Special Articles

Section 1031 Exchange

The 1031 exchange is a mechanism to DEFER the capital gain due on selling property by EXCHANGING it for similar property (i.e. this is NOT a tax free transaction). The investor can use 100% of his or her current property equity to purchase substantially more replacement property. The Section 1031 “like-kind” exchange should be considered by every taxpayer who is planning to reinvest the proceeds from a sale of investment property into another similar type of investment property. The IRS Code Section 1031 describes the “Like-Kind” exchange thusly:

No gain or loss shall 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 of business or for investment.
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What is “Like-Kind” Property?

“Like-Kind” property can be any real property used in a trade or business or as an investment. All of the following real estate can be exchanged as “like-kind” property:

  • Condos
  • Raw land
  • Apartments
  • Single family
  • Industrial property
  • Commercial
  • Duplexes
  • Retail

How the property is used by the taxpayer (investment/trade or business) is more critical then the type of property. What type of property cannot be exchanged?

  • Stock in trade or property held primarily for sale
  • Stocks, bonds or notes
  • Securities or evidences of indebtedness or interest
  • Certificates of trust or beneficial interests
  • Interests in partnerships
  • Planes, Boats and Vehicles
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Capital Gains

First let’s look at a simple example of the federal taxation of a sale of real estate.

Jane has an apartment building the she purchased 10 years ago for $500K. Over the course of the 10 years of rental the property she has deducted $138K in depreciation and made $100K in property and land improvements. Her taxable basis is as follows:

Original Cost $500,000
Improvements (thru the years) $100,000
Less Depreciation ($148,000)
Taxable Basis $452,000

If Jane SELLS her property for $1 million dollars her federal tax will be $117K and will be calculated as follows:

Sales price $1,000,000
Taxable Basis (from above) ($452,000)
Taxable Capital Gain $548,000
Tax Calculation:  
Capital Gain from Depreciation Recapture ($148K x 25%) $37,000
Long-term Capital Gain ($400,000 x 20%) $80,000
Total Federal Tax
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The 1031 Exchange Timetable

The critical time limits at work here are:

  1. 45 day rule - the exchanger MUST identity the potential replacement property of properties within the first 45 days of the 180-day exchange period.
  2. 180 day rule - the exchanger MUST acquire the replacement property of properties within 180 days, or the date the exchanger must file the tax return (including extensions) for the year of the transfer of the relinquished property, whichever comes first.
  3. There is no extension for the deadlines for Saturdays, Sundays or Holidays
  4. The time limits begin to run on the date the exchanger transfers the relinquished property to the buyer.
  5. The “date of transfer” will be the date of recording or transfer of the benefits and burdens of ownership, whichever occurs first.
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The Exchange - The Mechanics

An exchange is rarely an actual swap of properties between 2 parties, a majority of “like-kind” 1031 exchanges involve 3 parties facilitated by a “qualified intermediary”:

  1. The investor or exchanger who is doing the exchange
  2. The buyer who is purchasing the investors old relinquished property
  3. The seller who is selling the investor the replacement property

To accomplish the 1031 exchange you must follow the four “safe harbors” found in the Federal Regulations:

  1. Use of a qualified intermediary to create the exchange (cannot be a related party such as the exchangers accountant or attorney)
  2. Use of qualified escrow or trust to hold proceeds from the exchange
  3. Use of a guarantee of security arrangement to secure the exchange process
  4. Interest paid on exchange proceeds

The steps in a common “like-kind” exchange will generally look something like this:

  1. Exchanger signs a contract to sell relinquished property to the buyer.
  2. The exchanger assigns the exchanger’s rights in the sale contract to a qualified intermediary.
  3. At the closing of the relinquished property the exchange funds are wired to the qualified intermediary and the intermediary instructs the settlement officer to transfer the deed directly from the exchanger to the buyer.
  4. The exchanger must identify the possible replacement property or properties within 45 days.
  5. The exchanger then has a maximum of 180 days in the exchange period (or until the tax filing deadline, including extensions, for the year of sale of the relinquished property) to acquire replacement property.
  6. The exchanger signs a contract to purchase the replacement property with the seller and the exchanger assigns the exchanger’s rights to the purchase contract to the qualified intermediary.
  7. At the closing of the replacement property the qualified intermediary wires the exchange funds to complete the exchange and the intermediary instructs the settlement officer to transfer the deed directly from the seller to the exchanger.
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The Exchange - Tax Effects

In order for Jane to defer the entire gain she must do all of the following:

  • Purchase a property of equal or greater value
  • Obtain equal or greater financing on the replacement property than was paid off on the relinquished property (replacement property debt can be offset with cash put into the exchange)
  • Reinvest all of the net proceeds from the relinquished property
  • Receive nothing in exchange but the “like-kind”

    Thumb-nail test for 100% deferral: => in value, => in debt, spend net proceeds

If Jane wants to avoid any current tax payment her exchange would have to look something like this:

Value $1,000,000 $1,200,000
Mortgage $350,000 $400,000
Equity $650,000 $720,000

What is Jane wants some cash out, and her transaction looks like this:

Value $1,000,000 $1,010,000
Mortgage $350,000 $375,000
Equity $650,000 $635,000

In the above example Jane went up in value, up in the mortgage but kept $15,000 of the net proceeds, taxes will be due on $15K of cash boot.

What if Jane purchases a property worth less then hers:

Value $1,000,000 $975,000
Mortgage $350,000 $325,000
Equity $650,000 $650,000

In this case Jane went down in value, equity remained the same, but the mortgage went down $25K. Jane will owe taxes on the $25K of mortgage boot.

As you can see from these examples even when you have “boot” the tax consequences of utilizing the 1031 exchange will obviously be much lower then the taxation on the entire sale.

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In Closing ……….

Please keep in mind that this is just quick overview of the Section 1031 “like-kind” exchange, be sure to consult your tax advisor or a qualified intermediary if you are contemplating any type of property exchange. There are other types of exchanges that we have not discussed. You can, with proper planning, do reverse exchanges (where you buy the replacement property even before selling the relinquished property) and build-to-suit exchanges and even reverse build-to-suit exchanges.

Folks selling investment real estate should ALWAYS consider the 1031 “like-kind” exchange if they are planning to purchase other real estate subsequent to the sale of the first property. Remember that once you have sold your property and received the cash you cannot decide then to do an exchange, so advance planning is critical!

For further info on the Internet visit the excellent Websites of two of the best-known national qualified intermediaries:
Investment Property Exchange Services, Inc.
(local office in Boston) @ www.ipx1031.com

ipx1031@ www.ipx1031.com

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