Section 1031 of the Internal Revenue Code (IRC). The comprehensive set of tax laws created by the Internal Revenue Service (IRS). This code was enacted as Title 26 of the United States Code by Congress, and is sometimes also referred to as the Internal Revenue Title. The code is organized according to topic, and covers all relevant rules pertaining to income, gift, estate, sales, payroll and excise taxes. Internal Revenue Code provides taxpayers the ability to swap investment or business use real property for other like-kind property without realizing the gain, While these exchanges have been used for years by the most prudent of investors, they continue to gain traction due in part to the appreciation of real estate values. Executing a 1031 exchange can enable you to manage your real estate portfolio in a tax-efficient manner, allowing you to defer a portion or all of the taxable gains as your assets evolve. There's no limit to the number of times you can do a 1031 exchange – you can defer the gain from one piece of real estate to another, again and again. You may increase your portfolio value with each swap, but you defer the tax until you cash out only then realizing your gain.
The Tax Code isn’t known for its simplicity, but it’s in the details where many investors find tremendous opportunities. Revenue rulings and other administrative rulings issued by the Internal Revenue Service & U.S. Treasury provide direction on various factual situations. These rulings are often relied on as precedent by taxpayers and their advisors. Revenue Procedure 2000-37 offers guidelines for taxpayers to acquire replacement property before the sale of their relinquished property. Referred to as “reverse exchanges”, this ruling goes on to inform a taxpayer they cannot own both properties at the same time, thus a “parking arrangement” must be employed - either the relinquished property or the replacement property is acquired and “parked” by an The transfer of the relinquished property to the Qualified Intermediary, and the receipt of the replacement property from the Qualified Intermediary is considered an exchange. To be compliant with IRC Section 1031, the transaction must be properly structured, rather than being a sale to one party followed by a purchase from another party. Exchange Accommodation Titleholder (also, known as an ‘EAT’). To park title means the deed of a parked property is recorded, evidencing a transfer of ownership to the EAT.
What does this mean? In the instance where the EAT acquires title to the replacement property, it typically does so with funds the taxpayer lends to the EAT – in most cases the taxpayer borrows to afford such an acquisition. Within 180 days, the taxpayer sells the relinquished property and ownership of the replacement property is transferred to the taxpayer. This provides taxpayers an ideal solution if they cannot delay the closing of the replacement property.
“The reverse exchange helps investors meet several objectives…” says Martin Edwards, JD and Managing Director at Accruit. “…some are deterred by the 45-day identification period with a traditional tax-deferred exchange but implementing a parking arrangement minimizes risk while allowing an exchanger to find and secure the best property before disposition of their relinquished property.”
Many consider a seller’s market (where supply is low and demand is high) the typical situation in which to implement a reverse exchange, but in fact, its application is used in a variety of market conditions. Max Hansen, JD, CES and Managing Director at Accruit says, “as we know and from 30 years of experience, markets are cyclical…real property investors can feel pressure to perform when conditions are in favor of the seller, just as much as they may feel the same pressure when it’s a buyer’s market.”
It’s the savvy real estate investors who spot fortuitous gain irrespective of which course the economy takes. Stock market volatility adds to an investor's woes if stock prices are in flux. On the other hand, real estate's relatively low correlation to stock market movements can make it a more reliable choice during a downturn, but it’s the quality of a property investment that dictates how well it performs in contrast to other securities.
Over a decade ago, the 2008 financial crisis and subsequent downturn that followed, saw a surge in reverse exchanges as investors sought to take advantage of low-interest rates, create wealth-building opportunities and make advantageous acquisitions. Many of those acquisitions are now paying dividends in today’s market. Despite what the current real estate environment may be, reverse exchanges can still be a powerful tool providing certainty during these uncertain times. There’s an old investing adage, that says past performance isn’t a guarantee of future performance, but real estate can prove profitable when stocks and bonds waver.
For more information on reverse exchanges and parking arrangements, please contact Accruit.