Deferring the recognition of income taxes under IRC Section 1031 was the rage in the real estate boom years.  While the real estate market has cooled it is still important to know about like kind exchanges (“1031 Exchange”).  First, you or some of your Clients may own properties that were acquired in a 1031 Exchange. Second, despite the recent downturn, many people still own properties that, if sold, would result in large gains for income tax purposes.

Since there is a lot to know about 1031 Exchanges, and the rules are complex, I have broken this topic into 2 parts.  Part 2 will be released in the September, 2009 edition of Tax Law Explained.

 

What is a Like-Kind Exchange:

Briefly, a 1031 Exchange is a technique for trading/selling certain types of properties without having to recognize gain for income tax purposes.  The gain is not necessarily eliminated forever.  Rather, if done properly, the gain is merely deferred until it is triggered by some future event such as a sale of the newly acquired replacement property.

Of course, the general rule under the Internal Revenue Code is that any sale or trade creates a taxable event for which the government has an opportunity to collect a tax. The 1031 Exchange laws present an exception. The basic concept behind the 1031 Exchange exception is that if you trade properties with someone else but essentially end up with the same thing that you started with, then, perhaps, you should not have to pay a tax on the trade.

There are a variety of names used for 1031 Exchanges including:

  • Like kind exchanges.
  • Deferred exchanges.
  • Tax free exchanges.
  • Section 1031 exchanges.
  • Starker exchanges.

For sake of discussion, I have defined a few terms:

  • Client:  The person or entity trying to achieve the 1031 Exchange.
  • Relinquished property: The property that the Client owns, but wants to get rid of.
  • Replacement property: The property that the Client wants to buy.

General Statutory Requirements of Section 1031:

Both the Relinquished property and the Replacement property must be held either for productive use in a trade or business, or for investment.

  • The use is determined by how it is actually being used in the hands of the Client. It does not matter how the other parties to the exchange are using a property or how the property might be used.
  • If the use changes sometime in the future, and no longer qualifies, then the gain that was deferred in the 1031 Exchange is triggered. This is not uncommon where a residence is purchased to be held out for rental and later becomes the Client’s principal residence.  There is some relief for this particular situation that will be discussed in Part 2 that creates wonderful planning opportunities.

Under Section 1031, certain kinds of assets do not qualify even if they are held for productive use in a trade or business, or for investment. Here is a non- exhaustive list of things that do not qualify for a 1031 Exchange:

  • Mutual funds.
  • Stocks.
  • Bonds.
  • Inventory.
  • Personal property.
  • Partnership interests.
  • Real property located outside of the United States.
  • The Relinquished property and the Replacement property must be of “like-kind”
  • Like-kind refers to the nature of the property, not its grade or quality.
  • All real property is defined in the statute as being of “like-kind”. A 2-flat can be exchanged for vacant land; or a motel; or for a commercial office building; or for an apartment building.
  • While all real property is like-kind the Client’s principal residence does not qualify (either as the Relinquished property or the Replacement property) since a principal residence is not held for productive use in a trade or business or for investment.
  • While livestock are generally eligible for 1031 Exchanges, livestock of a different sexes are not considered to be of “like-kind”. For example, cattle are eligible for 1031 Exchanges.  A bull can be exchanged for a bull but not for a cow.  (For you city slickers, male cattle are bulls and female cattle are cows.)

Simple Like-Kind Exchange (2 Party Exchanges):

What it is: A simple 1031 Exchange takes place if a buyer and a seller simultaneously trade properties directly with each other.   This rarely happens because the chances that a buyer and seller both want the other’s property are low.

The Players:

In a simple 1031 Exchange, there are only 2 players:

  • The Buyer.
  • The Seller.

Deferred Like-Kind Exchange (3-Party or “Starker” Exchanges):

What it is:

While it is not common that 2 people simultaneously want the other’s property, it is very common that someone wants to sell one property and then, take the money to buy another property.  A guy named Starker did an exchange that was not a direct simultaneous exchange and wanted to defer the gain under Section 1031.  In Starker. U.S. (602 F.2d 1341), it was determined that certain exchanges qualify as 1031 Exchanges even if they are not direct simultaneous trades. There are 2 types of deferred 1031 Exchanges:

  • Forward (“Starker”): The Client sells before buying.
  • Reverse (“Reverse Starker”):  The Client buys before selling.

