Costs and Considerations When Performing 1031 Exchanges

As is widely known, many economic benefits may be obtained by taxpayers who perform 1031 exchanges.

Owners of real estate that is held for trade, investment purposes or use in a business are generally able to defer capital gains tax, depreciation recapture, and state tax (if applicable) on the sale if they perform an exchange to acquire the new property as opposed to a conventional purchase and sale transaction that does not take advantage of Section 1031.

By utilizing a 1031 exchange, taxpayers use that portion of the sales proceeds that they would otherwise pay to the government to potentially acquire more valuable property.   (“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayer s may consolidate or diversify their real estate holdings through an exchange by going from one property to many or many to one.  Estate planning advantages are also available in an exchange because a property owner’s heirs receive a stepped-up basis in the real estate upon death with the way the law is currently drafted.  (“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayer s may use exchange funds toward construction of improvements that are incorporated and made a part of the real estate during the 180-day exchange period window in an improvement/build-to-suit exchange as set forth in Rev. Proc. 2000-37.  There are even passive investments in real estate that generate a rate of return without the management obligations associated with owning investment property. (https://www.accruit.com/blog/delaware-statutory-trusts-1031-exchange-investments).    

The advantages of 1031 exchanges generally outweigh the disadvantages; however, certain costs and considerations are present that taxpayers should consider when contemplating whether to perform an exchange.

First, taxpayers receive a carryover basis in the replacement (new) property when exchanging real estate under Section 1031.  The basis in the replacement property is equal to its cost reduced by the amount of gain which is not realized in the exchange transaction.  When the real estate with the carryover basis is eventually sold, the deferred tax becomes due and payable.  The deferred tax is just that.  It is not a tax-free transaction.

Next, a 1031 exchange will result in an increase in transactional costs to taxpayers.  These costs are oftentimes small, such as the exchange fee paid to the Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary for providing exchange services, title company or settlement agent charges.  Taxpayers could also incur higher costs by way of attorneys’ or accountants’ fees related to consultation, preparation and execution of documentation associated with the deal.  The increase in transactional costs may be greater than the tax benefit if there is little gain to be deferred (such as when the taxpayer has not owned the real estate for a significant length of time) or the taxpayer may be able to offset the gain from the sale with other losses.         

Moreover, the taxpayer’s net equity in the relinquished property must be used to acquire other like-kind real estate (except for any portion that the taxpayer takes as “boot” at the relinquished property closing which would not be sheltered from tax).  While the definition of “like-kind” real estate is rather broad for 1031 purposes, the money is still tied up in the real estate and the taxpayers exchange funds held by the Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary are illiquid during the exchange period.  Plus, the taxpayer will need to hold the replacement property for an obligatory period of time and use it for the qualified purpose in order to suffice the statutory requirements of Section 1031. 

If the taxpayer does not perform a 1031 exchange, no constraints would exist on the use of the real estate or amount of time required to hold the property.  The taxpayer would be free to use the property as vacation home, second home or primary residence, or perhaps sell, gift or develop it as quickly as possible.

(“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayer s should always consult with their independent tax and legal professionals when contemplating whether to perform a Section 1031 exchange.  Accruit is available to help answer questions, work through the issues, and facilitate exchanges in cases where it is advantageous to do so.