAL TAX-DEFERRED
EXCHANGE" because you have not protected all of your sales proceeds
from being taxed. For example, if you sell a $200,000 rental and buy two properties totaling $150,000, you may pay income taxes on the $50,000 difference.
- Another example would be if you owned acreage worth $200,000, in which you had $100,000 in DEBT. You decide to sell it!
- You then buy a $200,000 duplex using a $50,000 loan (which gives you a $50,000 in equity). This means you went down in debt by $50,000 which is taxable income. Remember, for a totally tax deferred exchange, you must aquire replacement property(s) which are EQUAL to or GREATER in sales price (VALUE) "and" EQUAL to or GREATER in DEBT than the properties being sold.
As much as I would like to, it is difficult to anticipate all of the situations which may involve an exchange and discuss them at length. So, I will comment on some of the most common ones which may prove to be most helpful to you.
- You can acquire replacement properties that will be built for you.
However, the construction project must be at a point for all of your
equity to be used up and the fair market value equal to the sales price
of the property(s) you sold when you acquire title. Completion of the construction project out of your own funds after title passes to you is acceptable.
- Although it is not built, during the 45 day identification period, you must identify this property in as much detail as possible. Also, at the time of acquisition, the construction project must be substantially the same as it was at the time you identified it in detail. Only "usual or typical" construction changes will be allowed.
- A
partnership can sell real estate it owns and exchange it for more real
estate if it takes title to the replacement property in the name of the
partnership. For example, "ABC Ltd. Partnership" is the seller and the
replacement property is sold to "ABC Ltd. Partnership". However, if the
partnership only wants to sell a portion, such as the sale of "25%
interest in ABC Ltd." which owns a building, this would be unacceptable
and the IRS will DISALLOW the exchange.
- What if one or more members of a partnership wish to do an exchange and the other members do not? Well, although it sounds difficult, there is a way to accomplish a totally tax-deferred exchange. However, it would take too much space to explain it here. Buy my book and read the chapter on partnerships.
- Typically when the real-estate market softens, making it harder to sell, sellers often finance the purchasers themselves. THIS IS DANGEROUS!! Since the purpose of exchanging is to sell and roll over some or all of the sales proceeds into replacement property, any money pocketed is TAXABLE as a partial tax-deferred exchange (as we discussed earlier).
- Unless the seller of the replacement property is willing to take over your promissory note (with a Deed of Trust) or Real Estate Contract you received from your buyer; the payments will go directly to you as TAXABLE INCOME. So you may want to compare the tax savings of waiting for an all cash buyer and do a total tax-deferred exchange, compared with the taxes you would pay on an installment sale (which is what seller financing is). Read my book to see other ways around this problem.
- If there is a way to foul up your exchange and
end up having to pay taxes unnecessarily, this is where it usually
happens. For instance, if you or one of your agents (real estate agent
or any other person working in your behalf), directly or indirectly, exerts any control over the money received from your sale before the entire exchange is completed, the IRS will DISALLOW THE ENTIRE EXCHANGE.
- The
object of an exchange is to keep you away from the money until you have
acquired all of your replacement properties. If your attorney, CPA,
real estate broker, escrow officer, or an employee touches the money;
in the eyes of the IRS, it is as good as being in your pocket!!
This is why you must hire a stranger to act as a "Facilitator", or
"Qualified Intermediary" or "Trustee" to handle the exchange.
- The IRS will consider any one who has an existing "AGENCY" or "Fiduciary" relationship with you as being under your control, which in turn, means your money being under your control also. Most state laws automatically consider an escrow officer or closing agent as being your agent, so you cannot use them to hold your money (i.e., hold the proceeds from your sale until you need it to acquire the replacement property).
- It is important to document your intention to do an exchange as soon as you can and it MUST BE IN WRITING. You can establish your written intent
in the Listing Agreement with a real estate office; and/or in the
Earnest Money Agreement with your buyer. This can be done at the time
of negotiation, or later as an addendum to the Earnest Money Agreement
sometime before closing takes place.
- I recommend using the language in my book which obligates the buyer and seller to cooperate with your exchange at no extra cost or liabilities to them.
- We must pay careful attention to the timing rules set up by the IRS. When you sell your property(s) and title passes to the purchaser, the timing requirements to IDENTIFY (locate) and ACQUIRE your replacement property(s) begins. You will have 45
days to produce a written list of up to 3 potential replacement
properties (common addresses are OK) delivered to your Facilitator or
anyone else that is not your '"agent".
- A signed,
dated Earnest Money Agreement is an acceptable alternative to the
written list. If you wish to identify more than 3 potential replacement
properties, there are only 2 ways to do this:
1. _
200 PERCENT RULE: You can identify more than 3 properties if all of them add up to no more than TWICE the sales price (fair market value) of the property(s) you sold; or
2. _
95% RULE: You can identify as many properties as you wish AS LONG AS 95% of the fair market value of all property(s) identified are actually acquired. In other words, if you identify 5 properties worth a total of $100,000 you had better acquire at least $95,000 worth from that list.
- 180 DAY RULE: You
must ACQUIRE your replacement properties within the EARLIER of 180 days
from closing of the first sale, or, the DUE DATE FOR THE TAX RETURN
(including extensions) for the year of the sale.
- WARNING!! If you fail to properly and timely identify your potential replacement properties, or fail to acquire title to all of the replacement properties in time, the IRS could DISALLOW YOUR ENTIRE EXCHANGE.
SUMMARY OF SECTION 1031 REQUIREMENTS
AN ACTUAL "EXCHANGE" MUST TAKE PLACE. You must either directly swap properties with your buyer's property; or the buyer in exchange for your deed will acquire the replacement property for you; or you must hire an expert to act as the "Trustee", "Facilitator", or "Qualified Intermediary".
THE TRANSFER MUST INVOLVE REAL PROPERTY FOR REAL PROPERTY.
THE PROPERTIES YOU SELL AND ACQUIRE MUST BE HELD FOR PRODUCTIVE USE IN A TRADE, BUSINESS, OR AS AN INVESTMENT.
THE 45 DAY AND 180 DAY MAXIMUM TIMING RETUIREMENTS FOR IDENTIFYING AND ACQUIRING REPLACEMENT PROPERTIES MUST BE MET.
SECTION 1031 IS MANDATORY. If you have accomplished the above 4 requirements, the IRS and the courts will call it an exchange even if you did not intend for it to be so.
