IRC Section 1031 Tax Deferred Exchanges of Real Estate
As many real estate investors are keenly aware, the tax consequences of selling real estate can significantly impact the ability to acquire another property. In some cases, the tax owed from the capital gains and recapture of depreciation on a sale can leave a real estate owner with little or no cash to apply toward the purchase of a replacement property. Complicating matters further, banks continue to tighten their lending policies, making it more important than ever for potential buyers to maximize their cash resources. A 1031 Exchange, also known as a Starker Trust or Tax Deferred Exchange, is one of the most popular tax strategies available when selling and buying real estate “held for productive use in a trade or business or for investment.” By structuring the sale and purchase of property as an exchange, the owner can potentially reduce the recognized tax gain to zero. By reducing the taxes owed to the government, more cash is available for the purchase of new property.
Like-Kind Standard in Real Estate Exchanges
In the case of real estate exchanges, the "like‐kind" standard is usually easy to satisfy. Generally, any type of real property interest is like‐kind to any other type of real property. The properties do not have to be of the same nature. For example, a single-family home held as rental property could be exchanged for a vacant parcel of land purchased as an investment. Similarly, a leasehold interest of 30 or more years could be exchanged for a shopping center, and the sale of a fee interest in real estate can be exchanged for a purchaser’s interest under an installment agreement for deed. However, owner occupied residential property does not qualify and property located in the United States is not like‐kind to property located outside of the United States.
Eligibility for Real Estate Exchanges
Section 1031 of the tax code allows property owners to defer the taxes associated with the sale of their real estate that has been held for business or investment purposes. All types of taxpayers can qualify for the tax benefits–individuals, partnerships, limited liability companies, S corporations, C corporations and trusts (however, the same taxpayer that sells the relinquished property must purchase the replacement property). As long as the requirements for a tax‐deferred exchange are satisfied and the sale proceeds are reinvested in Like‐Kind property, the tax gain can be deferred. In some cases, the tax gain can be deferred indefinitely (exchanges of non‐depreciable land, step‐up in basis upon death, etc.).
Requirements for Real Estate Exchanges
In order for the taxable gain to be deferred, certain key requirements must be satisfied:
- Properties Must Be Exchanged: By itself, a sale followed by a purchase does not qualify as a 1031 Exchange. Instead, the transaction must be treated as an exchange for tax purposes. To convert a sale followed by a purchase into an exchange, a property owner will employ the services of a qualified intermediary (QI) who acts as a middleman to tie the sale to a buyer and the purchase from a seller as a verified exchange. It’s very important for the QI to be contacted prior to the closing of the sale and/or purchase transaction.
- Properties Must Be “Like‐Kind”: One of the advantages to exchanging real estate is that almost all real property is considered to be of “Like‐Kind” to all other real property.
- Held for Business or Investment Purposes: Both the relinquished property and the replacement property must be held for business or investment purposes. A sale of business property is not required to be replaced with other business property; it can be replaced with investment property or vice versa.
- Reinvest the Equity & Exchange Equal or Up in Value: To potentially defer all of the tax gain, a property owner must first reinvest all of the equity in the relinquished property into the replacement property. Second, the purchase price of the property acquired must equal or exceed the sale price of the relinquished property. Typically, this requires debt on the new property to equal or exceed the debt that is paid off on the relinquished property.
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- Simultaneous Exchange: In a simultaneous exchange the relinquished property and the replacement property transfer concurrently and involving the services of a Qualified Intermediary enables the exchanger to take advantage of the safe harbor provided for in the regulations.
- Forward Exchange: In a forward exchange, or forward delayed exchange, the exchanger first sells the relinquished property, then acquires the replacement property within 180 days of the sale or the due date for filing the tax return (as may be extended) for the year that the sale took place.
- Reverse Exchange: When an exchanger is unable to sell the relinquished property before purchasing the replacement asset, the exchanger can structure the transaction as a reverse exchange using an Exchange Accommodation Titleholder.
- Improvement or Build-to-Suit Exchange: An exchanger can purchase replacement property and use some or all of the proceeds to make improvements to the asset as long as the exchange is structured as a “build-to-suit” or improvement exchange with an Exchange Accommodation Titleholder. This process is often used to renovate an existing building or to construct a new building on vacant land. These complex exchanges may be either forward or reverse in nature.
Contact us for Information About How to Structure an Exchange
Accruit is a national leader in complex real estate exchange transactions specializing in reverse, build‐to‐suit and improvement exchanges as well as simple forward exchanges of real estate. Contact us for more information regarding our Qualified Intermediary and Exchange Accommodation Titleholder services. Our real estate specialists will work with the property owner and their attorney, if applicable, to carefully structure the exchange transaction using the arrangement that is best suited to the facts of the individual transaction.