7 Things You Need To Know About A 1031 Exchange
The 1031 Exchange
If you are a real estate investor thinking about selling one property to buy another (or several), you probably know about the 1031 tax-deferred exchange. There are many positives to the transaction as well as lots of information to digest to ensure it is executed properly. There are many types of 1031 Exchanges and several variables, not mentioned here, that need to be factored into your decision to pursue this type of investment.
The 1031 Exchange is a transaction which allowing the owner of an investment property to sell it and buy like-kind property while deferring capital gains tax. To qualify there are several rules, concepts, and definitions you MUST know. If you’re thinking of getting started with a 1031 transaction, it is a complex process and as such we encourage you to consult with a qualified intermediary and tax expert to fully understand the necessary requirements.
First American State Bank is active in lending to investors who take advantage of 1031 Exchange transactions. It is not uncommon for a lender to participate in such transactions, especially when investors “step-up” to higher valued real estate or wish to re-establish retired debt with new on the next subject investment. We welcome the opportunity to help with any financing needs after your discussion and outline with qualified intermediaries, your accountant, or attorney.
As an investor, there are several reasons why you may consider utilizing a 1031 exchange. Some of those reasons may include seeking a property that has better return prospects, you may wish to diversify assets, you might be looking for a managed property rather than managing one yourself, you might want to consolidate several properties into one, for purposes of estate planning, for example, or you might want to divide a single property into several assets. If your situation is the right fit the tax deferment provided by a 1031 exchange may a great opportunity for investors.
The primary benefit of carrying out a 1031 exchange rather than simply selling one property and buying another is the tax deferral. A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows you to avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale within certain time limits in a property or properties of like kind and equal or greater value.
The following are seven simple points relative to basic understanding of the 1031 Exchange transaction:
1ST REQUIREMENT: LIKE-KIND PROPERTY
The first requirement for a 1031 exchange (rollover) is that the old property to be sold and the new property to be bought are like kind. This is frequently one of the most misunderstood concepts involving 1031 exchanges. Like-kind relates to the use of properties. As a result, the old property and new property must be held for investment or utilized in a trade or business. Vacant land will always qualify for 1031 treatment whether it is leased or not. Additionally, commercial property may be used to purchase a rental home or a lot may be sold to buy a condo.
Section 1031 expressly states that property strictly held for resale does not qualify for an exchange. This means that investors and developers who strictly “flip” properties do not qualify for exchange treatment because their intent is resale rather than holding for an investment.
Additional factors to consider: 1. Primary residences can never be utilized in an exchange. 2. A taxpayer may sell a property to a related party which requires a two-year holding period, a taxpayer may never purchase the replacement (new) property from a related party. 3. Properties to an exchange must be within the United States border. Properties located outside the United States may not be involved in the exchange.
2ND REQUIREMENT: 45 DAY IDENTIFICATION PERIOD
A new property must be identified within 45 days of the closing of the sale of the old property. The 45 days commence the day after closing and are calendar days. If the 45th day falls on a holiday, that day remains the deadline for the identification of the new properties. No extensions are allowed under any circumstances. If you have not executed a contract by midnight of the 45th day a list of properties must be furnished and must be specific. It must show the property address, the legal description or other means of specific identification.
Up to three potential new properties can be identified without regard to cost. If you wish to identify more than three potential replacements, the IRS limits the total value of all the properties that you are identifying to be less than double the value of the property that you sold. This is known as the 200% rule. Accordingly, more than three properties may be identified as replacements however, if the taxpayer exceeds the 200% limit the whole exchange may be disallowed. As a result, the logical rule for investors is to keep the list to three or fewer properties. It is the responsibility of the qualified intermediary to accept the list on behalf of the IRS and document the date it was received. However, no formal filing is required to be made with the IRS.
3RD REQUIREMENT: THE 180 DAY PURCHASE PERIOD
This rule is simple and straight forward. Section 1031 requires that the purchase and closing of one or more of the new properties occur by the 180th day of the closing of the old property. The property being purchased must be one or more of the properties listed on the 45-day identification list. A new property may not be introduced after 45 days. These time frames run concurrently, therefore when the 45 days are up the taxpayer only has 135 days remaining to close. Again, there are no extensions due to title defects or otherwise. Closed means title is required to pass before the 180th day.
