A tax-deferred exchange involves selling investment property and acquiring new investment property without having to pay taxes on the appreciation or having to recapture depreciation at the time of the exchange. This allows you to keep all of your money invested when you sell a property rather than giving a large percentage of it to the government.
You don’t have to trade properties directly, invest in the same part of the country or stay in the same kind of investment. If you feel that growth has maxed out in the area where you own property, you can invest somewhere else. If you’re burdened by the amount of work your current investment requires, you can find a less labor-intensive property. If you hold undeveloped land, you can do an exchange for a property that produces income.
You can even do a series of Sec. 1031 exchanges over time, continuing to defer your gains through each exchange. To avoid giving the impression that you are trying to avoid taxes, however, you need to hold on to each new investment for a period that the IRS will view as adequate, usually at least a year and a day.
If you’re an older investor with a goal of preserving your assets for your heirs, you can continue to defer gains on your investment property by exchanging properties as they accumulate significant amounts of gain. Upon your death, your heirs will pay no capital gains taxes when they inherit the property because they will receive a stepped-up basis in the property.
To qualify for tax deferral on an exchange, you must follow certain procedures in handling the purchase and sale of the properties. Luckily for investors, the rules governing these procedures are clearer than in the past.
The IRS issued “safe harbor” regulations in 1991 that covered “simultaneous exchanges” (where you close on both new and old properties at the same time) and “delayed exchanges” (also known as “forward exchanges,” where you sell your property first and then purchase replacement property). “Reverse exchanges” (where you purchase replacement property first and then sell your property) were usually allowed, but the guidelines were unclear until Rev. Proc. 2000-37 was issued effective Sept. 15, 2000, spelling out safe-harbor requirements for these also.
All of the properties involved must be “like-kind” properties, which means that they must have been held for “productive use in a trade or business” or for investment. Like-kind properties have to be real property located in the United States, but they don’t have to be the same type of real property.
For instance, you can trade an apartment house for a ranch, a business, an undeveloped parcel, a warehouse, an office building, a strip mall, a motel, or another apartment house. You can trade one piece of property for a few pieces of property, or vice versa.
To defer all of the gain on the properties you owned, be sure that the value of your replacement properties is equal to or greater than the value of your relinquished properties and that you use all of the equity from your relinquished properties in the purchase. In an exchange, you will owe taxes on any money you get and on any assets that the IRS does not consider like kind.
Under any circumstances, you’d be wise to discuss your plans with a tax professional before you start your transactions.
Safe-harbor guidelines for delayed exchanges
The IRS requires that you do not have “constructive receipt” of the assets involved in an exchange in order for it to qualify for the tax-deferment advantages of a Sec. 1031 exchange. Safe-harbor guidelines spell out how to do this.
A “qualified intermediary” (QI), also known as an “exchange accommodator” or an “accommodation party,” must act on your behalf during the exchange of properties. The QI cannot be a related party or your “agent,” a category that includes your Realtor, your attorney, your accountant, a close relative, or a company, partnership or trust you control.
Many companies have sprung up to provide this service, and their fees can be as reasonable as $500 or $1,000. For federal income tax purposes, the QI is the “beneficial” owner of the property during the exchange period, so it’s wise to have a specialist handling the exchange. Be sure your QI is a CPA or attorney familiar with exchanges, and insist that they are bonded for at least $2.5 million per transaction.
In a delayed (or forward) exchange, you can market the property you are going to relinquish as you would normally. When contingencies are satisfied and before the actual close of the sale, you sign an agreement with a QI.
As Larry Jensen of Colorado’s 1031 Corp. puts it, the QI acts as the “substitute seller.” The QI holds the proceeds while you look for replacement properties.
From the date that you close on your sale, you have 45 days to list the legal descriptions of the replacement properties in which you are interested. If a property is not clearly identified and on that list, it will not qualify as like-kind property.
You can have up to three properties listed as replacement properties without regard to their sales prices. Maybe you intend to purchase only one, but you are protecting your options by listing a couple more.
Alternatively, you can have an unlimited number of properties on your list so long as the total value isn’t greater than 200% of the value of your relinquished property. You can even exceed the 200% rule, but if you do, you actually have to buy enough of them to equal 95% of the value on the list.
Including the 45 days, you have a total of 180 days to complete the exchange and take title to the new property. If the 180 days would extend past the April 15 tax-filing deadline, you would have to request an extension to take advantage of the full period.
