Section 1031 Exchanges

As an increasing number of people are coming into newfound wealth, they are looking for ways to invest it.  The volatility of the stock market during the past few years (especially the bursting of the tech-stock bubble) has caused investors to look for different investment opportunities to better diversify their portfolios.  One such alternative is real estate.  Over the past few years the value of real estate (both residential and non-residential) has skyrocketed.

An important tool in connection with investing in real estate is Section 1031 of the Internal Revenue Code.  This section provides that no gain or loss will be recognized on the exchange of property which is held for productive use in a trade or business or for investment purposes (not a personal residence) if the property is exchanged for a new property which will be either held for productive use in a trade or business or for investment purposes.  As a result, a taxpayer will not currently have to pay federal income taxes on the transaction. (However, other taxes such as the Pennsylvania realty transfer tax may still be applicable.)

Although there are several ways to structure a Section 1031 exchange (also referred to as a like-kind exchange), a taxpayer must follow the specific procedures that the I.R.S. has established regarding these transactions.  Typically, a taxpayer will sell a property (referred to in Section 1031 nomenclature as the “relinquished property”) and then purchase a “like-kind” property (referred to as the “replacement property”) within the statutory allotted time period.  Section 1031 does not require that a taxpayer purchase the replacement property simultaneously with the sale of the relinquished property.

However, in a non-simultaneous exchange the taxpayer cannot receive control (either direct or indirect) at any time of the proceeds from the sale of the relinquished property.  As a result, most taxpayers will engage the services of a company to act as a qualified intermediary (a defined term under the Code) to take custody of the proceeds from the sale of the relinquished property until the taxpayer purchases the replacement property.  The qualified intermediary will also help insure that the taxpayer complies with other Section 1031 requirements.

As explained above, the purchase of the replacement property does not have to occur at the same time a taxpayer sells the relinquished property.  At settlement of the relinquished property, the transaction will be structured so that the settlement sheet will list the qualified intermediary as the seller (although the deed will name the taxpayer as grantor and the buyer as grantee).  The qualified intermediary will hold the settlement proceeds in escrow to be used for the purchase of the replacement property.  Once the taxpayer sells the property, however, Section 1031 has strict deadlines that normally cannot be extended.

First, the replacement property must be identified in a written notice signed by the taxpayer and sent to the intermediary within 45 days.  Purchase of a property as replacement property which was not identified during the 45-day period will cause the Section 1031 exchange to fail.  More than one potential property can be identified under one of the following conditions: (i) any three properties regardless of their market values [the 3 property rule]; (ii) any number of properties as long as the aggregate fair market value of the replacement properties does not exceed 200% of the aggregate fair market property of all of the relinquished properties as of the initial transfer date [the 200% rule]; or (iii) any number of replacement properties if the fair market value of the properties actually received by the end of the exchange period is at least 95% of the aggregate fair market value of all the potential replacement properties identified [the 95% rule].

Second, the purchase of the replacement property must be completed within the earlier of 180 days after the sale of the relinquished property or the due date (with extensions) of the income tax return for the tax year in which the exchanged property was transferred.  At the settlement of the replacement property, the qualified intermediary will transfer the proceeds of the sale of the relinquished property directly to the seller of the replacement property, without the taxpayer exercising any control over such funds.

Before participating in a Section 1031 exchange, it is important to understand potential disadvantages.  One disadvantage is that the tax basis of replacement property is essentially the purchase price of the replacement property minus the gain which was deferred on the sale of the relinquished property as a result of the exchange.  As a result, the replacement property includes a deferred gain that will be taxed in the future if the taxpayer cashes out his investment.

This article is a basic overview of a Section 1031 exchange.  As failure to properly follow the I.R.S. prescribed procedures for such a transaction can have serious adverse tax consequences, please contact us if you need assistance or advice with your Section 1031 exchange.


– Andrew Berenson

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