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1031 Tax Deferred Exchanges

The IRS allows investors to defer tax on certain types of property held for investment, including real estate, by exchanging one property for another of "like kind." These are referred to as 1031 tax deferred exchanges. The IRS has specific rules for what exactly "like kind" means, but generally it entails that if a property is held for investment, it can be exchanged for another property that is held for investment, and the taxes will be deferred until the property is sold without the benefit of another exchange property being acquired. If, in the transaction, the seller of one property realized either cash in hand or debt relief, that amount is taxable and is known as boot.

Tax deferred exchanges can be simultaneous exchanges, which means that the properties close escrow at the same time, or delayed exchanges, where one property closes escrow at a delayed date. In a delayed exchange, which is more common, the seller sells Property A and buys Property B at a later date as an exchange. The seller has 45 days from close of escrow of Property A to identify Property B and up to 180 day from close of escrow of Property A to close escrow on Property B for the transaction to be legally considered an exchange.

Most exchanges are not two parties swapping property; rather, they are more likely to be a chain of transactions. For example, Seller A finds a buyer for Property A; then Seller A becomes the buyer of property B; however, the seller of Property B is not usually the buyer of Property A. Each of these transactions is known as a leg, and there are many multi-leg exchanges.

Like-kind, tax-deferred exchanges have been around for a long time - since about 1921. The section of the IRS code that permits like-for-like tax-deferred exchanges of property has very specific ideas about what "like-kind" means. First of all, the property must be held for productive use in a trade or business or be a property held for investment. The most important concept to grasp is that the property you acquire must be the same general type as the property you are giving up. In real estate, this is broadly defined. Bare land held for investment can be exchanged for a rental property. A multi-family rental property can be exchanged for a single-family residence as long as it is rented out and not your primary residence; an office building held for investment can be exchanged for a shopping center or an industrial building, mini-storage, bare land, or mixed-use property. It all goes to the intent to hold the property for investment.

As mentioned above, the code also allows for simultaneous exchanges and delayed exchanges. Until 1984, exchanges were always made simultaneously. The tax code was then amended to permit delayed exchanges. The rules governing delayed exchanges remained unsettled until 1991, but they are now well codified and stringent. Today we can dispose of one property and acquire a qualified property on a later date and still defer the taxes. However, before we dispose of the first property, we must declare our intent to exchange under the IRS code and we must not receive the proceeds of the sale of the property in any way; they (the proceeds) must remain under the control of a qualified intermediary: Touch them and the tax is due! Today, the vast majority of exchanges are delayed exchanges, and there are many qualified intermediaries to help you follow the rules of exchanges.

A typical exchange involves several parties: the investor, who is seeking a property with the intent to exchange; the (qualified) intermediary, who immediately transfers the property between parties; and the new buyer of the investor's property. The transfer of the property to the new buyer by the intermediary is often referred to as phase one of the exchange, or the first leg of the exchange. The intermediary holds the proceeds of the sales pending completion of phase two or the second leg of the exchange. This is the simplest form of an exchange; there are many multi-leg exchanges, but it would only muddy the waters to discuss them here. The concept to grasp here - as a seller intending to defer taxes using an exchange - is that in order to complete a successful exchange, you must use a qualified intermediary, not have access to the proceeds of the sale, and conform to certain time limits and procedures.

Understand that we are only deferring the taxes due on the gain realized when the phase one property is sold; we are not eliminating them - although if we defer them until we are dead, they effectively are no longer our liability!

The time frame for a delayed exchange is strict. It starts with the closing date of the sale of the phase one property. From the day after the title is transferred, the seller of the phase one property has exactly 45 days to identify in writing to the qualified intermediary up to three properties of any value that are targeted for acquisition or four or more properties with a combined value that does not exceed 200% of the phase one property sold. Should a targeted (identified) property become unavailable or undesirable, substitutions are permitted during the 45-day period. No substitutions are permitted after the 45 days - and we are speaking of calendar days here, not business days.

We now have 180 days from the day after the title transfer date of the phase one property to close on one or more of the properties that we have properly identified. However, there is one important and often overlooked exception: If the due date of the exchanger's tax return is less than 180 days from the transfer of title on the phase one property, then the new property must be acquired before that due date. The exchanger may get around this rule only if he or she obtains a tax filing extension.

Comments

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  Ken Johnson — almost 3 years ago

  Make sure the intermediary is financially sound and will still be in business to complete the exchange. Landamerica Title went bankrupt and tied up millions of exchange dollars last year. Ken