The Internal Revenue Code’s Section 1031 exchange is a program that’s becoming increasingly popular in commercial real estate circles as a way to defer tax payments. While it’s not as well known as many other financial strategies, the 1031 exchange is becoming an important tool for investors, with the potential to increase investment capital that would otherwise be impossible.
“Before sprinting off to initiate a 1031 exchange, the property owner should be wary not to overstep the boundaries, however broad they may be.”
The tax exchange is a complex strategy that must be understood completely before attempting and requires the help of a qualified professional. It has the potential of deferring both capital gains and any gains received from the sale of depreciated capital property that must be reported as income. Commercial mortgage brokers should be familiar with the 1031 exchange and how it works so they can better advise clients on whether they should use it to defer real estate taxes.
Deferred taxes
The 1031 exchange allows a property owner to “swap” one asset for another that is considered “like-kind.” Since the money never graces the investor’s pocket, any capital gains tax is suspended until the gains are eventually cashed in.
This scenario can be used repeatedly, with the seller rolling over the gain from one investment property to another. Even if there is a profit on each swap, the taxes are deferred until the buyer sells for cash at some point in the future.
This is a simplified explanation, and there are many nuances to the IRS regulation that must be understood, but it illustrates the basic function. By postponing tax payments, investors can trade with the full value of their properties — as long as they keep in mind that the IRS will eventually be owed the deferred gains.
As every investor knows, money now is always better, because a dollar in hand is a dollar that can be invested to grow wealth. Tax dollars will forever be tax dollars, but if they can be put to work for the investor before they go to Uncle Sam, so much the better.
Crucial details
A common question involves which types of property qualify as like-kind in a 1031 exchange. The term is ill-defined, but it essentially describes a tax-deferred transaction that allows for the disposal of one asset and the acquisition of another similar asset. Fortunately for the investor, the definition is quite open-ended. For something to be like-kind in real estate, it only needs to be some form of real estate, although primary residences do not qualify.
Before sprinting off to initiate a 1031 exchange, the property owner should be wary not to overstep the boundaries, however broad they may be. While most real estate is like-kind to most other real estate, it is like-kind only to real estate. For instance, the program doesn’t cover securities (such as stocks, bonds or notes), other evidence of indebtedness or interests in a partnership.
The 1031 exchange program has many rules that must be closely followed. For instance, in most cases, the process is classified as a delayed exchange in which one party will sell a property and then store the proceeds with a qualified intermediary, who is an independent and neutral party with no ties to any of the other parties involved. The intermediary holds the relevant money in an account that the seller cannot access.
Within 45 days of the sale of the first property, the former owner must designate the replacement property to the intermediary. The seller must then close on the replacement property within 180 days of disposing of the first property. Money left over from the transaction is taxed as partial sales proceeds. To offset the potential tax bill, the property buyer needs to demonstrate debt equal to or greater than what was paid off upon sale of the relinquished property.
Dubious connections
Due to the potential for tax avoidance, there are extensive guidelines in the tax code that require an expert’s guidance concerning “related parties” who enter an exchange. This term has a wide definition, ranging from family members to partnerships, corporations, trusts and entities in which more than 50% of the stock or capital interest is directly or indirectly owned by the taxpayer.
It is possible for related parties to use a 1031 exchange, but there are strict rules governing the procedure and it’s usually not advisable. Generally, buying property from a related party and selling it to an unrelated party is not allowed.
For related parties to qualify, they need to follow three conditions: They must hold the properties for a minimum of two years following the exchange; transaction details such as the sales price and rental income must be at prevailing market rates; and the taxpayer must be able to prove that the transaction did not result in tax avoidance through an income tax basis swap. There are other exceptions, but any property owner looking to avoid the prohibitions should seek professional help to make sure their financial plan is legal.
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For those in the business of real estate investments, 1031 exchanges can be a vital tool to defer capital gains and taxes, freeing up money for current ventures. It’s crucial for mortgage brokers to recommend that clients find qualified advisers and thoroughly understand the process to avoid running afoul of the IRS. Doing so can mean the difference between financial growth and legal trouble. When it comes to the IRS, due diligence is always a must. ●
