1031 Exchanges In-depth: A Powerful Tax Strategy
Tax deferred exchanges have been a part of the tax code since 1921 and are one of the last significant tax advantages remaining for real estate investors. One of the key advantages of a §1031 exchange is the ability to dispose of a property without incurring a capital gain tax liability, thereby allowing the earning power of the deferred taxes to benefit the investor instead of the government.
History of Tax Deferred Exchanges
Although many investors mistakenly believe an exchange is simply a "swap" of properties, most exchanges completed in recent years are variations of a "delayed" exchange. An investor by the name of T.J. Starker initiated the concept of a delayed exchange by trading timberland to the Crown Zellerbach Corporation in exchange for a promise to deliver suitable exchange properties in the future. The IRS challenged the transaction, and after a series of tax court trials, the 9th Circuit Court of appeals ruled in favor of Mr. Starker, which ultimately validated the "Starker" or "Delayed Exchange". Because of the Starker case, the 1984 Deficit Reduction Act created specific time frames for completing a delayed exchange. The delay period was set at 45 days to identify replacement property and 180 days to acquire it.
§1031 exchanges became increasingly popular in 1986 as a result of the 1986 Tax Reform Act, which eliminated the "preferential capital gain treatment" previously enjoyed by real estate investors. With the special treatment gone, investors faced combined State and Federal capital gains tax rates as high as 37%. In 1991 the IRS issued rules and regulations clarifying many of the grey areas concerning §1031 exchanges. Section §1031 of the IRS Code established "safe harbor" rules that include the use of a "qualified Intermediary, receiving of interest or "growth factor", the use of a qualified escrow account and the use of security instruments in an exchange.
In 2002 the IRS issued Revenue Procedure 2002-22, which established guidelines for §1031 exchanges using the tenants-in-common ownership structure. This guidance paved the way for dramatic growth in tenants-in-common real estate ownership.
§1031 Exchange Requirements
There are a number of requirements, which need to be met to qualify for tax deferral under Section §1031 of the tax code:
Requirement #1:
Both the "relinquished" and "replacement" properties must be held for investment or used in a business. The IRS uses the term "like-kind" to describe the type of properties that qualify. Any property held for investment or use in a business can be exchanged for any other "like-kind" property held for investment or use in a business. This definition covers a wide variety of developed and undeveloped real estate. Properties, which are clearly not like-kind, are an investor's primary residence or property "held for sale." The relinquished and replacement properties need not have identical functions. For example, you can exchange an apartment building for a commercial office building, raw land for a shopping center, a farm for a rental house, etc. Again, the main requirement for "like-kind" property is that it be held for investment or use in a business.
Requirement #2
The IRS requires an investor to identify replacement property(s) within 45 calendar days from closing on the sale of a relinquished property (including weekends and holidays). The 45-Day Identification Period begins the day after the closing date, and the replacement property(s) must be properly identified in writing by the Exchanger and received by the Accommodator by 12:00 am (midnight) of the 45th day.
The Exchanger has several ways to properly identify replacement properties. He or she may identify up to three properties without regard to the total market value (this is called the Three Property Rule). Alternatively, the Exchanger can identify an unlimited number of properties, providing the total market value of all properties identified does not exceed two times the value of the property sold (this is called the 200% Rule). As a final option, the Exchanger can ignore the above two rules if 95% or more of the replacement properties identified are purchased. The 95% exclusion is considered the most aggressive exchange strategy, and should be used only when the other two rules fail.
Requirement #3
The Exchanger must close on the replacement property within 180 calendar days after closing on the sale of the relinquished property, or by the tax filing deadline for the year in which the relinquished property was sold, whichever comes first. The tax-filing deadline (normally April 15th) will impact an exchange where property is sold after about October 15th. The Exchanger may obtain a tax filing extension to increase the exchange period back to 180 days. For example: If the Exchanger closes on the relinquished property on December 30th, he or she will only have until April 15th to complete the exchange transaction unless an extension is filed by April 15th.
Requirement #4
The most common exchange format, the delayed exchange, requires investors to work with an IRS-approved middleman called a "Qualified Intermediary" or "Accommodator." The Accommodator actually documents the exchange by preparing the necessary paperwork (Exchange Agreements), holds proceeds on behalf of the Exchanger, and structures the sale of the relinquished property and purchase of the replacement property.
To participate in a 1031 exchange, an Accommodator must be a "disinterested third party." Any agent who has represented the Exchanger within the past 24 months (such as an accountant, attorney or real estate agent) is ineligible. Since there are no specific licensing requirements for Accommodators, it is important to select an experienced and reputable accommodator in an exchange transaction.
Requirement #5
To defer all capital gains taxes, an Exchanger must buy property of equal or greater value (net of closing costs), and reinvest all net proceeds from the sale of the relinquished property. Any funds not reinvested, or any reduction in debt not made up for with additional cash from the Exchanger, is considered "boot" and is taxable. For example, Bill sells his rental house, which he held for investment, for $500,000. A hundred days later he closes on an office building, which he plans to hold for investment, for $440,000. Bill deposits the $60,000 in excess funds into his bank account. In this case, Bill must pay capital gain taxes on $60,000.
There is no limit on the number of exchanges you can do over your lifetime. In fact, if you continue to own investment property, the IRS will eventually forgive your gains taxes when you die.