Section 1031 of the Internal Revenue Code (“Code”) provides that no gain or loss is recognized upon the exchange of property held for productive use in a trade or business, or for investment, if the property received in exchange is of a “like kind”. The rule does not include exchanges of stocks, bonds, partnership interests, securities, notes, stock in trade or items held primarily for sale; the rule does cover most business and investment real estate, and not surprisingly, most “1031 swaps” involve real estate interests.
With the healthy economy, we are witnessing an increasing trend of Section 1031 exchanges, fueled by the desire of many investors to lock in gains on appreciating real estate without the “pain” of current taxation, even if it is at capital gain rates. Indeed, an entire cottage industry has developed to assist investors in doing so. More on that below.
Let’s look at an example: Suppose you own an investment property worth $500,000 with a cost basis of $300,000. If you sell the property, your taxable gain is $200,000; assuming a 20% capital gains tax rate, you would owe $40,000 in tax on the sale. If, however, your intent was to reinvest the proceeds of the sale in similar investment real estate, you might be able to defer the $40,000 tax bite by swapping your existing property for the property that you would otherwise acquire with the sale proceeds. Now the rub: What if the owner of the property you wish to acquire doesn’t want your property in exchange? Or, what if you haven’t even found a replacement property to purchase? Not to worry.
Section 1031 has evolved to allow what has become known as a “deferred like-kind exchange”. An exchange can still qualify for like-kind tax deferral even if the replacement property is received after you sell your existing property, provided that certain statutory requirements are met. After transferring your existing property, you must identify a replacement property within 45 days and generally must close on the acquisition of that property within 180 days. The Code allows a third party, known as a qualified intermediary, to assist in the exchange by acquiring the replacement property and exchanging it with you for your property. When the dust settles, your old property winds up in the hands of your buyer, the replacement property is yours, and the seller of the replacement property receives cash payment. Your transaction is treated as a swap under Section 1031, and as long as the value of the replacement property equals or exceeds the value of your original property, your entire $40,000 gain is deferred and will be taken into account if and when you sell the replacement property.
Congress added the “qualified intermediary” requirement to the Code as a “safe harbor” to insure that such deferred exchanges would qualify under Section 1031. The primary purpose of the qualified intermediary is to ensure that the seller does not receive or have access to the cash proceeds of the first sale prior to acquisition of the replacement property; otherwise, the transaction would be too similar to a sale. Since a qualified intermediary may not be affiliated with the taxpayer (realtors, attorneys, accountants, employees and agents are excluded), companies have been formed for the sole purpose of acting as qualified intermediaries in Section 1031 transactions. Such companies, of which there are several in the region, act essentially as escrow agents; the sale property and the replacement property pass through the qualified intermediary to effect the tax deferred exchange.
While the statutory requirements of a Section 1031 exchange are detailed, there is some degree of flexibility reflected in the court decisions and rulings interpreting Section 1031. For example, even though the exchange properties flow through the qualified intermediary, the rules allow a direct deed between the “real” owners, thus avoiding an additional transfer tax.
Fees charged by qualified intermediaries generally bear a relationship to the value of the properties being exchanged. In our example above, typical qualified intermediary fees would be in the range of $2,000. This would seem to be a reasonable charge to pay given the value of the tax deferral.
Appropriately structured, Section 1031 exchanges provide a unique and valuable opportunity for tax preferred real estate transfers. Call us if this area interests you.