§ 1031 Tax Deferred Exchange

Contents:

• Introduction

  • General Considerations

  • Highlights of a Valid § 1031 exchange

• Fee-Title vs. Leasehold 

• Furniture, Fixtures, and Equipment

• Statements that should be included in the sales contract

• Tenant-In-Common (TIC)

• Private Annuity Trusts may be used as a safety net in case 1031 deadlines are not met.  

Introduction

Section 1031 of the IRS code allows investors to defer capital gain taxes while disposing of investment property. A properly structured exchange of "like-kind" assets allows an investor to sell a property and reinvest the proceeds in a new property, deferring all capital gains taxes.

General Considerations of a Section § 1031 property exchange include:

• The original purpose for purchasing the property was as an investment and classified as either § 1231 property (used in trade or business or rental property) or § 1221 property (capital asset held as investment such as land with under 30% of the basis allocated to improvements) and exchanged for other § 1231 or § 1221 property:

  • typically held for one year or more

  • there were no listing agreements or other marketing agreements to sell the property that were initiated immediately after acquisition

  • did not personally use the property (ie, a house that is leased was not originally used as a homestead -- must be treated as an investment for IRS purposes)

  • Property that is classified as "Dealer Inventory" is not eligible for exchange --  a dealer is someone who holds property for the primary purpose of selling the property in the ordinary course of business.  For example a developer who buys raw land, subdivides the land into lots and sells the lots is classified as a dealer in land.  

• Must reinvest all exchange proceeds

• Must acquire property with the same or greater debt

Highlights of a Valid § 1031 Exchange

1. The Exchanger should establish the intent to perform an exchange in the contract. 

2. Consult with a "Qualified Intermediary" and tax attorney before closing the sale and execute the Qualified Intermediary's Exchange Agreement prior to closing the sale

3. Ensure that the Sales Contract is Assignable and that the buyer is made aware of an assignment in writing; it is common to show the seller as "John Doe and/or Assignee."

4. The Qualified Intermediary should oversee the closing to ensure that the closing properly reflects the § 1031 exchange.  

5. Within 45 days, the Exchanger must identify the property(s) to be acquired in accordance with the Rules of Identification, including a requirement that acquired properties have a mortgage of the same or greater value.

6. The Exchanger must close on the new property(s) by the 180^th calendar day after closing (or their tax filing date -- which ever is earlier) from the close of the property being "sold."  If the 180^th day falls on a holiday or weekend, the dates are NOT extended.

Fee-Title vs. Leasehold 

While the typical § 1031 exchange involves fee-title transfers of real estate, leasehold interests can under some circumstances be used in an exchange transaction.

• Long-Term Lease -- a leasehold of over 30 years is of like-kind with fee-title. Also qualifying would be a 20 year lease with three five year options (35 year term for lease plus options).

• Short-Term Lease -- a short-term lease is of like-kind with other short-term leases

• Leasehold Improvements -- A fee-title sale, under certain conditions, may be of like-kind with leasehold improvements, if the lease is a long-term lease and the leasehold improvements are completed within the 180 close window.  Carefully structured transactions may allow the use of this technique where leasehold improvements are on ground already owned or controlled by a related party because there are two separate conveyable elements: the fee-title ownership of the land and the leasehold interests in the improvements to the land.  

Furniture, Fixtures, and Equipment

IRS regulations suggest that personal property in the same general asset class (four-digit product class in the Standard Industrial Classification Manual) can be considered like-kind.  At times the sale of furniture, fixtures or equipment (FF&E) may trigger taxable gain because the items have been depreciated.  To avoid this taxable gain, one may exchange old FF&E (in the relinquished property) for FF&E that is purchased in the newly leased space (the replacement property).  Regulations involving FF&E exchanges are complex and a tax professional should be consulted.   

It is important for the taxpayer to create a paper trail establishing intent to complete the exchange.

The following statement should be included in the sales contract:

It is the intension of the seller to effect an IRC §1031 tax deferred exchange.  Seller may assign rights in this contract to a qualified intermediary for the purpose of effecting such exchange.  Buyer agrees to cooperate and execute necessary documents to allow seller to effect such exchange. Seller agrees to hold buyer harmless from any and all claims, liabilities, costs or delays in time resulting from such an exchange. However, any warranties that may be expressed in this contract shall remain and be enforceable between the parties executing this document.

Asset Preservation Incorporated is a Qualified Intermediary
Stewart Abstract & Title is a closing agent familiar with the procedures needed for a § 1031 Exchange

The IRS has issued restrictions on the process of identifying properties for exchange:

• Three-Property Rule -- identify, at most, three properties, regardless of their value in relation to the value of the property given up

• 200-Percent Rule -- identify any number of properties as long as their aggregate fair market value, as of the end of the identification period, does not exceed 200 percent of the value of all relinquished properties

Under certain conditions, the owner of property may acquire replacement property first, then sell the original property and claim that a tax-deferred exchange has taken place.

While the IRS (at this date) has not issued regulations on a Reverse Starker Exchange, a key to being able to have such a transaction seems to be in the interdependency of the transactions -- in the ability to  trace the equity from the relinquished property into the property acquired.  

For example, the Tax Court has approved an exchange where the taxpayer borrowed money from a bank, using his current property as collateral.  This money was then used to make a down payment on a new property and closed on the new property.  At some time in the future, the original property was sold and the proceeds was used to pay off the loan.

Condemnation Caveats

• Replacement Period: If the property is condemned or about to be condemned, the taxpayer has three years (two years if property is sold before condemnation) after the close of the first taxable year to replace the property.

• Condemned real property can generally be replaced by "like-kind" rather than "similar-use" found in the typical 1031 exchange.  

Tenant In Common (TIC) structures are often used as a safe-harbor for 1031 Exchanges