November 2001
Like-Kind Real Estate Exchanges Under IRC Section 1031
By William J. Coffey, PhD, CPA, and Lewis Schier, PhD, Pace University
The recent surge in buying and selling commercial and residential real estate creates significant tax-deferral opportunities for real property investors under IRC section 1031. Investors (exchangers) may sell investment property without paying capital gains tax if they replace relinquished property with like-kind investment property. In effect, the capital gain from the sale of one property is transferred to the replacement property. In general, the deferred capital gain will be taxed only when the replacement property is sold. Successfully effecting the deferral of capital gains tax under section 1031 involves specific timetables and inflexible rules. Although the IRS regulations are intended to allow tax deferral, there may be a future opportunity to eliminate any deferred tax on an exchange transaction.
To achieve the benefits of a tax-deferred exchange, investors need a third party to act as a “qualified intermediary.” Typically the intermediary temporarily holds escrow funds; this money comes from the sale of relinquished property and is used to buy replacement property. The intermediary must be independent to qualify under the tax regulations.
Many investors employ national title companies, many of which have departments that provide services as qualified intermediaries for IRC section 1031 exchange transactions. The fee charged may be in the $1,000 range for a simple sale-and-replacement transaction. Some reputable boutique firms will provide the same service starting at $500. Other variables include mortgages, liens, other encumbrances, and special arrangements such as enhanced escrow fund security. Theoretically, any independent person or entity can serve as an intermediary, although CPA firms and law firms tend to avoid providing this service because of strict IRS restrictions on contemporaneous use of other services by investors.
IRC Section 1031 Property Criteria
To qualify under IRC section 1031, property must either be held for investment or used in a trade or business. Property held for personal use or for accommodation or property held for resale will not qualify. Moreover, the properties exchanged must be of a like kind.
Like-kind property is broadly defined by its use, not its characteristics. For example, land may be exchanged for rental property such as a house, condominium, or commercial real estate. Vacation homes may qualify for exchange if rented and not used for personal use more than 14 days per year. Business property such as machinery and equipment held by corporations, partnerships, or other entities may be exchanged for like-kind assets. The rules for like-kind exchanges of personal property are, however, more restrictive than those for real property.
Sale and leaseback transactions qualify under section 1031 if the lease extends at least 30 years. Operating leases do not qualify, nor do 30-year financing leases with prepayment provisions. Foreign property sold or exchanged for property either outside or within the United States does not qualify. Exchanges of partnership interests (irrespective of geography), inventory, securities, or debt instruments do not qualify.
Rules for Replacement Property
Timing is critical for an effective exchange. IRC section 1031 requires the exchanger to identify the like-kind property explicitly in writing to the intermediary within 45 days from the date of the sale of the relinquished property. Furthermore, acquisition of the replacement property must be completed within 180 days from the date of the sale of the relinquished property.
The rules give some flexibility for identifying replacement property. An exchanger has two options under the 45-day rule:
Parties to the Transaction
The exchanger sells an investment property (the relinquished property) and replaces it with like-kind property. The qualified intermediary acts as a principal for the sale of the relinquished property and the purchase of the replacement property. The exchanger must take care not to receive or constructively receive any of the cash proceeds from the sale of the relinquished property, because they would be taxable as boot in the year received.
Investors may reap substantive critical benefits under section 1031 apart from tax deferral. Among these is the exchange of non-income-producing land for cash flow property such as rental real estate. Similarly, a low-cash-flow investment may be exchanged for one with significantly higher cash flow, or an investment in one location may be exchanged for a more desirable area. Estate planning may be a goal; some investors may want to exchange a large holding for smaller ones to be distributed to family and heirs. Conversely, several smaller properties may be exchanged for a larger property to reduce management responsibilities. Business owners that own their own buildings or suites may want to use section 1031 to convert to other like-kind replacement property should their businesses expand, contract, or terminate.
