Some of our clients are fortunate enough to have rental property that has increased in value. With real estate sales relatively slow, there has been an increase in questions about using Internal Revenue Code Section (§) 1031. What does it mean, 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 but 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 unimproved 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 in Destin 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 “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 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. 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 and 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. 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.), 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, however, 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.
If you use a qualified intermediary, regardless of the type of exchange, 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.
Within 45 days after the “sale,” the taxpayer must identify in writing and signed by the taxpayer, one or more properties as potential replacement properties. More than three properties can be identified, but the rules get stickier. If you are in this situation, you should consult with knowledgeable counsel.
The identification must be specific. For example, you must identify “3735 Cherokee Street” or “Unit 25 The Moorings.”
You must acquire substantially the same property. If you identify “Unit 25 The Moorings” and acquire only a partial interest (the other half being acquired by a relative), the partial interest is not substantially the same property as identified. If you wish to acquire a partial 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 six months. We are dealing with IRS codes and regulations. Therefore, 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, the net debt relief, 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.
- 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 Henssler Financial at 770-429-9166 or [email protected].