1031 Tax Deferred Exchange and Like-Kind Exchange Agreements
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2.1 Taxation Upon Disposition of Real Property. Disposition of a capital asset used for business or investment purposes [IRC § 1221] ordinarily triggers taxes per IRC § 1001. At the federal level, long-term capital gains are taxed at a lower rate than other income, and if you have a loss on the property, you can deduct it. You may have, however, ordinary income as a result of expensing or depreciation. Property held for one year or less is treated as a short-term holding period. Any short-term gain that is not offset by losses or long-term capital gain is taxed at ordinary income tax rates. Property held for more than one year is considered “long-term” property. This gain (after all gains and losses are netted together) will generally be treated at the far more favorable long-term capital gains tax rate, 15% above $37,950 annual income and 20% above $418,401 annual income.
2.1.1 Depreciation and Recapture. Business and investment real property qualifies as IRC §1250 Depreciable Real Property. The IRS permits amortizing the depreciation of improvements of varying depreciation lives. The 2017 Tax Cuts and Jobs Act retains the current Modified Accelerated Cost Recovery System (MACRS) recovery periods of 39 years for nonresidential property and 27.5 years for residential rental property. The 2017 Tax Cuts and Jobs Act simplified treatment for (also qualified leasehold improvements with a general 15-year recovery period.
If you realize a capital gain when you dispose of investment or commercial real estate, you must report all or part of the gain as “recaptured” income to reflect the amount of any depreciation claimed on the asset. Depreciation taken during ownership must be recaptured when property is sold. Depreciation recapture is taxed at twenty-five percent (25%) regardless of one’s tax bracket. The amount that must be recaptured is equal to the lesser of [i] the total depreciation allowable on the asset, or [ii] the total gain realized.
2.2 IRC § 1031 Non-Recognition of Taxes. IRC § 1031 provides an exception to defer the capital gain and recaptured depreciation taxes when real property [the 2017 Tax Cuts and Jobs Act eliminated deferral of taxes for personal property] held for use in a business or for investment is sold and replaced within 180 calendar days of the first closing if the proceeds from the first closing are reinvested in similar ‘like-kind’ property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC §1031 is tax-deferred, but it is not tax-free.
IRC §1031 regulating the exchange of property held for productive use or investment reads:
(a) Nonrecognition of gain or loss from exchanges solely in kind. (1) In general. –– No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.
2.2.1 Significance of IRC §1031 for the Taxpayer. The key benefit of a 1031 exchange, and why it is the preferred choice for astute real estate investors to use upon disposing of real estate, is that the taxpayer has much greater investment equity retained from the relinquished/sold property to reinvest in the replacement/purchase property. In other words, the funds that would otherwise have been paid to the IRS can instead be reinvested in replacement property.
2.2.2 1031 Exchange Types
2.2.2.1 Simultaneous 1031 exchange. Permits the simultaneous sale of relinquished property and purchase of replacement property.
2.2.2.2 Delayed exchange. A non-simultaneous 1031 exchange of properties must be completed within 180 days of the closing of the relinquished property. Acceptance by the IRS of delayed exchanges resulted from the famous Starker 1976 case. Today, most exchanges are conducted as “deferred exchanges,” where the relinquished property is sold to one party and the replacement property is subsequently purchased from another party. This requires that the taxpayer employ the services of a qualified intermediary, who must be disinterested in the transaction (this normally disqualifies the taxpayer’s attorney, accountant or real estate agent). The qualified intermediary prepares certain documentation necessary for the exchange transaction and holds the exchange proceeds from the time the relinquished property is sold until a replacement property is purchased.
2.2.2.3 Reverse exchange. In a reverse exchange, the taxpayer buys replacement property before disposing the owned property. The taxpayer may want to improve the replacement property with the sales proceeds from selling the relinquished property, or the replacement property may no longer be available for purchase.
2.2.2.3.1 Example. In a reverse exchange, the taxpayer, through an intermediary and an Exchange Accommodation Titleholder (“EAT”), acquires the replacement property before selling the relinquished property. The taxpayer must have the financial resources available to fund the purchase of the replacement property prior to the sale of the relinquished property. In a “build to suit” or “construction” exchange, the taxpayer sells property and, again using an EAT, acquires replacement property on which he will construct improvements. This type of exchange allows the taxpayer to use the exchange funds to not only buy the property but also to construct improvements. The exchange still must be completed with the 180-day period noted above. In both reverse exchanges and construction exchanges, the intermediary, using an EAT, takes title to the replacement property and eventually conveys it to the taxpayer. In a deferred exchange, the intermediary does not need to take title to either the relinquished or replacement property.
2.3 1031 Exchange Requirements. To properly conduct an exchange, the Code and IRS regulations must be strictly followed.
