A 1031 Exchange Can Save Lots of Taxes

You have just sold an investment property which you have had for many years making a huge profit. That is the good news. The not so great news is you will be giving a significant percentage back to Uncle Sam in the form of a capital gains tax. Back to the good news. You can avoid the tax payment through a “1031 Exchange” also known as a like kind exchange. Actually, both this sentence and the headline of this article are not really accurate, you neither save nor avoid taxes, what you really do is “defer” them. What a 1031 exchange does is allow you to put off the tax day until a much later date. You must make the decisions to seek the 1031 exchange protection before you sell your property. At closing, your proceeds of sale must be held in trust by a “qualified intermediary.” The qualified intermediary acts as a buffer to make sure you cannot be deemed to have constructively or actually received any of the sales proceeds.
There are two timelines that anybody electing for a 1031 exchange must observe regarding the replacement properties to be purchased. The first of these is the “Indemnification Period.” This period is exactly 45 days from the day of selling the relinquished property. This 45 days timeline must be followed under any and all circumstances and is not extendable in any way, even if the 45th day falls on a Saturday, Sunday or legal US holiday. Usually, you are allowed to identify up to three properties, but in some instances may identify more.

The Exchange Period is the period within which a person who has sold the relinquished property must receive replacement property. It is referred to as the Exchange Period under 1031 exchange rule. This period ends 180 days after the date on which the person transfers the property relinquished or the due date for the person’s tax return. Again, as with the 45 day identification period, the 180 days timeline has to be adhered to under all circumstances and is not extendable even if the 180th day falls on a Saturday, Sunday or legal holiday.

There are several types of exchanges as follows:

Simultaneous Exchange: This occurs when two properties are exchanged simultaneously. This can happen when two properties are swapped, property for property, which is called a two-party exchange. This can also happen when a property is sold and the replacement property is purchased simultaneously. As with any exchanges, to ensure 1031 protection, a Qualified Intermediary should still facilitate the exchange.

Forward Delayed Exchange: This is the most common type of exchange and occurs when a property is sold (relinquished property) and another property is purchased (replacement property) within 180 days following the sale of the relinquished property. For a 1031 forward Delayed Exchange, the sale proceeds must be held by a qualified intermediary between the sale of the relinquished property and the subsequent purchase of the replacement property.

Construction Exchange: This is otherwise known as Build-to-Suit Exchange and occurs when the taxpayer uses the funds from the sale of the relinquished property to construct improvements on the replacement property. The property on which the improvements are constructed cannot be held by the taxpayer but must be held by a third party called an exchange accommodation title holder until either the improvements are complete or until the end of the 180 day Exchange period, after which the title holder is deeded the replacement property with the improvements. This is a more complicated process than either the simultaneous exchange or forward delayed exchange.

Reverse Exchange: The replacement property is purchased before the sale of the relinquished property. The replacement property must be held by an exchange accommodation title holder until the sale of the relinquished property, which must take place within 180 days following the purchase of the replacement property. This is also a more complicated process.

The advantages of a 1031 like kind exchange are:

Avoid paying taxes associated with selling the property and conserve equity. You keep 100% of your equity working for you instead of giving a portion to the IRS.

Move real estate investment from one geographic location to another, as in a job relocation or job transfer or retirement.

Increase cash flow. An exchange can be used as a way to sell a property with either no current income or a small return and replace it with one that provides better current cash flow. Property that is not providing enough income may be exchanged for a better performing property. This can be done if you own raw land and receive no income from the property. An investor may decide to sell his raw land through a tax deferred exchange and acquire income producing property that will produce cash for him each month.

Improve investment appreciation. You can invest in a property that has greater appreciation potential than your existing property.

Consolidate or diversify investments. You can sell multiple properties and exchange into one larger property to reduce the management and accounting work associated with owning multiple real estates.

Eliminate management hassles. Exchanging is a method that can be used when selling a time intensive property (such as a shopping center) and reinvesting in a type of property that requires less attention (such as a single tenant warehouse).

Lastly, know that a “like kind” exchange is a bit of a misnomer. You do not need to buy exactly the same type, say a restaurant for a restaurant. Rather “like kind” has a broader definition, generally one investment property for another.

Like every “silver lining” there is a little bit of a cloud with a 1031 exchange. They are not easy. They do require substantial help from a good commercial lawyer and a qualified intermediary. Multiple closings and very careful attention to tax regulations are absolutely critical in making a 1031 exchange work.

James J. Delia is a Partner at WJ&L and practices in our Land Use and Real Estate areas.

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