If you know me and follow my posts you know that I do both leasing and sales of commercial property. This past year I have completed more 1031 exchanges than ever before. Why you ask? Real estate markets are cyclical and constantly in flux. Property values have emerged from the depths of the Great Recession and back at all-time highs. Investors, large and small, are capitalizing on this opportunity to realize the gains and move their money, preferably without paying taxes. This is where a 1031 exchange comes into play.
A 1031 tax deferred exchange comes from the IRS tax code, Section 1031 “like kind” exchange. This allows a seller to exchange one or more pieces of business or investment real estate for another without realizing capital gains taxes- assuming you follow the rules established by the IRS.
You benefit by deferring taxes and then having those dollars that you would have otherwise paid to Uncle Sam, working for the investor to grow the value of his or her investment. There is no limit on the number of times you can complete an exchange. Some sellers continue to exchange numerous times until their death, at which time the property then goes to the heirs at a stepped-up basis, hence creating a powerful estate planning tool.
Despite the term “like-kind”, an exchange provides flexibility for an investor to purchase different property types, as long as they are held for investment. For example, if an investor sells an apartment building and wants to reinvest that capital into an office building, that is completely acceptable. The key to avoiding capital gains tax in an exchange is to ensure that you never possess or control the sale proceeds. With a deferred exchange, you sell the relinquished property (or properties) and engage a qualified intermediary (I use Exeter Exchange) to hold the proceeds while you identify and close on a replacement property (or properties). When escrow closes on the relinquished property, you have 45 days to identify a replacement and 135 days to close on that property. The result: capital gains taxes are deferred.
All proceeds from the relinquished property must be used for purchasing the replacement property. The debt on the replacement must be equal to or greater than the debt on the relinquished property. The exception is that a reduction in debt can be offset by adding additional cash; however, a reduction in equity cannot be offset by increasing debt.
There are several IRS safe harbors that enable you to complete a like-kind exchange. Deferred exchanges are among the most common. Alternatively, you have the option of a reserve exchange. With a reverse exchange, you engage a qualified intermediary to acquire the replacement property before you sell the relinquished property. To avoid holding title to both properties at the same time, you must “park” replacement properties with an “exchange accommodation title holder” until the transaction is completed. These aren’t the only way to compete a 1031 exchange; however, if you do an exchange outside these parameters the IRS may challenge you and create a whole lot of headache.
As a broker, it is imperative that I have this conversation with the client prior to listing their property so we can structure our overall strategy accordingly. There are two main things a broker should be doing. First, it’s important for your broker to have language in the escrow notifying the buyer that the sale is contingent upon the seller completing a 1031 exchange. The escrow can have extensions, allowing more time for your client to find an acceptable replacement. Second, I always make sure we have properties lined up to purchase prior to the close of the initial sale. Once the initial property closes escrow, the clock starts and those 45 days always go by faster than you think, especially in the current competitive market.
I routinely work closely with the client’s CPA, financial advisor, and attorney on these transactions. They are not easy and I have only scratched the surface on the ins-and-outs of 1031 exchanges in this article. I strongly urge any investor to consult their trusted advisors prior to embarking on your next exchange. Feel free to contact me directly to learn more and continue the conversation.
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