SELLING REAL ESTATE? IS A TAX DEFERRED EXCHANGE (1031) RIGHT FOR YOU?

Have you or your family owned an investment property for a long time but are afraid to sell it because of the income tax consequences? If so, the time may be right to cash in, secure your profits and not pay any tax on the gain.

Thanks to §1031 of the Internal Revenue Code, a properly structured transaction will allow an investor to sell a property, to reinvest the proceeds in a new property and to defer all capital gains taxes. Such a transaction is commonly referred to as a “tax deferred exchange” or  a “1031 exchange.” The procedure for facilitating the exchange is conceptually fairly straightforward, however the process may not be.

In order to accomplish a successful 1031 exchange, there are three conditions that must be met, and they are as follows:

1.    There must be an actual exchange, not just a transfer of property for money only;
2.     The properties exchanged must qualify, and be of “like-kind”; and
3.     The time requirements must be strictly followed.

AN EXCHANGE OF PROPERTY

The most significant requirement of a 1031 exchange is that the sale proceeds MUST be reinvested in other investment property. As part of the reinvestment one property must be exchanged for the other, meaning that you must avoid receiving any of the sale proceeds or other property during the transaction. Any portion of the sale proceeds actually or constructively received will not qualify for §1031 treatment.

While this may sound easy to avoid, it’s not always the case. You may be considered as being in receipt of sale proceeds if you receive the economic benefit of the money or property. The IRS takes the position that you are in constructive receipt of money or property at the time the money or property is credited to your account, set apart for you, or otherwise made available to you so that you may draw upon it at any time. In addition, actual or constructive receipt of money or property by an agent is actual or constructive receipt by you.

The use of a third party, known as a “Qualified Intermediary,” to hold the proceeds from the sale of the property owned until they are reinvested in the new property, is the best way to ensure that the sale proceeds are not received by you.

WHAT IS “LIKE KIND” PROPERTY?

The question that often arises in the context of a like-kind-exchange transaction is what type of property qualifies as “like kind.”

This does not mean that if you are selling a 2,000 sq. ft. office you must buy a 2,000 sq. ft office. Rather, the term is interpreted very loosely to mean virtually any real estate held for productive use in a business or for investment, whether improved or unimproved, can be exchanged for any other property to be used for productive business or investment purposes. So, if you sell an unimproved lot of land and purchase an improved one or vice versa, this still qualifies, just as selling industrial property and buying rental resort property does. The point here is that while “like-kind” is an important restriction, it has been interpreted so broadly as to give individuals a lot of free reign.

The eligibility of an investment property is assessed primarily on the intent of the taxpayer. The duration a property is held is one factor considered by the IRS in assessing a taxpayer’s intent. Some tax advisors recommend that taxpayers hold property for a minimum of one-year as an investment property, while others recommend a more conservative two-year hold. There is no definitive rule.

TIMING ISSUES

There are two deadlines relating to 1031 exchanges which MUST be strictly followed – they are as follows:

1.  You must identify the new property to be purchased within 45 calendar days after the close on the sale of the old property.

2.  You must close on the purchase of the new property within 180 calendar days from the closing date of the sale of the old property.

These are just some of the basics relating to structuring a proper 1031 exchange. There is a lot more to know and consider when planning for a 1031 exchange. If you or anyone you know is considering such a transaction, it is best to consult with an experienced attorney or tax professional as early into the process as possible, preferably at the time a party is first considering a sale, in order to insure that all issues relating to the particular transaction are properly addressed.