There is a purgatory period for deferred 1031 Exchanges until both the purchase and sale are completed.  The purgatory period begins on the date of the closing on the first transaction and ends on the date of the closing on the second transaction. For a Forward 1031 Exchange, the Client cannot touch the money that they get from selling the Relinquished property.  That money must go directly to buy the Replacement property.  In a Reverse 1031 Exchange the Client cannot hold title to the Replacement property until the Relinquished property is sold.  Instead, all of the proceeds and title must be held by a third party referred to as the “Qualified Intermediary”

The Client must be sure to get special language into the real estate contract to be sure that the 1031 Exchange can be completed.  This is true whether it is a Forward or Reverse 1031 Exchange.  This special language obligates the other party to cooperate with the Client in achieving the 1031 Exchange.  For example, for the Client’s contract in buying the Replacement property in a Reverse 1031 Exchange, the seller must be legally obligated to transfer title to the Qualified Intermediary rather than only to the Client.  This legal obligation not only satisfies the IRS, but also guarantees that the seller will do so as a contractual obligation rather than merely as a courtesy to the Client.

The Players:

In a Starker 1031 Exchange, there are 4 players:

  • The Client: This is the person who has a property and would like to exchange it for a different property while deferring the gain.
  • The Buyer: This is the person who wants to acquire the Client’s property.
  • The Seller: This is the person who owns the property that the Client would like acquire.
  • The Qualified Intermediary: This is the party who takes title to the properties and holds the cash until the transactions can be properly completed pursuant to the Section 1031 rules.

Timing is Everything.

There are strict time periods in which a Forward or Reverse 1031 Exchange can be completed.  If you fail to meet one of the time periods, then you do not qualify for the 1031 Exchange.

45 day Identification Period.

  • The Client must identify which property is going to be used as the Replacement property within 45 days of the date that the Relinquished property is transferred. If the Client is not sure which property he wants (or can get), the Client can identify up to 5 different potential Replacement properties.
  • The identification must be done in writing. B.  180 day Closing Period.

The Client must receive the Replacement property within the earlier of

  • 180 days after the date that the Relinquished property is transferred or
  • the date in which the Client’s income tax is due (including valid extensions) for the tax year in which the transfer took place.

This means that the amount of time that the Client has to complete the exchange could be less than 180 days, depending upon what time of the year the transactions take place, the type of entity the Client is and the tax year of the Client.

The “transfer date” for both the 45 day and 180 day periods is normally the Closing date for the sale of the property exchanged.

Getting things done within the 45 day and 180 day periods have always presented challenges and risks.  The Client can want a property, enter into a contract for that property, and the deal could later fall apart.  The transaction process often takes many months.  For example, the Client enters into a contract and then the attorneys negotiate modifications for a month.  The contract contains contingencies that allow the Client or the other party in the transaction the right to get out of the contract. Common contingencies include inspections, environmental testing, verification of leases, getting zoning changes, etc.  Sometimes many months will go by before the contract is terminated.  The Client could then be left scrambling to find another property and then go through the same negotiation process, attorney review, contingency periods, etc. before a closing can take place.  The IRS has no sympathy for your timing problems.

Some people will only sell a particular property if they can defer the gain in a 1031 Exchange.  However, because of the timing issues, they might have closed on the sale (or closed on the purchase) before they discover that they cannot get the second leg of the transaction completed in time.  They can get stuck recognizing the gain (Forward 1031 Exchange) or buying a property that they end up not wanting (Reverse 1031 Exchange).

 

Conclusion

Section 1031 Exchanges present wonderful tools to defer taxes.  However, there are many traps for the unwary in successfully completing a 1031 Exchange.  The government created a minefield and then gave us the map to that minefield.  It then becomes our job to carefully navigate. One small misstep and you step on a mine and trigger the gain. Even if you succeed in completing the 1031 Exchange, you could trigger the recognition of the gain later on if you sell the property or change the like-kind nature of the property.

Due to a variety of factors, many people choose not to attempt a 1031 Exchange even though doing so would significantly reduce their tax bill.  The reasons include:

  1. They do not want to own that type of property any more.
  2. They want to take advantage of historically low tax rates.
  3. They do not want to be pressured into buying a property just because the 1031 Exchange clocks are ticking.
  4. There are legal fees and costs associated with 1031 Exchanges.

Section 1031 Exchanges will be explored further in the September, 2009 issue of Tax Law Explained.

 

 

08/2009

Copyright ©, Keith B. Baker – 2009

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