As the value of real estate has skyrocketed in
many spots where our clients own rental property, there has been an increase in
questions about using Internal Revenue Code Section (§) 1031 — what
it means, how do you do it, and when should you do it.
Code
§1031 allows for the tax deferred exchange of like-kind property. This allows
the taxpayer to defer the tax on the gain in the property he currently owns, by
acquiring a "like-kind" property in which to invest.
For
example, you purchased land in Destin for $200,000 a while ago. It is now worth
$500,000. You would like to continue to hold land as an investment, but think
that St. Augustine presents better opportunities. If you sold the Destin property,
you would incur an approximate $300,000 gain. If you are not subject to alternative
minimum tax (a whole other subject), you will pay $45,000 in federal capital gains
tax, plus any state tax due. This is a substantial tax bite, and would reduce
the amount of cash available to buy another property.
If
you exchange the $500,000 piece of property for a $500,000 piece of property in
St. Augustine, you will not pay the tax on the increase in value at this time
— you will defer it. Your adjusted basis in the St. Augustine property will
be $200,000 (fair market value of acquired property less deferred gain).
What
is an "Exchange"?
An
exchange occurs when a taxpayer conveys property (the "relinquished property")
to the same party from whom the taxpayer acquires "replacement property."
If
a taxpayer conveys relinquished property to a purchaser and acquires replacement
property from someone other than the purchaser, an exchange has not occurred.
The conveyance will be deemed a sale and tax will be due.
However,
the chances of your finding someone in St. Augustine willing to exchange their
property for your Destin property are pretty slim.
The
"Qualified Intermediary"
The
IRS devised regulations authorizing the use of a "qualified intermediary"
to create an exchange.
- Prior to
the sale of relinquished property a taxpayer executes an agreement with an intermediary;
- The
taxpayer assigns the intermediary his rights under a real estate sale agreement;
- Prior
to the taxpayer's acquisition of replacement property the taxpayer assigns
to the intermediary his "rights" under a real estate purchase agreement.
By
executing an exchange agreement, and assigning to the intermediary, rights under
the real estate sale/purchase agreements, the taxpayer is treated as if he conveyed
relinquished property to the same party from whom he acquired replacement property.
To
have this work, you must never have actual or constructive receipt of the sale
proceeds. Therefore, you cannot sell your property and then decide you want to
do an exchange. Further, you cannot just give the proceeds to your real estate
attorney "to hold" for you, as the IRS may construe this person to
be your agent, and thus "you."
According
to the regulations, an agency relationship exists between a taxpayer and a person
acting as the taxpayer's employee, attorney, accountant, investment broker,
or real estate agent within two years of the exchange.
Providing
performance of services as a qualified intermediary, in which the intermediary
and taxpayer have entered into an agreement to acquire and transfer property is
not an agency relationship, and you can use the same intermediary repeatedly.
While
many attorneys provide these services, it cannot be "your" attorney. Tax deferred
exchanges have become a specialty, and many companies advertise their services
in real estate magazines, accounting publications, or by contacting attorneys,
accountants, real estate brokers, etc. These services are listed or identified
as §1031 or "Starker" services (named
after the first tax case on the topic). Finding a qualified intermediary should
not be difficult.
What is
Like-Kind Property?
Property is
of like kind if it is of the same nature or character. The like-kind definition
for real property is very broad and any type of real property that is considered
primarily "held for investment" is considered like-kind.
A
rental house, a tract of land, an office building are all like-kind to each other.
Most
real property comparisons are like-kind — however real property located
in the United States and real property located outside the United States are not
like-kind.
Property must be held for
investment or for use in a trade or business to qualify, and therefore, you cannot
exchange your residence or vacation home. Property you own for personal purposes
does not qualify for §1031. If you own a second home (or third, etc.), and
rent it and follow the vacation home rules, it may qualify for §1031.
