By: James T. Walther, Esq., LL.M.
Exchange Director, Legal 1031 Exchange Services, LLC
What is a 1031 Exchange?
Although tax deferred exchanges have been part of the Tax Code in one form or another since 1921, many people are not aware of this powerful and easy to use tax benefit. In general, an I.R.C. §1031 Exchange (“Exchange”) allows owners of business or investment real estate to defer the recognition of all or most of the capital gains taxes and depreciation recapture normally due upon the sale of the property so long as they use the proceeds to buy replacement business or investment real estate, within 180 days. An Exchange is a tax strategy that with proper planning, can be utilized to reduce tax liability, preserve equity, increase purchasing power, and increase annual returns. Although most people think about Exchanges only in conjunction with commercial or industrial property, there is a huge need for Exchanges when dealing with residential properties as well. There are structures that allow Exchangers to purchase vacation homes, retirement homes, and under some very special circumstances, the ability to combine an Exchange with a primary residence.
Misconceptions About Exchanges
Often, when real estate investors hear about the benefits of a 1031 Exchange for the first time, they ask the question “If this process is so beneficial, then why doesn’t everyone do it?” The simple answer is that many people have misconceptions – a lack of understanding and a lack of planning. This article will explore and dispel some of the more common misconceptions about 1031 Exchanges for those who are unfamiliar with the process.
Misconception 1 – I need to do an actual “swap” – property for property with another person interested in exchanging
While this is how Exchanges were once structured, Exchangers are now free to sell their property to anyone they wish, and to buy from anyone they wish. Although there are a few issues regarding sales and purchases between related parties, most Exchanges are structured not unlike any other typical sale and subsequent purchase; the benefit is the capital gains tax deferral which provides investors with additional purchasing power. A 1031 Exchange does not obviate the need for a realtor. Quite to the contrary, in most cases an Exchanger has an even greater need for a realtor due to the time constraints placed on Exchangers. Simply put, an Exchange is a sale, just like any other sale, and a purchase just like any other purchase, but with some additional rules, time deadlines, and the involvement of a Qualified Intermediary.
Misconception 2 – The “swap” must occur in one simultaneous transaction
By virtue of a favorable court ruling for the taxpayer in the now famous case of Starker v. United States in 1979, and a subsequent re-write of I.R.C. Section 1031, Exchangers can complete an Exchange on a delayed basis so long as they purchase replacement property within 180 days of selling their first relinquished property. Other structures, including reverse exchanges and improvement exchanges, afford the Exchanger even more flexibility to utilize the exchange process.
Misconception 3 – An Exchanger must buy the exact type of property that they are selling
One of the greatest misconceptions of 1031 Exchanges involves the requirement that the real estate exchanged must be “like kind” to what is purchased. Many people wrongly assume that “like kind” means the same type of real estate (i.e. – apartment building exchanged for an apartment building or that the number of units or the size of the building matters). However, if the real estate to be sold, and the real estate to be purchased are held for the productive use in a trade or business, or for investment purposes, Exchangers are free to purchase whatever type of real estate they want. The use/intent of the Exchanger is what really matters and not the type of property. If an ownership interest is considered real property per the laws of the state in which the property is located, the interest will most likely qualify as a valid replacement property. In addition to exchanges of traditional interests in real property, exchanges of development rights, air-rights, timber rights, and mineral rights are not uncommon, depending on state law.
Misconception 4 – Residential property will not qualify as replacement property in a 1031 Exchange
Under the rules discussed above, residential property can be considered “like-kind” if it is held for investment purposes. The property type, zoning, and whether the real estate is improved or unimproved are not factors in determining whether property will qualify for an Exchange (i.e. vacant land can be exchanged for an apartment building, or even a shopping center or a factory). Residential property that is part of an exchange can even be rented to a relative, if properly documented, and leased at fair market value. However, a residential property for which the taxpayer’s primary intent for ownership is personal use, will not qualify as exchange property. For instance a taxpayer’s primary residence will not qualify and likewise, a vacation home that does not meet the IRS’s safe harbors may face scrutiny. In addition, real estate held primarily for re-sale or as inventory will not qualify (where a taxpayer has manifested an intent to sell the real estate at a gain, rather than hold it as an income property). All of these situations can be remedied by converting the disallowed use into a use which complies with the requirement of holding the property for business or investment purposes.
Misconception 5 – the legitimacy of the process: “1031 Exchanges are a tax loophole”
The above statement is incorrect. Exchanges are written into the U.S. Tax Code and have been available to taxpayers in one form or another for almost 100 years. Exchanges have been available in their current structures since 1986 and aren’t a loophole or some “tax magic.” Exchanges are allowed as part of the rules! Below is a famous quote explaining why there is nothing wrong with tax planning if one follows the rules:
“Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. … Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.”
— Judge Learned Hand, Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934), aff’d, 293 U.S. 465 (1935).
Misconception 6 – I will be penalized if I start an exchange, but do not complete it.
