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The Delayed Exchange of Real Property Under IRC §1031: Benefits, Requirements and Procedures

The Delayed Exchange of Real Property Under IRC §1031: Benefits, Requirements and Procedures

Introduction

Capital gains tax (“CGT”), loosely defined, is a tax imposed upon profits realized from the sale of investment real estate, i.e., the difference between the amount the taxpayer sold investment property and the lower amount at which that taxpayer purchased such property (plus capital improvements less depreciation taken).  The 2015 top federal CGT rate is 23.8 % for taxpayers with adjusted gross incomes of at least $200,000 ($250,000 for married couples filing jointly).  In addition, most states and some localities impose CGT. New Jersey imposes a 9 % CGT, New York’s CGT is 8.8 %, and California has the nation’s highest state CGT at 13.3 %.  Internal Revenue Code § 1031 (“IRC 1031”) allows an investor to defer CGT on the sale of real property by reinvesting the net sale proceeds in other real property, in other words by transferring a taxpayer’s investment from one property to another (“1031 Exchange”).1

Benefits of a 1031 Exchange:

There are many benefits of a 1031 Exchange, including the following:

  • Deferring GCT: The primary benefit of a 1031 Exchange allows a taxpayer to defer up to 100% of CGT, and by such deference can potentially reduce or eliminate future CGT. The deferral continues until the replacement property is ultimately sold (unless sold in a future 1031 Exchange). Deferral of CGT allows for full reinvestment and is akin to long-term interest-free loans from the Federal and State governments.

  • Equity Preservation: All of the taxpayer’s equity in the property can be preserved.2

  • Leveraging: The investor can exchange from a high equity position (or “free and clear” property) to a larger property with some financing in order to increase return on the investment.

  • Diversification:  The taxpayer can expand the number or types of properties owned, perhaps purchasing properties in multiple markets or states.

  • Consolidation:  One can sell multiple small properties and purchase one larger property to maximize ownership benefits and reduce management responsibilities.

  • Cash Flow:  The investor can sell property that is producing little or no income (such as vacant land) and purchase rental properties with greater cash flow performance.

  • Management Relief:  The taxpayer who no longer wants to manage high-maintenance properties can reinvest in properties requiring little or no management.

  • Cost Reduction:  One can reduce expenses for overhead and repairs attendant to high-maintenance properties in favor of properties which are newer and require less maintenance.

  • Depreciation Increase:  An investor can exchange from a non-depreciable property (such as vacant land) to a property that can be depreciated.

  • Estate Planning:  A taxpayer can continue to replace properties through consecutive 1031 Exchanges, preserving profits until an estate can be passed down.  For CGT purposes, a property’s tax basis is “stepped up” to the current value of the property when it is transferred through inheritance, replacing the amount at which the decedent originally purchased such property.  The “stepped up” valuation can potentially eliminate CGT entirely.

1031 Exchange Requirements and Procedures:

There are many ways to structure a 1031 Exchange3, but the most common method is known as the “delayed exchange”.  A delayed exchange happens when the exchanger/taxpayer closes on the sale of his/her relinquished property on one date, and then acquires a replacement property from a seller at a later date.  To effectuate a delayed exchange, IRC 1031 qualifications and time requirements must be strictly followed.  

The primary qualification for a 1031 Exchange has a two-pronged requirement.  The first prong requires that that the relinquished and replacement properties be “like-kind” to one another.  The second prong requires that both the relinquished and replacement properties were “held for productive use of trade or business or for investment”.  In the context of this article:

  • The first prong is met when both the relinquished and replacement properties are any kind of real property or quasi-real property, regardless of whether the relinquished and replacement properties are of a similar nature (e.g., a large commercial strip mall may be relinquished and replaced by a dozen residential condominium and coop units).

  • The second prong is satisfied if both the relinquished and replacement properties are held for investment purposes, which requires the taxpayer to show that his/her primary intent was to hold both the relinquished and replacement properties for investment purposes.  There are no statutory guidelines for making such determination and each situation is considered on its unique facts.  However, a paramount consideration is the duration that the taxpayer held each property.  IRC 1031 does not contain a “safe harbor” provision specifying a compliant “hold” period, and investors are relegated to case law and professional advice for guidance.  Most attorneys advise that a minimum “hold” period for each property is one year and one day, but some attorneys advise longer “hold” periods.

Prior to closing on the relinquished property, the exchanger/taxpayer should enter into a written agreement with a Qualified Intermediary (“QI”).  A QI is a third party which meets certain IRC qualifications, but is not licensed or nationally regulated.  The QI is involved in the closing process as an assignor or assignee and escrows the net proceeds from the sale of the relinquished property.

Important 1031 Exchange Deadlines

One important deadline for the delayed exchange is known as the “identification period”.  After closing on the relinquished property, the exchanger/taxpayer has 45 days to identify to the QI potential replacement properties.  The exchanger/taxpayer is permitted to identify multiple potential replacement properties, valued in excess of the proceeds from the sale of the relinquished property, although the number and value of the properties identified are limited by specific IRC 1031 provisions.

Another important deadline is known as the “exchange period”.  From the date of closing on the relinquished property, the exchanger/taxpayer has a maximum of 180 days, or the tax filing deadline (which can be extended), whichever is earlier, to complete the exchange, i.e., to close on the purchase of a qualifying previously identified replacement property.  

Conclusions:

1031 Exchanges are valuable tools for maximizing real property investment portfolios, deferring, reducing or eliminating substantial tax obligations, and more fully controlling investors’ particular needs.  1031 Exchanges are complex and should only be handled by counsel experienced in these type of transactions.

Rea & Associates, LLC have successfully structured and closed 1031 Exchanges involving tens of millions of dollars.
We would be happy to discuss possible 1031 Exchange needs with you.



1CGT is also imposed upon profits realized from the sale of all non-inventory assets, such as stocks, bonds, and precious metals, and investors can invoke the benefits of IRC 1031 to defer CGT arising from such profits.  However, this article is limited to 1031 Exchanges relating to the sale and purchase of investment real estate.

2An exchanger is permitted at the closing of the relinquished property and at certain times thereafter to withdraw and retain sale proceeds.  Such retained proceeds are referred to as “boot money”, and CGT are imposed upon the boot money.  This would be a partial 1031 Exchange.

3Other 1031 Exchange structures include the “reverse exchange”, involving replacement property purchased prior to the sale of relinquished property, and those involving fractional ownership of properties, but discussion of such transactional structures are beyond the scope of this article.

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