The days of oil and gas and real estate
limited partnerships — tax shelters
with 3 to 1, 4 to 1 and 5 to 1 write-offs — are but a distant and faded memory in
the minds of most experienced investors
and real estate professionals. Nonetheless,
even in today’s significantly more conservative climate, there is a vehicle available
to help taxpaying businesses and individuals defer taxation in connection with the
disposition and acquisition of property. It’s
Section 1031 of the Internal Revenue Code
and it is commonly referred to as a tax-free
exchange, a like-kind exchange, or simply
as a 1031 Exchange.
“In a typical situation, an owner selling its
property would be taxed on any gain realized
from the sale of the property,” says Claude P.
Czaja, an attorney in the Real Estate Practice
Group at Gambrell & Stolz LLP. “Section 1031
provides a mechanism that allows the property owner to defer taxation on the gain and
keep all the proceeds invested.”
Smart Business spoke with Czaja about
the benefits of a 1031 Exchange.
How does a 1031 Exchange work?
Typically, as a company outgrows its
building, it develops a need for more space,
and thus a new location. In a retail setting,
the desire is to add new stores while reducing underperforming or older units. In each
of these situations, the property to be sold,
known as the relinquished property, is
exchanged with the property to be purchased, known as the replacement property.
At the sale of the relinquished property,
the proceeds are not tendered to the seller,
also known as the exchangor. Rather, they
are placed into an escrow account with a
qualified intermediary, who holds the
funds for eventual disbursement to pay for
the purchase of the replacement property.
Exchangor has 45 days to identify a limited
number of replacement properties and 180
days to close on the purchase of the
replacement property. If these and other
technical requirements of the tax code are
met, the exchangor will be able to roll the
proceeds from the sale into the new facility and be spared from paying any tax on
the gain that otherwise would have been realized in a routine sale of the property.
This type of exchange is commonly
described as a deferred exchange.
Besides real estate, can any other type of
property benefit from a 1031 Exchange?
Yes, provided the subject property is like-kind or like-class to the property being relinquished or replaced, as the case may be, personal property used in a business can qualify for the tax shelter effect of Section 1031.
Besides real estate, it is not uncommon to
see equipment and furnishings, collectibles
or larger-ticket items such as aircraft, being
exchanged under Section 1031.
Actually, there are certain types of property
that are specifically excluded from Section
1031 treatment. This group includes property
held primarily for sale, inventory, stocks,
bonds and other securities, and notes and
other evidences of indebtedness. In general,
if the property is not on the excluded list, it
can qualify for tax-deferred treatment provided it is like-kind or like class property.
Are there any types of transactions that qualify for treatment under Section 1031 other
than the deferred exchange?
Yes. In addition to the deferred exchange, there are a few other types of exchanges
worth mentioning:
- Simultaneous exchange. As its name
implies, the consummation of the closing
of the sale of the relinquished property and
the closing of the replacement property
occur at the same time. - Reverse exchange. This is a more
complicated, costly and less frequently-used exchange method. In it, the replacement property is actually acquired prior to
disposition of the relinquished property.
These transactions are sometimes referred to as parking arrangements
because the replacement property is purchased and ‘parked’ with an exchange
accommodation titleholder who holds
title to the replacement property until the
exchangor is able to sell the relinquished
property. - Multi-asset exchange. This is an
exchange that involves both real estate and
personal property. Typical examples
include exchanges of hotels or restaurants.
In such transactions, the exchangor will
exchange the real property as one part of
the exchange and the furnishings and
equipment as the second part of the
exchange, with careful attention paid to
ensuring that the furnishings and equipment are separated into groups of like-kind
or like-class property. - Construction exchange. In the construction exchange, the exchangor is
allowed to build on or make improvements
to the replacement property which is
parked with an unrelated entity much like
in the reverse exchange method. The
exchangor can utilize escrowed exchange
proceeds from the sale of the relinquished
property to fund construction on the
parked property. However, construction
cannot occur on replacement property the
taxpayer already owns.
CLAUDE P. CZAJA is an associate in the Real Estate Practice
Group at Gambrell & Stolz LLP, concentrating on commercial real
estate and business transactions. Reach him at (404) 223-2218
or [email protected].