Using 1031 Transfers To Close More Deals
What Is A 1031 Exchange?
- IRS Code Section 1031 permits someone selling an investment property at a profit to sell the property, purchase another property of “like kind” of at least equal value, and pay no capital gains tax until after the sale of the second property.
- What is the benefit? An owner of investment property is permitted to exchange property and defer paying federal and state capital gain taxes. These taxes could be as much as 15% or 20% Federal, depending on their bracket, 25% depreciation recapture, and any additional state taxes. This allows investors to use all of the sale proceeds to leverage into more valuable real estate. The benefits also include increased cash flow, property diversification (multiple properties), and depending on the investor, consolidating holdings and/or reducing management involvement.
- Like-kind does not mean identical. The IRS cares more about the use of the property. A 1031 exchange must be between investment properties. You can sell a condominium that was rented out and buy an apartment building, you can sell an office building and buy a piece of vacant land. Vacant land always qualifies for
1031 treatment, whether it is leased or not, apparently the intent being to encourage development.
- Relinquished Property- This is the old property or the property being sold.
- Replacement Property- This is the new property, or the property that replaces the one being sold.
- Investment Property- Properties being used in a 1031 Transfer must be investment properties.
- Intent is the key!
- Properties purchased for resale cannot be part of a 1031. Another term for this is “flipping”.
- Primary residences cannot be part of a 1031…unless you talk to me first!
- Properties utilized in a trade or business are investment properties. Plumbing supply store, medical office, etc.
- Qualified Intermediary- A qualified intermediary is an entity that facilitates the exchange. Because the taxpayer must not at any time possess any of the sale proceeds in his individual name, the qualified intermediary enters into an exchange agreement with the taxpayer. Basically, the intermediary acquired the relinquished property from the taxpayer, transfers the property, acquires the replacement property and then transfers it to the taxpayer, in order to comply with the IRS regulations regarding the taxpayer’s possession of assets from the sale.
- Boot- Any non like-kind property received. Boot is taxable to the extent of a capital gain.
- Cash Boot- Any proceeds actually or constructively received by the Exchanger.
- Constructive Receipt- Where an Exchangor (taxpayer) receives proceeds in a manner not permitted by the IRS, such as having the money held by someone having a fiduciary relationship with them, this can create a taxable event.
What Are The Requirements For A 1031 Exchange?
Here are the 7 Rules
- LIKE-KIND EXCHANGE.The properties exchanged must be like-kind. Simply put, it is the use of the properties that is key. All that is required is that both properties be utilized in some trade or business, or as an investment property.Vacant land will always qualify for a 1031 Exchange. Properties purchased to flip cannot be part of a 1031 Exchange.
- 45 DAY IDENTIFICATION PERIOD.IRS Code requires that the replacement property (new property) be identified within 45 days of the closing. 45 days are calendar days and is not extended because it falls on a holiday.
- Up to three potential new properties can be identified without regard to cost.
For 99.9% of people, just stop here! However…
- 200% rule- permits individuals to identify more than 3 properties, with a critical limitation: The total value of all of the properties that you are identifying must be less than double the value of the property that you sold. Simply put, you can identify more than three properties as replacements, but if the taxpayer exceeds the 200% limit, the whole exchange may be disallowed.
- John’s Rule- Keep it simple. Investors should keep the list to three or fewer properties.What do you do with the list? Send it to your qualified intermediary.The IRS gives the qualified intermediary the responsibility for receiving the list on behalf of the IRS. The qualified intermediary must record the date it was received, but there is no formal filing required with the IRS.
- Examples:UP TO 3 POTENTIAL PROPERTIES- Steve sells his old property for $2,000,000.00 on April 30th. He has until June 14th to identify up to three new properties of any value (this is within forty-five days of closing).200% Rule- Steve has 6 “perfect” properties that are run down and he can buy each for about $800,000. If fixed up, Steve is sure that each will sell for $2,000,000. Can Steve identify all 6? Answer: He can buy all 6, but he cannot identify all 6. All 6 would cost him $4,800,000 and exceed the 200% rule, because they would exceed 200% of the property being sold.
- 180 DAY PURCHASE PERIOD.After selling the old property, an investor has 180 days to purchase at least one of the new properties on the 45 day identification list.
Warning: The property being purchased must be one or more of the properties listed on the 45 day identification list and cannot be any property not on the list.
Warning: The 45 days is part of the 180 days. An investor that waits 45 days to identify, has only 135 days left to close!
Warning: If an investor is buying new construction, and the developer is not ready to close by day 180, there are no extensions and the profit from the old property will be fully taxed!
- A QUALIFIED INTERMEDIARY MUST BE USED A Seller cannot hold the money received from the old property’s sale, even for one second! During the time that they are identifying and getting ready to close on their new property, the money in between the sale of their old property and the purchase of their new property, must stay in an escrow account under the control of an independent third party until the closing on the new property.Under the Internal Revenue Code, the investor/seller must use an exchange partner and/or intermediary to handle the exchange. The entity that serves as the intermediary cannot be someone with whom the taxpayer has had a family relationship, or a business relationship, during the preceding two years.The qualified intermediary will prepare documents the IRS requires, both for the sale of the old property and for the purchase of the new property. The taxpayer should earn interest of these funds and if earned, must treat the interest as ordinary income during the escrow period.
- What if the intermediary is not qualified or screws up? The IRS will disallow the exchange. Warning: Qualified Intermediaries are not regulated or supervised by any state or federal agency. Most companies functioning as qualified intermediaries are not bonded. There are no licensing requirements.