While
this article is primarily addressing real estate transactions, §1031 also
applies to businesses that may exchange personal property that is like-kind and
defer tax. The identification of like-kind is a little stickier in these situations,
and should be thoroughly investigated first. For instance, exchanging a crane
for a crane is obviously like-kind; I did learn in the course of my research that
a steer cannot be exchanged for a cow, and that a copyright on a song cannot be
exchanged for a copyright on a book.
Types
of Exchanges and the Identification Period
Generally,
there are three types of exchanges:
- Simultaneous
exchange: The taxpayer conveys relinquished property and simultaneously receives
replacement property;
- Deferred
exchange: The taxpayer conveys relinquished property and subsequently acquires
replacement property, or
- Reverse
exchange: The taxpayer acquires replacement property, and thereafter, conveys
relinquished property.
Regardless
of the type of exchange, in order to use a qualified intermediary, the taxpayer
must execute an exchange agreement and assign to the intermediary the rights under
real estate sale/purchase agreements and generally provide written notice to the
purchaser or seller.
In the case of
a deferred exchange, the taxpayer must also:
- identify
replacement property within the 45-day identification period;
- acquire
replacement property within the exchange period; and
- avoid
constructive receipt of the sales proceeds during this period.
Identification
Within
45 days after the "sale," the taxpayer must identify, in writing,
signed by the taxpayer, one or more properties as potential replacement properties.
More than 3 properties can be identified, but the rules get stickier, and if you
are in this situation, you should consult with knowledgeable counsel.
The
identification must be specific. For instance, you must identify "3735 Cherokee
Street" or "Unit 25 The Moorings."
You
must then acquire substantially the same property. If you identify Unit 25 The
Moorings, and then acquire only half interest (the other half being acquired by
a relative) then the half interest is not substantially the same property as identified.
If you wish to acquire only a half interest, then the identification should include
this fact.
The Exchange Period
The
exchange period ends on the earlier of the 180th day following the "sale"
or the due date of the taxpayer's income tax return for the year in which
the "sale" takes place.
Note
that the above definition is not 6 months. We are dealing with IRS codes and regulations,
and it is important to read the specifics as well as the "or" and
"and" words carefully.
The
taxpayer should be careful with any "sales" occurring after October
15th, as the due date of an individual's tax return is April 15th, unless
an extension is properly filed.
Other
Items of Interest
- To the extent
you receive any cash or unlike property in the transaction, you will recognize
gain. This means that you will pay tax on the gain to the extent of boot received.
- If
the other party assumes any of your liabilities, you will be treated as if you
received cash, and again, you will pay tax on the boot. (The boot is the net debt
relief.)
- If you "sell"
or "buy" with a related party, the property must be held at least
two years, or the exchange is disqualified.
- There
is no codified amount of time you must have held the property you are relinquishing
before you can exchange it. However, since the property you are relinquishing
must have been held for investment, and the property you are acquiring must be
acquired with an intent of holding such property for investment, the conservative
approach would be to hold property for at least one year (the longer the better).
The operative word here is intent. The onus is on you to prove intent to the IRS
if the transaction is under scrutiny.
For
instance, in one ruling, the taxpayer acquired property for the specific purpose
of exchanging such property for other property. The IRS ruled that the relinquished
property had not been held for investment and denied the nonrecognition treatment.
If
you exchange your rental for another, hire an agent to find a tenant, and that
same day your personal residence burns down, you have a legitimate reason to alter
the character of your new rental into a personal residence without tainting your
intent at the time of the exchange. However, this set of facts and circumstances
is rare.
The complexities of §1031
and the risks if it is done wrong, necessitate early professional advice and guidance.
While your C.P.A. should be able to help you with the various tax consequences
of the transaction(s), we strongly suggest that you receive legal guidance from
an attorney with experience in this area. If you would like any further information regarding this issue as well as any other tax related issue, please contact The Henssler Financial Group Tax & Accounting Division at 770-428-4025.