Generally, a QI will terminate the exchange and return all of the assets held for you if you fail to meet the 45-day or 180-day requirements. The safe-harbor guidelines do not provide for an extension of the deadlines in a delayed exchange for any reason.
Although the IRS doesn’t require you to sign a contract for any of the properties on your list within 45 days, your exchange won’t be valid if you end up being unable to buy any of your listed properties. As Jensen puts it, just listing the properties within 45 days is “good enough for the IRS but not good enough to be successful.”
Practically speaking, you should have your replacement property under contract, not just on the list, within the 45-day period.
Because it is difficult to find the replacement properties you want within 45 days, you may want to consider a reverse exchange, where you buy your replacement properties first and then have 180 days to sell your relinquished properties.
Safe-harbor guidelines for reverse exchanges
The guidelines for reverse exchanges are similar to those for forward exchanges, but there are some important differences beyond the order in which properties are bought and sold.
You find your replacement properties and enter into a contract to buy them, but an “exchange accommodation titleholder” is the party who will actually take title when the purchase closes, not you. This person, or entity, will be the beneficial property owner.
The exchange accommodation titleholder cannot be a related party, just as a QI cannot. Because the exchange accommodation titleholder must be knowledgeable about exchanges and comply with the same tax-reporting responsibilities in a reverse exchange as a QI must in a delayed exchange, many investors choose to use a professional QI as their exchange accommodation titleholder.
Within five business days after the exchange accommodation titleholder takes title to your replacement property, you must enter into a “qualified exchange accommodation agreement” with the titleholder that acknowledges various factors such as your intent to do a reverse exchange.
A 45-day clock also begins on the day that the exchange accommodation titleholder assumes title to your property. In a reverse exchange, where you already have your replacement property, what you need to identify within 45 days is which of your existing properties you are going to relinquish.
You have 180 days, including the 45 days, to complete the sale of your relinquished property to remain under the safe-harbor guidelines. As with a forward exchange, you will need to file for an extension to get the full 180 days if the period extends beyond the April 15 tax-return deadline.
Unlike with a forward exchange, however, a reverse exchange is not necessarily invalid if the sale of your relinquished property is not complete within 180 days. In fact, Rev. Proc. 2000-37 specifically states that reverse exchanges “can be accomplished outside of the safe harbor of this revenue procedure.”
Getting the ‘boot’
“Boot” is not an IRS term, but it is the word commonly used to refer to any asset involved in an exchange that is not considered like kind and is therefore taxable. It includes cash left over from buying a replacement property that costs less than your relinquished property, personal property that does not qualify as like kind, certain loan acquisition costs, the amount by which debt on the replacement property is lower than on the relinquished property, rent prorations during the exchange period, tenant damage deposits transferred to the buyer, seller financing, notes taken by the exchanger, certain closing costs and a variety of other items.
Unless you want to pull money out of the exchange and are willing to have it taxed, you will want to avoid boot. A rule of thumb is to find a replacement property that is of equal or greater value than your relinquished property, but as you can see from the examples given, sometimes it’s hard to anticipate what is considered boot.
Because boot is taxable and the rules can be complex, you should discuss this area with your qualified intermediary as well as with a tax consultant as you consider various properties. You go into an exchange with the purpose of deferring taxes, and with good advance planning, you can minimize, offset or avoid boot.
Disadvantages of exchanges
Luckily, the advantages of exchanges greatly outweigh the disadvantages for most people. The tax basis of your replacement property is decreased by the amount of gain that you deferred. Let’s say your gain on the relinquished property was $50,000. The basis of your new property is decreased by that $50,000 of deferred gain. Most people would rather pay taxes later rather than sooner, so that isn’t a huge drawback.
This reduced basis also gives you less to depreciate. On the other hand, you may have nearly exhausted your depreciation period on the relinquished property, and you get to start a new period with your replacement property.
This discussion of Sec. 1031 exchanges is a summary of the basic concepts. Some aspects of exchanges are complicated even for accountants because tax law is not straightforward: It is a combination of actual codes as well as court decisions, technical advice memoranda, private letter rulings, and so forth. Further, the IRS is not always consistent in its rulings.
You need to consult a tax professional familiar with exchanges, who can provide you with more complete information, talk to you about your particular investments and your goals, and give you all of the details that you need to decide whether an exchange will work for you.