2.3.1 Timing Rules. The most important requirements are the timing rules. Once the relinquished property is sold, the taxpayer must identify potential replacement property within 45 days and acquire the replacement property within 180 days. Accordingly, a prudent strategy for the real estate investor is to place the replacement property or properties [see below] under contract as soon as possible within the 45-day identification period, with closing scheduled on or before the 180-day acquisition period expires. Taxpayers affected by a Presidentially-declared disaster or who are serving in a combat zone are entitled to an extension of these two deadlines. Otherwise, once the closing on your relinquished property has occurred, you cannot qualify for a 1031 exchange. So a 1031 exchange must be set up before the closing of the relinquished property. The directory is full of Accommodators/Qualified Intermediaries.
2.3.2 Like-Kind Exchange. Another requirement of a 1031 exchange is that the relinquished and replacement properties be “like kind.” This was important if someone is exchanging personal property (e.g., yacht, art, airplane). With real estate, however, this requirement is easy to satisfy, since the Code treats most real property interests as like kind with other real property. Thus, residential condominium units can be exchanged for a shopping center, and an apartment building for farmland.
2.3.3 Identifying the Replacement Property or Properties. The two most common identification methods are:
2.3.3.1 Three-Property Rule. Up to three properties may be identified without regard to the fair market value. You may acquire any number of them. one, two, or all three. If acquiring just one property, good practice is to identify two additional properties for safety. You may substitute identified properties via documentation of revocation and replaced identification to the Qualified Intermediary if in the 45-day time period.
2.3.3.2 200% Rule. The 200% rule is used if the taxpayer wants to acquire more than three properties. Any number of properties may be identified so long as their combined fair market value does not exceed 200% of the fair market value of all relinquished property.
2.3.3.3 The 95% Rule. Additionally, if the taxpayer exceeds both the Three-Property Rule and the 200% rule, a valid 1031 exchange if both the Three-Property and 200% Rules are exceeded is to acquire at least 95% in value of all identified properties.
2.3.4 Avoiding Taxable Boot. To fully defer capital gain, there are three rules.
2.3.4.1 The taxpayer should acquire replacement property of equal or greater value than the relinquished property.
2.3.4.2 The taxpayer should not take any cash out of the transaction; all the equity from the relinquished property should be invested in the replacement property. Failure to follow these two rules can result in all or part of the gain being taxed as “boot.”
2.3.4.3 The taxpayer who sells the relinquished property must be the same taxpayer who purchases the replacement property. So a taxpayer holding title to the relinquished property in his own name cannot take title to the replacement property in the name of his corporation.
2.3.5 Holding Period for Relinquished Property. There is no minimum “hold time” with a 1031 exchange, but the IRS typically wants to see that the relinquished property is held for investment, even if used in a trade or business. IRC § 1031 expressly states that property “held primarily for resale” does not qualify for an exchange. An IRS challenge is likely if exchanging a property held less than a year for two reasons: [1] the IRS could reasonably claim that the property was not held for investment but instead for resale, and [ii] the IRS fights taxpayers trying to transmute short-term capital gains into long-term capital gains by doing an exchange. Almost all properties sold in a 1031 exchange are long-term investments and taxed at the long-term capital gains tax rate. Hold the property at least a year to qualify for long-term capital gains treatment.
2.3.6 Assignment Language Requirement. When in a forward exchange, the relinquished property is sold prior to acquiring the replacement property. The contract is assigned to the Qualified Intermediary or Accommodator in both the sale and the purchase.
2.3.6.1 When selling, assignment language is not required, but is suggested so everyone in the transaction is aware of the intent. Sample Relinquished Property Sale Language: “Buyer is aware that Seller has the option to qualify this transaction as an Internal Revenue Code Section 1031 tax deferred exchange. Buyer shall cooperate with Seller in the event of an exchange and hereby agrees to the assignment of this contract to a Qualified Intermediary by the Seller. Seller hereby agrees to hold the Buyer harmless from any and all claims, liabilities, costs, and delays of such an exchange.”
2.3.6.2 When purchasing, assignment language is required because the assignment requires the Seller’s permission. Sample Replacement Property Purchase Language: “Seller is aware that Buyer has the option to qualify this transaction as an Internal Revenue Code Section 1031 tax deferred exchange. Seller shall cooperate with Buyer in the event of an exchange and hereby agrees to the assignment of this contract to a Qualified Intermediary by the Buyer. Buyer agrees to hold the Seller harmless from any and all claims, liabilities, costs, and delays of such an exchange.”
2.4 The 2017 Tax Cuts and Jobs Act. Investment property owners will continue to be able to defer capital gains and depreciation recapture taxes using 1031 tax-deferred exchanges which have been in the tax code since 1921. No new restrictions on 1031 exchanges of real property were made in the tax law. However, the tax law repeals 1031 exchanges for all other types of property that are not real property. This means 1031 exchanges of personal property, collectibles, aircraft, franchise rights, rental cars, trucks, heavy equipment and machinery, etc. will no longer be permitted.
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Reference: National Business Institute, Inc. Real Estate Transactions: Buying and Selling Commercial Real Estate [78952] Pages: 95-99 (2018)