Not Your Father's 1031 Exchange
By Richard Kohn, Tax Division
Anyone selling a significant property at a gain is well advised to familiarize themselves with all the options under an IRS Code Section 1031 tax-free exchange. The rules to qualify for tax-free treatment are straightforward and relatively easy to meet as long as you are selling an investment property or rental real estate (i.e., any property that is not a primary residence or non-rented vacation home). This article addresses not only the basic rules but also covers several planning opportunities available to the well informed real estate owner.
Section 1031 of the Internal Revenue Code provides a tax-free rollover of the sales proceeds of investment or rental property if the taxpayer follows a set of rules provided under this Code Section.
For the divested property to qualify, the rules require only that it be held for investment or for rental income. The sales proceeds must be used to acquire a replacement property. The definition of like kind replacement property is very broad and almost any type of property qualifies. You are permitted for example to swap; land for an apartment building, a shopping center for an office building, a warehouse for a hotel property, etc.
Fundamentally, you need to identify up to three potential replacement properties within 45 days after the sale of your property. There are several ways to increase the list of potential properties, but the three property rule is the simplest. You need only acquire one of the three identified properties, but it must be within 180 days of the original sale. Due to the timing difference between the sale and the replacement purchase, the services of a qualified intermediary are typically used to escrow the proceeds of the sale while awaiting reinvestment and to insure compliance with all the IRS rules. Exchange intermediaries charge a very modest fee and a good one can make the transaction extremely simple for you and your attorney. They add an important level of assurance that the transaction will qualify for tax free treatment. There is also a provision in Section 1031 for purchasing a replacement property first, in anticipation of a divestiture sale. Quite logically, this is called a reverse exchange. If a replacement purchase fails to proceed for any reason, there is no penalty. The same taxes on the gain will be due as they would have for a simple sale.
Another common question is whether or not a vacation home would qualify. This answer is easy…NO. However, if you have significant appreciation in your vacation property, we would recommend that you rent your property in at least 2 consecutive tax periods prior to the sale. This provides justification that it has been converted from a personal vacation home to a qualified investment property and therefore is exchangeable tax-free. The reverse situation is also true. If your replacement property is intended to become a second home, we would recommend that you rent the property for at least 2 consecutive tax periods after its purchase. This is an aggressive tax strategy that you should discuss with your personal tax advisor.
TENANTS IN COMMON (T-I-Cs)
What if you want to sell your investment property or rental real estate in an effort to relieve yourself of the headaches of managing property? A strategy has developed around a revenue procedure pronouncement by the IRS whereby you can exchange your individual property for a Tenant In Common interest in a fund or pool of real estate properties. Under this strategy, you receive an interest in a large portfolio of properties. Now you have diversified your risk, added a level of professional property management, and can hold your new interest as a relatively passive investor. The IRS has established a revenue procedure to request permission to have these transactions approved. Although many of the funds that permit “TICs” do not request permission from the IRS, they do mirror all the rules outlined in the Rev Proc. It doesn’t make it bulletproof, however most of the funds structure the transactions properly and have a likely chance of IRS approval in the event of an audit.
A variation of the Tenant In Common strategy, is the Net Lease Exchange. Net lease transactions allow you to own property occupied by credit tenants under long term absolute triple net leases. The investment grade credit rating of these name brand tenants provide the vehicle to obtain favorable rate long term mortgages at 85% to 90% loan to value. The debt service is typically matched to the rental income, and because they are truly net-net-net leases (the tenants are responsible for all repairs, maintenance, and expenses), there are no economic surprises (other than the occasional CircuitCity or Filene’s Basement). The high LTV mortgages allow you to cash out much of your equity and reinvest it as you see fit. Although reinvestment of the loan proceeds is not limited to real estate, it does give you the opportunity to reinvest back into the real estate market without the 45 or 180 day Section 1031 grenade exploding. However, if you use the cash proceeds for personal purposes instead of an investment, then the interest will not be deductible. Unlike the Tenant in Common strategy, a Net Lease gives you more control of your property since there are no other owners or partners.There are many organizations that exist to match your individual sale and tax situation to an inventory of CVS’, Walgreens, and other credit tenant properties.
In summary, Section 1031 exchanges have been around for a long time and permit the real estate owner to reinvest all of their cash proceeds in a replacement property while deferring the tax. It is important to remember that this is simply a tax deferral, not tax avoidance. Although you can continue to keep exchanging your replacement property for new replacement property in perpetuity, at some point when the music stops, the IRS will be sitting in the remaining chair waiting (patiently) to collect the tax due on the ultimate gain on sale. In the meantime, you have hopefully at least enjoyed the benefit of compounding all your pretax dollars. Many variations to the theme outlined in this article should be explored, as they offer additional benefits. Please discuss your transaction in great detail with your tax advisor because every individual has a different tax situation. You may have large capital losses as a result of the stock market correction over the past several years and therefore would have the opportunity to offset a portion of their capital gain with the sale of real estate and their capital loss carry forward. Your tax advisor would tell you that not all of the gain from the sale of real estate can be offset with capital loss carry forward as a result of depreciation.