IRC 1031 TAX-DEFERRED EXCHANGE FOR INVESTORS
By: Roman P. Mosqueda, Esq.
Real Estate Broker & Attorney
What is an IRC Section 1031 tax-deferred exchange?
According to Internal Revenue Code Section 1031, a correctly structured exchange allows an investor to sell a property, reinvest the proceeds in a new property or properties and defer capital gains taxes.
Section 1031 provides that “no gain nor loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.”
But a developer who constructs and sells single-family homes cannot exchange such properties which are considered inventory not held for investment.
Shelter To Defer
Capital Gains Taxes:
A 1031 exchange provides one of the best shelters for deferring capital gains taxes by reinvesting the proceeds from the relinquished property (also known as “Phase I” or “down-leg” property) into a like-kind property without recognizing any gain.
Like-kind real property may be raw land, rental home, condominium, apartment complex, or commercial building as replacement property (also known as “Phase 2” or “up-leg” property).
But one of the few types of property that does not qualify as a replacement for exchange property is the taxpayer’s principal residence, unless it is a mixed use (live-work) property, which requires an allocation of the portion for personal residence and the portion for office use, to qualify for the exchange.
In addition to the deferment of federal capital gains taxes (lowered by Congress earlier this year to as low as fifteen (15) percent), an IRC 1031 exchange is an exempt transaction under the new California revenue withholding requirement.
It should also be noted that the IRC 1031 tax-deferred exchange also applies to personal property, such as livestock, valuable works of art, and business assets.
History Of Section 1031
Exchange:
The much-criticized Tax Code (Internal Revenue Code) was enacted during World War I as a temporary revenue-making measure.
But one of the unintended adverse consequences of the Tax Code was that it tied up capital. So, in 1921, Section 1031 exchange was adopted to stimulate economic activity.
Due to the stock market crash in the 1920’s, the Section 1031 exchange was disallowed in stocks and bonds, and partnership interests. But a partnership (not partners) and a limited liability company with more than one member can participate in a Section 1031 exchange. And a trustor or a sole limited liability company member who owns a property in his/her name can exchange it for property which he/she acquires in the name of his/her revocable trust or of his/her limited liability company.
The exchange transaction was required to be simultaneous until July 18, 1984, when the 45-day rule (starting from close of escrow of the first relinquished property) to identify the replacement property, and the 180-day rule (starting likewise from close of escrow on the first replacement property) to close escrow on the second replacement, were promulgated as regulations.
Thus, before 1984, both the ownership of the relinquished property, as well as, of the replacement property must transfer at close of escrow at the same time, in order to qualify as a simultaneous exchange.
After 1984, the most common type of Section 1031 exchange is the delayed or Starker (named after T.J. Starker, who had a land exchange in Oregon, and won his case in the 9th Circuit Court of Appeals) exchange, whereby the relinquished property is sold first and the replacement property then acquired, with compliance of the aforesaid 45-day and 180-day rules.
In 1991, the IRS Exchange Regulations provided for “safe harbors” for the taxpayer’s funds in a delayed transaction through qualified intermediaries (also known as accommodators) who shield the taxpayer from actually or constructively receiving money or other real property, in order to quality for IRC 1031 exchange.
And on September 15, 2000, the Treasury Department published Revenue Procedure 2000-37,which established a “safe harbor” for structuring reverse exchanges.
Reverse exchanges may be “exchange last” (a replacement property is purchased by an exchange accommodation titleholder [EAT] and holds it for the investor while the latter markets the old, relinquished property) or “exchange first” ( a relinquished property is transferred to a qualified intermediary [Q.I.] who sells it to an EAT, then the Q.I. purchases the replacement property and transfers it to the investor in exchange for the relinquished property).
Basic Mechanics of A 1031
Delayed Exchange:
There are two basic rules that the taxpayer must meet to completely defer income taxes on the gain realized from the sale of a relinquished property in a IRC Section 1031 delayed exchange.
They are:
(1) the purchase price of the replacement property or properties must be equal or greater than the net sales price of the relinquished property; and
(2) all the cash money received from the sale of the relinquished property must be paid to buy the replacement property or properties.
Thus, a taxpayer qualifies for a 100% tax deferral if the replacement property is of equal or greater value than the relinquished property and all cash proceeds of the sale thereof were used to acquire the replacement property.
And the relinquished and replacement properties must be of “like kind,” defined under the Internal Revenue Code as “property held for productive use in a trade or business or for investment.”
Cash Boot and
Mortgage Boot:
If a taxpayer does not use all of the cash proceeds from the sale of the relinquished property as part of the acquisition cost of the replacement property, and takes out “cash boot,” the amount of the cash is taxable income, even if the replacement property is of equal or greater value than the relinquished property.
And even if all of the cash proceeds were utilized to acquire the replacement property, but if the value of the replacement property were less than the relinquished property, the taxpayer incurs a taxable mortgage boot.
But any mortgage boot may be offset with additional cash contribution by the taxpayer, after using up all of the cash proceeds from the sale of the relinquished property.
Role Of Qualified Intermediary
(Q.I.) And Identification Of
Replacement Property:
In order to qualify for a Section 1031 exchange, the taxpayer-exchangor selects a qualified intermediary (Q.I.) who prepares the Exchange Agreement to be signed by the exchangor, which states the taxpayer’s rights and obligations through the end of the exchange period.
The transaction is required to be an exchange, rather than a sale followed by a purchase. So, the qualified intermediary (Q.I.) purchases the relinquished property from the taxpayer-investor, sells it to a third-party buyer, and subsequently purchases the replacement property from the third-party seller, and transfers it to the taxpayer-investor in exchange for the relinquished property.
Although the qualified intermediary (Q.I.) appears to be the seller of the relinquished property and the buyer of the replacement property, direct deeding from the taxpayer-investor to the third-party buyer, and from the third-party seller to the taxpayer-investor, is permitted by the regulations.
After the sale of the relinquished property, the taxpayer-investor must identify in writing up to three properties without regard to their fair market value, that he/she intends to acquire within 45 days of the closing of escrow or sale.
This is a “drop-dead” period. If the 45th day is a Sunday or holiday, it cannot be extended to the next business day by the taxpayer-investor, nor by the qualified intermediary.
If four or more properties are identified in writing within the 45-day period, their aggregate fair market value cannot exceed 200 percent of the sales price of the relinquished property.
And if neither the “three-property identification rule” nor the “200% rule” for four or more properties is followed, the taxpayer-investor can identify an unlimited number of properties with unlimited aggregate values, if he/she purchases 95% of the properties identified at their fair market values.
The taxpayer-investor must close on the purchase of the replacement property or properties on or before the earlier of 180 days after close of escrow on the relinquished property, or the date the taxpayer-investor’s income tax return is due for the year in which the relinquished property is sold.
Conclusion:
Real estate investors can expect to pay from as low as 15 percent all the way up to 27.81 percent of their capital gain in federal taxes plus any applicable state taxes, up to 33 percent in combined federal and state income taxes, after selling investment property.
But investors who structure the sale and purchase as a Section 1031 exchange can defer payment of the capital gain taxes, have more money available to invest in the new property or properties, and continue to defer paying capital gain taxes by continuing to dispose of investments only through tax-deferred exchanges under IRC Section 1031.
They may want to diversify or consolidate their investment holdings, like to invest elsewhere in the United States, or desire to simply exchange a property or properties in accordance with business objectives. They need to pay taxes on any capital gains, unless deferred through IRC Section 1031.
(The Author, Roman P. Mosqueda, is a real estate broker and attorney, who can advise real estate investors on IRC Section 1031 exchanges in investment, trade or business properties.)