In considering selling an investment property in a hot real estate market through a 1031 exchange, owners are rightfully concerned about finding a suitable replacement property. The 45-day identification rules under a 1031 tax deferred exchange can feel like too small a window when supply is limited and there are many bidders in the market. (To read more about 1031 exchange process and rules, visit our 1031 exchange explained page) In places like Denver, Colorado or Salt Lake City, Utah attractive properties will receive multiple offers on the first day of listing and can go pending same day. So, what do you do when you still want to defer your taxable gain while taking advantage of a hot real estate market from a seller's perspective?
Luckily, the 1031 exchange rules provide alternatives to the traditional exchange that can be beneficial in a tight market. These alternatives are deemed Reverse Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange s and Improvement Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange s.
Reverse 1031 Exchanges
Under the Treasury Regulations, exchanges must be completed in the proper sequence. This means the sale of the relinquished property must take place before the acquisition of the new or replacement property. However, on occasion, the facts are such that a taxpayer wishes to acquire the new property before the sale or risk losing the desired new property. This reverse sequence is often referred to as a “reverse 1031 exchange” and codified in the tax code.
The reverse exchange technique essentially consists of an exchange facilitator holding or “parking” title to the new property on behalf of the taxpayer to avoid the taxpayer having simultaneous ownership of two properties. Immediately after the sale of the old property (but no later than 180 days) the exchange company affiliate transfers the new property to the taxpayer. This 'technically' creates the proper sequence.
For example, an investor holding a multi-family rental property in Denver is looking to take advantage of the hot market to sell their property but is concerned about finding the right replacement property in Colorado Springs. That investor decided to wait to list their property and found the perfect property replacement 60 days later and purchased it through a A Reverse Exchange is typically conducted under the safe harbor established in Rev Proc 2000-37. These are "parking arrangements" where either: (i) a property is purchased and "parked" as a potential replacement property for the benefit of a specific taxpayer by an exchange accommodation title holder until such time as the taxpayer arranges for the transfer of the relinquished property to the ultimate transferee in a simultaneous or deferred exchange; or (ii) a taxpayer transfers the relinquished property to be "parked" by an exchange accommodation title holder in exchange for immediately receiving the replacement property, and the exchange accommodation title holder later transfers the relinquished property to the ultimate transferee Reverse Exchange with the help of an exchange facilitator. Upon closing on the new purchase, the investor can now continue earning rental income on the Denver property and has 180 days to close on the sale to defer their gain into the newly purchased Colorado Springs property.
Build-to-Suit or Improvement Exchange
Build-to-Suit, also known as Construction-to-Suit or Improvement Exchange refers to a type of exchange done where some of the proceeds of the sale of the relinquished property will be used to complete improvements on the replacement property so that the taxpayer can finalize the exchange where both the value of the land and the enhanced improvements will count for the amount the taxpayer traded for. Investors may want to build on raw land or put in new heating, ventilating, air conditioning, roof, and windows on an existing property. All of which can qualify if executed properly.
In this type of exchange, the exchange facilitator parks the replacement property on behalf of the taxpayer while the desired improvements are made. Upon the earlier 180 days or the completion of the improvements, the entire value of the real property and improvements is conveyed directly to the taxpayer to complete their exchange.
As an example, an investor owns a commercial property in Salt Lake City and wants to invest in new vacation rental units in Park City. However, the only homes for sale need significant improvements to command a premium rental income. The investor can engage an exchange facilitator to consummate an improvement exchange of real estate whereby the purchase price and improvements to the vacation rental properties can be funded through the tax deferred proceeds of the sale of the commercial property in Salt Lake City.
As you can see, tools are available to real estate investors to defer taxes and grow their portfolios in any environment. Accruit is well versed in executing all types of exchanges. You can reach our Headquarters in Denver, Colorado or our Western Regional Office in Dillion, Montana by calling (800) 237-1031 or emailing firstname.lastname@example.org for more information.