Commercial Real Estate | Jim Costello | Wilmington North Carolina

Untitled Document

What is the purpose of a 1031 exchange?

When you sell your home or investment real estate, you have to pay tax on the gain from the sale of your property. This gain is caused either by the property appreciating over time or by taking depreciation deductions for tax purposes.

A 1031 tax deferred exchange allows you to roll-over all of the proceeds received from the sale of an investment property into the purchase of one or more other comparable investment properties. At closing, proceeds are transferred to a third party - called a facilitator or qualified intermediary - who holds them until they are used acquire the new property.

With a 1031 Exchange, named for the Internal Revenue Code Section, you can defer the payment of the tax that is normally due on the sale.

The deferment is like getting an interest-free loan on the tax dollars you would have owed for a cash sale. More equity is retained, and that helps you move into properties of higher value each time you perform a 1031 exchange.

If you want to use the proceeds from the sale of your property to buy more business or investment real estate, a 1031 Exchange can provide you with more funds for investment than can be achieved through the investment of after-tax proceeds from the sale of your current property.

How a 1031 Exchange Works:

The old property and the new property must qualify as investment or business use. If the property qualifies, you can exchange any type of real estate for any other type of real estate.
From the date of closing on the old property, you have 45 days to determine a list of properties you wish to buy.
You have 180 days from the date of closing to close the purchase of one of the properties submitted on your 45-day list.
You cannot control the money. By law, the money is held by a "Qualified Intermediary" (sometimes also called an "Accommodator" or a "Facilitator").
Whoever holds title on the previous property must also hold title on the new property.
To avoid taxable gain, you must reinvest all your proceeds and buy a property of equal or greater value.

Who should consider a 1031 exchange?

If you have real property that will net you a gain upon sale (generally property that has been substantially depreciated for tax purposes and/or has appreciated in fair market value), then you are exactly the person who should consider a 1031 exchange.

Properties that typically qualify for a 1031 exchange include:

Property held for investment.
Property used as a vacation home.
Property held primarily for sale to customers.

Why should you consider a 1031 exchange?

Defer paying capital gains taxes.

Leverage.
A properly structured exchange can provide real estate investors with the opportunity to defer all of their capital gains taxes. By exchanging, the investor essentially receives an interest-free, no-term loan from the government.
Relief from property management. The lessee takes the responsibility to sublet and maintain the property allowing real estate buyers to avoid most of the day-to-day management headaches.
Upgrade or consolidate property.
Diversify. Own multiple properties rather than just one.
Relocation to a new area.
Differences in regional growth or income potential.
Change property types among residential, commercial, retail, etc.

What are the 1031 exchange rules?

The real property you sell and the real property you buy must both be held for productive use in a trade or business or for investment purposes and must be like-kind.

The proceeds from the sale must go through the hands of a qualified intermediary and not through your hands or the hands of one of your agents or else all the proceeds will become taxable.

All the cash proceeds from the original sale must be reinvested in the replacement property - any cash proceeds that you retain will be taxable.

The replacement property must be subject to an equal level or greater level of debt than the relinquished property or the buyer will either have to pay taxes on the amount of the decrease or have to put in additional cash funds to offset the lower level of debt in the replacement property.

1031 Timeline:

Identification Period: Within 45 days of selling the relinquished property you must identify suitable replacement properties. This 45 day rule is very strict and is not extended should the 45th day fall on a Saturday, Sunday, or legal holiday.

Exchange Period: The replacement property must be received by the taxpayer within the "exchange period," which ends within the earlier of... 180 days after the date on which the taxpayer transfers the property relinquished, or... the due date for the taxpayer tax return for the taxable year in which the transfer of the relinquished property occurs. This 180-day rule is very strict and is not extended if the 180th day should happen to fall on a Saturday, Sunday or legal holiday.

Replacement property identification

3-property rule: You may identify any three properties as possible replacements for your relinquished property. More than 95% of exchanges use the 3-property rule.

200% rule: You may identify any number of properties as possible replacements for your relinquished property as long as the aggregate value of those properties does not exceed 200% of the value of your relinquished property.

95% exemption: You may identify any number of properties as possible replacements for your relinquished property as long as you end up purchasing at least 95% of the aggregate value of all properties identified.

Like-Kind Property

In a 1031 exchange you can exchange any real property for any other real property within the United States or its possessions if said properties are held for productive use in trade or business or for investment purposes. Examples of like-kind property include apartments, commercial, condos, duplexes, raw land and rental homes*. As used in IRC 1031(a), the words "like-kind" mean similar in nature or character, notwithstanding differences in grade or quality. One kind of class of property may not, under that section, be exchanged for property of a different kind or class.

Examples of qualified like-kind exchanges:

office building for hotel
raw land for retail space
unimproved property for commercial property
airplane for airplane
apartment building for farm/ranch

The role of the Qualified Intermediary (QI)

The QI is a person or entity that can legally hold funds to facilitate a 1031 exchange. To be qualified, the intermediary must not be relative or agent of the exchanging party. As an exception, a real estate agent may serve as an intermediary if the current transaction is the only instance in which the agent has represented the exchanging party over the past two years.

The use of a QI is essential to completing a successful 1031 exchange. The QI performs several important functions in the 1031 exchange process including creating the exchange of properties, holding the exchange proceeds and preparing the legal documents.