The buyer of relinquished property has few obligations that would create impediments. The seller of the property simply needs an agreement that the buyer will cooperate in a section 1031 tax-deferred exchange. Adding an exchange cooperation clause to the purchase and sale agreement, wherein the buyer agrees to cooperate by accepting a qualified intermediary as the principal to complete the exchange, will achieve this.
Similarly, the seller of the replacement property agrees to cooperate with the buyer of the replacement property and the qualified intermediary to complete the exchange. An exchange cooperation clause incorporated into this purchase and sale agreement allows the intermediary to act as principal for the exchanger.
The duties of the qualified intermediary are to act as a principal for the exchanger in relinquishing property, to hold exchange proceeds, and to disburse these proceeds to the seller of the replacement property. The intermediary is required to ensure that the exchanger adheres to the IRS timing and property identification rules.
Because a qualified intermediary must be independent, previous engagements within the past two years by a CPA, attorney, or real estate broker will generally prohibit these professionals or their associates from serving as an intermediary for an exchanger. A failure of intermediary independence can taint the entire transaction, making gains on the sale of relinquished property immediately taxable.
Cautions
The most important part of a successful IRC section 1031 exchange is planning. The professionals involved in the exchange—accountant, attorney, real estate broker, qualified intermediary, and lender—should communicate thoroughly and often.
To have the full benefit of tax deferral, the full proceeds from the sale of the relinquished property must be used to buy replacement like-kind property; any excess will be subject to tax in the current year.
Although property already owned cannot qualify as replacement property, a recent change in the tax law now explicitly permits the purchase of replacement property within a specified time limit before the sale of relinquished property, in what is called a reverse exchange.
The titles to relinquished property and to replacement property must be held in the same name; a few exceptions are permitted in the case of some trusts.
Failure to meet either the 45-day identification deadline or the180-day exchange deadline will disqualify the exchange from favorable section 1031 treatment.
Tax Considerations
Replacement property basis. The objective of IRC section 1031 is to permit the deferral of capital gains tax by transferring the tax basis of the relinquished property to the replacement property. That basis increases when additional funds are invested in purchasing or improving replacement property. Similarly, the tax basis of replacement property is decreased if the entire relinquished property proceeds are not used for the purchase of replacement property (boot goes to the exchanger).
Depreciation. Real estate is generally amortized using IRS depreciation methods, usually straight-line. When real estate is sold, capital gains are computed in accordance with current tax rates (with depreciation recapture, if applicable).
Rental property. To comply with IRS regulations, exchangers must demonstrate intent to acquire and use replacement property for genuine business reasons and not primarily for tax avoidance.
Although the regulations are clear about investor intent for section 1031 exchanges, they do not specify a minimum acceptable holding period for replacement rental property. The consensus among professionals is that two or more consecutive tax returns should satisfy the intent criterion.
Conversion. If the investor has satisfied the intent rule by holding the property two or more years, circumstances may change and the investor may decide to convert a rental property to a primary residence. The basis of the property at the time of conversion becomes the basis of the primary residence, and no taxable event is recognized.
A subsequent sale will be taxed according to the regulations governing a primary residence. For the sale to qualify for favorable tax treatment, the property must have been a primary residence for two of the last five years. The first $500,000 of capital gain on a qualifying residence is exempt for a married couple, as is the first $250,000 for a single individual.
IRS reporting requirements. The taxpayer’s federal tax return for the year in which the investor sells a section 1031 relinquished property and buys a replacement property must include Form 8824, Like-Kind Exchanges. Part I requires descriptions of property given up and property received. The exchanger also must provide information on the dates of disposal and acquisition to show compliance with the 45- and 180-hr day rules. Part II requires additional information to clarify and document taxpayer intent if related parties are engaged in the exchange. Part III calls for detailed financial information regarding the exchange, including the original cost, the current basis, fair market valuations, any boot, and deferred gains. The final figure shows the basis of like-kind property received by the exchanger, and will it be vital for depreciation and any subsequent sale or use.
Editor:
Edwin
B. Morris, CPA
Rosenberg, Neuwirth & Kuchner
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