If you hold real estate for investment or business purpose -- it is well worth your time to learn
more about tax-deferred property exchanges. While admittedly being a complex topic, this
area of the tax code offers one of the most powerful tools for deferring payments of substantial
capital gains taxes.
Property exchanges are known by several names. The Internal Revenue Service calls them
‘1031 Exchanges’, or more formally, Real Estate transactions which comply with Section 1031
of the Internal Revenue Code. They are also frequently referred to as ‘Like-Kind exchanges’,
‘Delayed Exchanges’ or ‘Starker Exchanges’. Named after the owner/investor whose case
first reached the United States Supreme Court, successfully both legitimizing and clarifying
such transactions).
WHY DO PROPERTY EXCHANGES?
Without 1031 Exchanges, any real estate investor who wants to sell property after owning it
for at least one year, will owe capital gains taxes on any profits from the sale. Currently,
Federal Capital gains are taxed at 15 percent. In strong real estate markets, capital gains
taxes can be quite significant.
For example, an investor who purchased property for $250,000 then sold it for $500,000
would be subject to $37,500 in federal taxes (15 percent of the $250,000 profit),
But assume that this same investor also plans to purchase a different investment property.
In this case, they could defer paying the capital gains tax by exchanging one property for
another, so long as the transaction complied with strict IRS guidelines. The original
$250,000 basis would be applied to the new property, regardless of what the investor paid
for it. In effect, the philosophy behind a 1031 tax exchange, is that as long as a real estate
investment remains intact, Capital Gains Taxes should not be assessed.
The Advantages of 1031 Property Exchanges:
Delaying tax payments is much like receiving an interest-free loan from the government.
After factoring in the time value of money, it becomes even more apparent that the longer
the payment can be delayed, the larger the benefit of deferring it. But the benefits don’t
stop there. By keeping more money in their pockets, investors have additional proceeds
to reinvest from the original property, or may opt to reinvest in a higher-priced property.
Basic Qualifications:
What types of properties qualify for a like-kind exchange? Real property held for Business
or Investment must be exchanged for other like-kind real property. But beyond this, rule,
investors have a great deal of latitude. For example, an apartment building can be
exchanged for a farm; or a condo unit for vacant land. But while 1031's offer considerable
flexibility; there are very clear and strict time parameters and other restrictions placed on
deferred-tax exchanges.
To "exchange” one property for another, investors should work with a qualified 1031
intermediary who handles the transfer of funds and properties between the parties.
Of course it is rare that the two properties involved in an exchange will be equal in value
and equity. Therefore, to balance the transaction, one party typically pays in additional
funds, or assumes a larger amount of the underlying debt. If the investor seeking the
exchange receives this money, or reduces his debt, then the offsetting amount is referred
to as ‘Boot’.
Any gains received in the form of ‘boot’ would taxable, regardless of whether it was taken
in actual funds, or in the form of debt relief.
Are There Disadvantages?
The primary disadvantage of 1031 exchanges is that they are complex transactions which
must be properly structured and documented, utilizing third-party experts to manage
certain aspects of the deal. Beyond this, it is important to consider the fact that future
taxes, while deferred, may be higher, particularly after a succession of tax-deferred
exchanges, all built upon the original, low basis.
Part of the complexity of a 1031 exchange, stems from the fact that tax laws change
periodically, with clarifications and interpretations modifying many subtle transaction
details. This is an area of Real Estate that truly requires the involvement of both tax and
legal experts. While it is perfectly appropriate for a buyer’s (or seller’s) agent to introduce
1031s to clients, and to discuss his or her knowledge and involvement in past transactions,
agents must take care to never cross over the line of providing legal or tax advice.
Four Basic Rules of 1031 Exchanges:
1. Property must be held for investment, or used productively in trade or business.
2. Property must be exchanged for like-kind property.
3. Replacement properties must be identified within 45 days after the relinquished
property is transferred.
4. The exchange must be completed, (replacement property received) by the earlier of:
180 days, or the tax return due date.
TREASURY REGULATIONS AFFECTING PROPERTY IDENTIFICATION:
The information discussed here below is critical to a successful Starker transaction.
The Legislature passed Treasury Regulations applicable to property identification
under Section 1.1031(k)-1(c).
Failure to comply with the identification rules and requirements can cause an exchange
to fail. Below are the requirements for meeting the identification rules.
The Exchanger can choose only one of the following methods below for identification:
1) ‘THREE PROPERTY RULE’ - You are identifying three properties or less;
OR
2) The '200% RULE’ - You wish to identify more than 3 replacement properties.
Identified property must be unambiguously described in a written document signed by
the taxpayer and hand delivered, mailed, tele-copied, or otherwise sent before the end
of the identification period to Starker Services, Inc.
THE THREE PROPERTY RULE:
No more than three properties can be identified of any fair market value.
a) Exchanger must list the street address or legal description, the city, and the
state for each property identified. The “% interest” should be used when
acquiring a partial interest such as 50%, if you are buying only 1/2 the property.
b) If the exchanger is planning on purchasing only one of the identified properties,
"OR" must be circled on the form between each identified property.
c) If the exchanger is purchasing more than one property, "AND" is circled between
each properties listed.
WARNING: If "AND" is circled, none of the remaining proceeds will be released until the
end of the 180 day period, unless all identified properties are purchased. If the exchanger
identifies a property, and is not able to negotiate a contract with the seller, the exchange
funds will not be released until the end of the 180 day replacement period. If the exchanger
feels they might not complete the exchange, and are concerned about access to the exchange
proceeds, they must contact their exchange counselor prior to the end of the 45 day
identification period, for instructions on how to properly cancel their exchange.
THE 200% RULE:
Exchanger may identify any number of properties if their aggregate fair market value as of
the end of the identification period does not exceed 200 percent (twice) the value of the
relinquished property.
a) Exchanger must list the street address or legal description, the city, and the state
for each property identified.
b) The total value of the identified properties must not exceed 200% (twice) the value
of the relinquished property(s),
c) If exchanger is unable to purchase every property identified, and funds remain,
the residual proceeds will not be released until the end of the 180 day period.
These funds will be placed in an interest bearing account, until they are transferred
on the 181 st. day.
95% EXCEPTION TO THE 200% RULE:
If more than three properties are identified and the aggregate fair market value exceeds
200% (twice) the relinquished property, the taxpayer must acquire identified properties
representing at least 95% of the aggregate fair market value of the identified properties.
PROPERTY TO BE CONSTRUCTED OR IMPROVED:
If exchanger is identifying property to be constructed on or improved, they must identify
this property and the planned improvements in as much detail as possible.
The replacement property the exchanger receives must he substantially the same as what
was listed in the Identification Form. Please call both tax and legal experts for more
information, if you are considering acquiring property to be constructed or improved.