- What if the seller needs some cash? He or she can take it and pay tax on that portion. Any money actually or constructively received by the seller is called “boot”. It will be taxed at the taxpayer’s ordinary rate.Example: Sam the Seller purchased an investment property in 1977 for $250,000.00, which he now owns free and clear. Sam received an offer for $8,000,000. Sam would like to sell and use some of the money to purchase a new primary residence and to invest the rest.
- Can Sam do a 1031 exchange? Absolutely, but Sam will be taxed on that portion that he receives. So, if Sam wanted $2,000,000 to purchase a new primary residence, the $6,000,000 could be used for a 1031 exchange. Sam would owe capital gains tax on the $2,000,000 amount, less his original purchase price, and any depreciation/capital improvements adjustments.
- MIRROR IMAGE RULE: Simply stated, the taxpayer listed on the old property be the same taxpayer listed on the new property. If the seller/taxpayer is a married couple, then they must both go on title for the purchase of the new property. If the seller is an LLC or trust, then that identical entity must purchase the new property. The Seller cannot create a new LLC to purchase the new or replacement property.Strategic Considerations:Wife owns old property, which she is selling for $750,000. Can wife and husband purchase new property together and do a 1031? Yes, but the purchase price needs to be at least $1.5MM (approximate- as the wife has her original basis, depreciation, improvements, etc) to avoid all tax.If only the wife is on the old property and they don’t want to acquire a much more expensive property, or the husband is required to be on title to the new property to help qualify for the loan, one solution to avoid this problem prior to the sale would be for the wife to Quit Claim her interest to herself and her husband.If shareholders of a corporation or partners in a partnership or members of a LLC want to sell their respective interest, this is prohibited. What qualifies for 1031 treatment is real estate, and not partnership interests. To accomplish this objective, they must liquidate the entity. Deeds can then be issued to the individual shareholders/members/partners and they can hold as tenants in common. The entity must be liquidated and deeds must be issued to provide the respective partners with a tenants in common interest in lieu of a partnership or related interest.Example No. 1: Steve owns an apartment building in his own name but wants to buy a medical office condominium in the name of a new LLC. Can he do this? No. The new property must be acquired in his own name.Example No. 2: Alma owned her condo prior to getting married and buying a home with her husband, Anthony. Alma wants to buy a vacant lot on the ocean for potential development. Can she take title with Anthony as husband and wife? No. Alma must first complete her exchange in her own name. She may later quit claim her interest to “Anthony and Alma”, as husband and wife after the exchange is complete.
- THE NEW PROPERTY HAS TO BE OF EQUAL OR GREATER VALUE. In order to defer 100% of the tax on the gain of the sale of old property, the new property must be of equal or greater value. Additionally, all of the cash profits must be reinvested (but if you don’t, you simply pay tax on the “boot”). In reality you may deduct closing expenses and commissions from the sale of the property being sold. If the property is being sold for $2,500,000.00 and the actual net amount after closing expenses is $2,400,000.00 all that is required to be spent for the replacement property is a total of $2,400,000.00. You can include the closing expenses incurred in purchasing the new property, as well as an unlimited amount on capital improvements completed within 180 days of closing, as well as up to 15% of the purchase price on furnishings or other personal property.
- REVERSE EXCHANGES: Suppose a seller found a phenomenal investment and would love to sell this property he no longer desires, but he cannot risk the fact that by the time he sells his property, the property he desires might be sold to someone else? LET HIM DO A REVERSE EXCHANGE.
To avoid confusion, I will list the requirements as follows:
- The first rule is that a taxpayer may not have both the old and new properties titled in their name at the same time and still qualify for a reverse exchange.
- All other rules for 1031 exchanges also apply.
PRACTICAL USE: A seller can acquire the new property before the old property is sold. However, title must be taken in the name of the exchange accommodation title holder, or as we have been calling them, the qualified intermediary. Usually, an LLC is created to take title to the new property. In this type of case, an entity will hold legal title.
This is commonly referred to as a qualified parking arrangement and title will stay this way until such time as the old property is sold. Like a regular 1031 exchange, the old property must be sold and closed within 180 days of closing on the new property. As soon as the old property is sold, the proceeds are sent to the exchange accommodation title holder at which time the property may be transferred from the parking arrangement directly to the taxpayer.
WARNING: Most lenders will not lend to a third party entity and in reality, almost all reverse exchanges are “all cash”, which makes pretty straight forward.
3. What if the seller needs to finance the new property? If the seller has to finance the new property, then he or she must convey themselves out of title of the old property before buying the new property. We call the titleholder of the old property a “straw buyer”. This solves the problem of having both properties in the taxpayer’s name at the same time, and also permits the seller to borrow from a commercial lender. The IRS permits straw buyers in these instances and this transaction would be reported. It is an arm’s length transaction in which the straw buyer will covey title to the old property to whomever is the eventual purchaser.
SELLING STRATEGIES: Answer These Questions:
1. Is it easier to speak to a stranger or a friend?
2. Would you rather sell one property or three or more?
Using 1031 exchanges as part of your sales strategy enables you to separate yourself from most other agents. Simply put, just understanding these 7 rules puts you miles ahead of most attorneys, even real estate attorneys. Most importantly, you can work with people you like. 1031’s allow you to reach into your CRM (database for those a little older…and rolodex for those a little older still) and create a transaction where minutes before there might not have been one.
For example, if you sold someone a condo three years ago, that is now up say 50%, you can structure a 1031, so that they could sell their investment condo and purchase a small apartment building. Likewise, you could reconnect with old clients that might not be aware that they can defer any capital gains tax or recaptured depreciation and purchase another investment property that provides a greater return, or is in a better location, or of a type that they could better utilize. There are many opportunities for 1031 transfers. It is limited to your imagination, and of course, the law.