There is no tax penalty for starting an exchange and cancelling it or failing to complete the exchange. The taxpayer would simply report any capital gains from the sale of relinquished property on their tax return for the year in which they received the exchange funds. If a taxpayer starts an exchange in one tax year, however, does not complete the exchange and receives sales proceeds in the next tax year, those proceeds are deemed taxable and may be reported in the year they are received. An exchange which is not completed can still sometimes benefit the taxpayer by pushing the gain into the next tax year under this scenario.
Misconception 7 – Exchangers must use all the proceeds from the sale of relinquished property to purchase replacement property and cannot use proceeds for other purposes.
Exchanges are not all or nothing, thus a partial tax deferral is possible. If an Exchanger buys a replacement property of equal or greater value as to the value of the relinquished property, uses all of the equity realized from the sale to purchase the replacement property, and obtains equal or greater financing on the replacement property as was in place on the relinquished property, the Exchanger will have a fully tax deferred exchange. In general, an Exchanger who wishes to buy a replacement property of a lesser value, or with less financing, or who wishes to use a portion of the proceeds from the sale of the relinquished property for something other than purchasing replacement property, will recognize a capital gains tax on only that portion of the funds which were not used for purchasing replacement real property. However, an exchanger subject to “debt boot” tax liability because they exchanged into a property with less financing, can use cash to offset the difference in financing and avoid recognition of a capital gain.
Misconception 8 – An Exchange must be one property for one property
There are no statutory limits to how many properties can be involved in an exchange. Some common motivating factors for multiple property exchanges include consolidating multiple properties into one replacement property or diversifying by using the equity in one property to purchase multiple replacement properties. In addition, it is common for an exchanger to purchase a fractional real estate interest like a tenant-in-common interest or an interest in a Delaware Statutory Trust when they have purchased a primary investment but have leftover exchange funds that are not enough to buy a net lease investment. There are considerations that do sometimes work to limit the number of properties which can be bought and sold, including the requirements of the 1031 exchange identification rules, as well as market forces dictating how quickly transactions can be completed with the 180-day time period.
Misconception 9 – I don’t need a Qualified Intermediary, I can simply have my attorney or accountant hold the sale proceeds until the replacement property is purchased.
A Qualified Intermediary is essential to completing a valid delayed Exchange. Basically, the IRS has disqualified from acting as an intermediary most any person or entity who you would normally trust with your Exchange funds. Some examples of disqualified parties are related persons and entities, any person or firm that has acted as an employee, real estate broker, attorney, accountant, agent or investment banker or broker within two years preceding the date of transfer of the relinquished property. If the Exchanger or any one of the disqualified parties comes into receipt of Exchange funds it would void the Exchange. Using a well-established Qualified Intermediary allows an Exchanger to take advantage of the “Safe Harbors” provided for in the Treasury Regulations and protects the Exchanger against “constructive receipt” of the Exchange funds. It is also a good practice to research the nature of the guaranties offered by the Qualified Intermediary.
Misconception 10 – Timing – I shouldn’t start considering the exchange until my relinquished property closes or is near closing.
A common mistake in the real estate industry is to wait until there is a sale contract in place for the relinquished property before discussing what to do with the proceeds from the sale. This misconception often leaves Exchangers with too little time to adequately prepare for an exchange and find a replacement property. The earlier an Exchanger considers options and discusses an exchange with their advisors, the smoother the exchange transaction will go. If the relinquished (sale) property is held in a business with a partner, both partners should discuss the exchange with their tax advisor, prior to the exchange process, ideally before listing the relinquished property for sale. In addition, Exchangers can begin looking at or conducting due diligence on replacement property early in the process of selling relinquished property. Doing so helps set expectations regarding the market and timing for potential replacement properties and gives the Exchanger extra time to prepare for the exchange and to evaluate potential replacement properties, versus waiting until the relinquished property is under contract.
In conclusion: These common misconceptions often prevent taxpayers from taking advantage of one of the best real estate tax strategies provided by the U.S. Tax Code. A 1031 exchange is much broader and inclusive than many investors initially believe and thus there are many more situations in which it is applicable. If you plan on selling real estate used in a trade or business or held for investment purposes, you should consult with your tax and legal advisors early in the sales process in order to properly plan, maximize tax benefits, and to make informed decisions on the exchange process.
1 See Moore v. Commissioner, T.C. Memo 2007-134, (May 30, 2007).
2 Rev. Proc. 2008-16, available at: https://www.irs.gov/pub/irs-drop/rp-08-16.pdf, provides a safe-harbor if the following criteria are met: 1. The dwelling in question must have been owned by the taxpayer for at least twenty four months immediately before the exchange (defined as the “qualifying use period”); 2. During each of those two years the taxpayer must rent the dwelling at a fair market amount for at least fourteen days, and; 3. The taxpayer’s personal use of the property each year must not exceed more than fourteen days or 10% of the days that the property was rented.
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