Real estate investors of all sizes and backgrounds are enjoying the benefits of tax deferral by exchanging real estate.
If you are contemplating disposal of business or investment property, consider how generous the IRS can be in allowing you to acquire different kinds of replacement property. The “like kind exchange” rules under Code Sec. 1031 impose limitations, but most exchangers with proper guidance can effectively navigate through the safe harbors.
For real property to qualify for 1031 exchange treatment, it must be held for investment, for rental or for use in a trade or business. Qualifying property can include raw land, farm and timber land, rental units and offices, retail and commercial property, even mineral, water and easement rights.
Excluded from 1031 are personal use property such as vacation homes and interests in entities such as LLCs and partnerships. This “holding purpose” test is measured at the time of closing but analyzed based upon actual use during the nearest six to 12 months.
Most safe harbor exchanges are conducted on a forward basis using a commercial qualified intermediary (QI). This QI service is provided by attorneys, CPAs, title companies, some banks and other professionals. The QI must be engaged well before the first closing, and serves as escrow agent for the proceeds and quarterback for the exchange process. The QI cannot be related to the exchanger or its professional service provider.
The QI sends its exchange documents to the closing attorney and establishes an escrow account to hold the exchange proceeds. This arrangement must be formalized in writing before closing. The QI participates again at the acquisition of the replacement property and delivers the exchange funds to that closing. Both contracts are assigned to the QI, but it normally does not take title to any property.
If the exchanger receives cash, a note or other nonlike kind property (called “boot”) during the exchange, then the boot is taxable. To achieve full tax deferral, the exchanger must reinvest all cash proceeds and buy replacement property worth as much as the relinquished property. In 1031 shorthand, the exchanger must trade “equal to or up in equity and value.”
The IRS imposes two critical and challenging timing deadlines on the exchange process. Eligible replacement property must be specifically identified in writing within exactly 45 days after the relinquished property closing. This 45-day rule allows only a limited number of properties to be identified. It can be a very difficult deadline to meet for the exchanger who does not know what to buy, so start shopping before the first closing.
Closings of all replacement property must occur within 180 days after the relinquished closing. This presents a problem if the replacement property is under construction, such as in a build to suit exchange. One cannot construct a replacement building on land one already owns, so in build to suit exchanges, a third party must sell the building and land to the exchanger. The 1031 rules also prohibit acquiring replacement property from a related party and impose restrictions on exchanging relinquished property to a related party.
As IRS rules have developed in a fashion friendly to taxpayers, there are several variations. When the replacement property must be closed ahead of the relinquished property, a reverse exchange can be structured. However, it is more complicated and expensive, so it represents a last resort.
Fractional interests in large commercial rental properties are now available from syndicators. These tenancy in common or TIC interests are popular because exchangers receive a regular net rent check with no effort, but they involve tax risks and fees to promoters and managers, which must be evaluated carefully.
A wise investor will consult a tax professional for guidance in any 1031 exchange.
Jed Steven Beardsley practices tax and commercial real estate law as a partner with Gambrell & Stolz LLP. His specialties include real estate, business, taxation, mergers and acquisitions, like-kind exchanges and securities transactions. Reach him at (404) 223-2214 or [email protected].
