30 June 2015

A Resurgence in Internal Revenue Code Section 1031 Exchanges

Now that the commercial real estate market has rebounded, it is a good time to remember the benefits of structuring a sale as a Section 1031 exchange. For several years, since commercial real estate values were depressed, sellers did not need to think about how to shelter the gain on a sale. While it is true that certain members of Congress have been considering limiting exchanges to a $1,000,000 deferral or a complete repeal of Section 1031, we do not expect either of those two options to pass in 2015.

Basic Rule
The basic rule is: No gain or loss will be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment. This mechanism results in a deferral of your gain on sale, not a complete elimination of the gain. However, when coupled with certain estate planning techniques, you may be able to accomplish a complete avoidance of tax on all gains that have accumulated in your real estate investments.

So what does all of this mean? It means that if you have been holding onto investment property, you are now considering selling that investment, and you do not need the cash that will be generated by the sale, you should consider reinvesting the sales proceeds in another real estate investment in order to take advantage of the tax deferral afforded by structuring the sale as a Section 1031 exchange.

Held for Productive Use or For Investment
Let’s break down the pieces. First, what does it mean for a real estate investment to be held for productive use in a trade or business or for investment? The test as to whether or not the property fits this definition is made at the time of the exchange. The owner’s intent is the key. Housing inventory held by a home builder does not qualify. Neither your personal residence nor your vacation home will qualify with one exception. If there has been a change in use, such as, a vacation home that has been converted to a rental property, you can qualify that property for a Section 1031 Exchange if it was actually rented at fair market value for not less than 14 days per year for each 12 month period preceding the sale. And the personal use by the taxpayer cannot exceed more than 14 days or 10 percent of the time that the property was actually rented.

Next, what does the term “like-kind” mean? It does not mean that the new investment must be the exact same kind of investment as your current investment. In other words, if you sell an apartment complex, you need not buy another apartment complex. But you must buy some other investment type of real estate. Like-kind property can include retail property, commercial property, industrial property, condominiums, duplexes, apartments, single family homes (if not your personal residence) and raw land. However, an interest in a partnership does not qualify as a like-kind investment.

The Process
Oftentimes, the seller is not prepared to simultaneously close on the purchase of a new property when it sells its sale property. That is fine. In those instances, however, the seller cannot touch the sales proceeds. Instead, they must be given directly to a “Qualified Intermediary” who holds the funds until you are ready to close on the replacement property.

If you decide to take advantage of the Section 1031 gain deferral, you need to strictly follow certain deadlines.

  • You must identify the replacement property, in writing, within 45 days of closing on the sale property. That identification can include up to three properties of any value or more than three properties if the total fair market value of the multiple properties does not exceed 200 percent of the fair market value of the sale property; and
  • You must close on the purchase of the replacement property within 180 days of the closing on the sale property.

There are many nuances to these basic rules, such as those related to underlying debt on the sale property and the replacement property; exchanges between related parties; how depreciation factors into the calculations; who may act as a Qualified Intermediary; and how a raw land/new build property can be used in an exchange. Those matters are far too complicated to explain in this article.

Suffice it to say, if you are a candidate for a Section 1031 Exchange, you should contact your Miller Johnson real estate attorney before you sign a sales agreement. We can work with you to make sure all the required specialized language related to the intended Section 1031 Exchange is included in the sales agreement. You may also contact the author for any questions on this article.