WHAT IS A 1031 TAX-DEFERRED EXCHANGE?

It is a legal technique utilized to avoid taxes on the sale of investment real estate by re-investing in another “like-kind” investment property under specified IRS regulations.

HOW DOES A 1031 EXCHANGE WORK?

A property owner will sell the relinquished property and acquire a replacement property, from an unrelated third party, within 180 days. The third party is known as the Qualified Intermediary or Accommodator. Buyer and Seller have nothing to do with the exchange process.

ARE REINVESTMENT OPTIONS LIMITED BECAUSE OF THE LIKE-KIND REQUIREMENT?

There are many options. “Like-kind” is a broad category under which many types of investment real estate may qualify. Examples are rental houses, condominiums, duplexes, apartment buildings, shopping centers, retail and commercial buildings, trailer parks, storage facilities, hotels and motels, parking lots, and factories. Even raw land, if held for investment or business purposes, may qualify.

AREN’T 1031 EXCHANGES USED PRIMARILY BY WEALTHY CORPORATIONS IN LARGE COMMERCIAL TRANSACTIONS?

Approximately 60% of exchanges are residential rental properties, one to four units in size. The 1031 Exchange is an integrated vehicle of wealth accumulation for both large and small investors.

WHAT IS THE IRS POSITION ON 1031 EXCHANGES?

In 1991, the IRS published its Safe Harbor regulations giving real estate entrepreneurs the green light on using the tax-deferred exchange. Assuming that the investor adheres to the guidelines, including utilization of a Qualified Intermediary (Accommodator), there should be no IRS problems. Safe Harbor regulations resolved much of the mystery of the 1031 Exchange.

IS THE GAIN ON THE SALE OF INVESTMENT PROPERTY SIMPLY THE PROFIT DIFFERENCE BETWEEN THE ACQUISITION AND SUBSEQUENT RESALE PRICES?

The computation of taxable gain on the sale of investment property must be done in accordance with IRS guidelines and includes certain adjustments that could still result in a taxable gain even if there were no property appreciation.

For example, all tax depreciation deductions taken must be added to gain. Postponed gains from any prior tax-deferred rollovers must also be added to gain. Realtor commissions and other costs of sale, capital improvements and certain loss carryovers will reduce taxable gain.

IF A PROPERTY OWNER OWES MORTGAGES OR OTHER DEBT THAT EXCEED THE GAIN, WOULD THERE THEN BE NO GAIN AND NO NEED FOR A 1031 EXCHANGE?

The mortgage balance or any other property debt does not reduce the taxable gain. This is why it is possible to have negative equity in a property but still have a taxable gain.

UPON THE SALE OF INVESTMENT PROPERTY, IS THE TAXPAYER SUBJECT ONLY TO CAPITAL GAINS TAX?

The gain in the sale of a property can result in other hidden tax liabilities. For example, most states, and even some locales also tax gains. Additionally, all or part of a gain may be treated as ordinary income if depreciation recapture is necessary. In a non-1031 sale, the gain can substantially increase adjusted gross income which, in turn, can create tax liability. Utilizing the 1031 Exchange can eliminate all of the above taxes.

MUST THE AMOUNT OF THE CAPITAL GAIN BE REINVESTED IN A ROLLOVER PROPERTY IN ORDER TO DEFER ALL OF THE TAXES?

In order to completely defer tax on the gain, the seller must invest in like-kind replacement property, the cost of which must equal or exceed the net selling price of the relinquished property. Net selling price is the total sales price less commissions and other selling expenses, not to include the mortgage payoff.

CAN AN INVESTOR WITHDRAW CASH FROM A 1031 EXCHANGE?

One of the requirements of a 1031 Exchange is that a seller may not receive constructive receipt of the proceeds from sale of the relinquished property. The proceeds must be held in a qualifying escrow account until a like-kind replacement property is acquired. However, an investor may choose not to reinvest all his equity into a replacement property. He may take part of it as taxable income and reinvest the remaining portion into the replacement property. Another method of taking cash from a move-up exchange is to refinance before or after the exchange.

ARE 1031 EXCHANGES LIMITED TO THE SELLING OF ONLY ONE PROPERTY AND THE ACQUISITION OF ONLY ONE REPLACEMENT PROPERTY?

An investor is not limited to exchanging or acquiring just one property. Several properties can be exchanged/acquired in one 1031 transaction.

CAN A QUALIFYING 1031 EXCHANGE BE EFFECTED BY ALLOWING A TITLE COMPANY TO ESCROW THE FUNDS FROM SETTLEMENT?

Escrow and Intermediary are two separate IRS requirements. An Escrow deposits and holds proceeds from the sale of the relinquished property. An Intermediary acts as a middleman in the transaction by managing the exchange; that is, processing and filing the required 1031 documentation so the investor is assured of proper tax treatment.

ARE THERE ADVANTAGES, OTHER THAN SAVING CAPITAL GAINS TAXES, IN UTILIZING A TAX-DEFERRED EXCHANGE?

There are multiple advantages. In addition to the taxes saved, an investor should consider what can be done by combining the saved dollars with leveraging and compounding.Because of the 1031 Exchange, the investor reduces or eliminates capital gain tax. Taxes saved along with leverage increases buying power. Increased buying power compounds wealth.
The benefits of a 1031 Exchange are not just the dollars saved, but also the additional wealth which can be attained with the saved tax dollars.

DO 1031 EXCHANGES MERELY POSTPONE THE PAYMENT OF TAXES OR CAN THE TAX LIABILITY BE ELIMINATED?

When a property is rolled over via a 1031 Exchange, the untaxed gain remains and will become taxable if a property is ever sold outright. This is why the term “tax-deferred” exchange is appropriate. There is, however, an old adage “defer, defer, defer → die!” That is, by continuing to exchange property until death, the gain is permanently eliminated. This is because the death of the property owner effectively eliminates gain by a “step-up” in the tax basis of the property to its fair market value. Therefore, as a result of employing IRS Code Section 1031, heirs will have a larger estate, not only from the taxes saved, but also from years of compounded earnings on the saved dollars.

ARE THERE SITUATIONS WHEREIN AN EXCHANGE SHOULD NOT BE UTILIZED?

When the adjusted tax basis of a property exceeds the net selling price, a realized loss will occur on the sale of the relinquished real estate. Under Section 1031, losses are deferred as well as gains; therefore, to recognize and deduct a loss there should be a sale and not an exchange. Also, it may not be cost effective to employ Section 1031 if only a nominal amount of taxes are due upon a sale.

RK PROPERTIES DOES NOT PROVIDE LEGAL OR TAX ADVICE. YOU NEED TO DISCUSS THIS WITH YOUR TAX PROFESSIONAL OR ATTORNEY.