4TH REQUIREMENT: USE OF A QUALIFIED INTERMEDIARY
Sellers have no access to the sales proceeds between the sale of their old property and the purchase of their new property. By law the taxpayer must use an independent third party commonly known as an exchange partner and/or intermediary to handle the change. The party who serves in this role cannot be someone with whom the taxpayer has had a family relationship or alternatively a business relationship during the preceding two years. The function of the exchange partner/intermediary is to prepare the documents required by the IRS at the time of the sale of the old property and at the time of the purchase of the new property. The intermediary must hold the proceeds of the sale in a separate account until the purchase of the new property is completed. The taxpayer is entitled to the interest of these funds and must treat the interest as ordinary income during the period of escrow.
If 1031 documents are prepared incorrectly, the IRS will disallow the exchange. Errors can be very costly to the investor. Neither state nor the federal government regulate qualified intermediaries. Companies performing this function may not be bonded as there are no licensing requirements. It is IMPERATIVE as an investor to do complete diligence and find an intermediary that IS licensed and has adequate E&O and fiduciary insurance as well as robust processes and procedures to ensure proper management.
5TH REQUIREMENT: TITLE MUST BE MIRROR IMAGE
Section 1031 requires that the taxpayer listed on the old property be the same taxpayer listed on the new property. If you and your wife are married and sell the old property than you and your wife must also be on the title to the new property. If a trust or corporation is in title to the old property that same trust or corporation must be on title to the new property.
If only the husband is on the old property, but his wife is required to be on title to the new property to help qualify for the loan, one solution to avoid this problem prior to the sale would be for the husband to Quit Claim his interest to himself and his wife. However, if shareholders of a corporation or partners in a partnership or members of an LLC are desirous of selling their respective corporate interest, this is prohibited. What qualifies for 1031 treatment is real estate entitlement and not partnership interests. In this case the entity must be liquidated and deeds must be issued to provide the respective partners with a tenants in common interest in lieu of a partnership or related interest.
6TH REQUIREMENT: REINVEST EQUAL OR GREATER AMOUNT
In order to defer 100% of the tax on the gain of the sale of old property, the new property must be of equal or greater value. There are two requirements within this rule. First, the new property must be of greater or equal value of the one which is sold. Secondly, all the cash profits must be reinvested. You may deduct closing expenses and commissions from the sale of the property being sold. If the property is being sold for $500,000, net amount after closing expenses is $465,000, required investment into for the replacement property is $465,000. Closing expenses associated with the purchase may be added into the purchase, as well as capital improvements completed within 180 days together with furnishings. In fact, a taxpayer may make an unlimited number of capital improvements as well as spend up to 15% of the acquisition cost on personal property.
A party who elects to do an exchange and take cash out may do so, however, any cash received will be taxed at the corresponding rate of ordinary income if held for less than one year or 15% if held for more than one year.
7TH REQUIREMENT: REVERSE EXCHANGES – TITLE TO BOTH PROPERTIES CANNOT BE IN SAME NAME AT SAME TIME
All previous requirements are applicable…and then some. A reverse may come in handy when a seller does not yet have a buyer for the property that he wishes to sell and is afraid of losing the new property he wishes to acquire. In the fall of 2000, the IRS issued a revenue procedure that established the concept of an exchange accommodation title holder (which is another name for a qualified intermediary). Simply put, a taxpayer may not have both the old as well as the new property titled in their name at the same time and still qualify for a reverse exchange.
The IRS has set up guidelines which allow the taxpayer to acquire the new property before the old property is sold provided title is taken in the name of the exchange accommodation title holder (typically a limited liability company which is created). Under this scenario an entity, other than the taxpayer, will hold legal title in what is commonly referred to as a qualified parking arrangement until such time as the old property is sold. The old property must be sold and closed within 180 days of first acquiring title to the new property. As soon as the old property is sold the proceeds are then directed to the exchange accommodation title holder at which time the property may be deeded out of the parking arrangement directly to the taxpayer. This is straightforward provided cash is utilized to fund the new purchase. Most lenders simply won’t lend funds to an unrelated third-party entity.
In conclusion, there are many types of 1031 Exchanges and several variables, not mentioned here, that need to be factored into your decision to pursue this type of investment. If your situation is the right fit the tax deferment provided by a 1031 exchange may a great opportunity for investors.
As mentioned previously, there are many complexities that go with successfully navigating this type of transaction. We urge you to consult with qualified intermediary, CPA, or an attorney who has experience and is knowledgeable with 1031 tax deferred exchanges. You will need expert guidance through the process every step of the way.
First American State Bank has experience as a lender to 1031 exchange transactions. Once you have been advised by a professional (again CPA, intermediary, attorney) and would like lender involvement in your steps forward we can help make this a success. Contact us to get started.