We look at how Reverse 1031 Exchanges can help sophisticated investors avoid losing the right deals in today’s turbulent real estate market.
Real estate, a primary source of wealth generation for many investors, has suffered the worst recession since the 1970's. The combination of increasingly demanding lenders, worsening loan performance and higher inventories of available properties have all contributed to a plunge in consumer confidence. That said, for the savviest investors, the current real estate market has created the perfect storm of opportunities.
The current competitive pricing environment, rising inflation likely in the near future and the increasing attractiveness of tangible assets, all trend to a ‘buyer’s market and new alternatives for profits for those with sufficient foresight. Knowledgeable real estate investors are not only finding great deals to improve their portfolios, but they are using Reverse 1031 Exchanges as a powerful tool to protect their equity from premature taxation.
A Quick Review Of 1031 Exchange Basics
Most people generally understand the exclusion of taxes on the sale of their personal residence. Married couples can receive up to $500,000 of tax-free gains if they have lived in their home for two of the previous five years. However, many people are less familiar with the preferential tax treatment of investment property under Internal Revenue Code Section 1031 (IRC §1031).
The Department of the Treasury Publication 544 states: "A sale is a transfer of property for money or for a mortgage, note, or some promise to pay money. An exchange is a transfer of property for other property..."
"Like-kind investment property exchanges defer capital gains tax recognition"
Accordingly, a sale for cash or a promissory instrument will generate taxes on any gain. But the government allows an investor to defer capital gains taxes if they participate in an exchange and do not receive cash. In order to qualify, they must instead reinvest all cash proceeds into other investment property(s) equal to or greater in value to defer all taxes. Capital gains taxes are not paid with qualified exchanges until the property is eventually sold.
IRC §1031 states: "No gain or loss shall be recognized if property held for productive use in a trade or business or for investment is exchanged solely for property of like-kind".
Investors are often surprised to learn how inclusive this definition of like-kind is. “Like-kind” does not refer to the type of property - rather it describes the use of the property.
For example, any of the following can be considered like-kind to each other:
- exchange of raw land for a rental home,
- an apartment complex for a shopping center, or
- an office building for ranch land.
Essentially, any property used for income production and held for investment (as opposed to personal use) can qualify as ‘like-kind’ to each other.
It's important to note that while this powerful mechanism for protecting equity has been around since 1921, early exchanges were performed as 'swaps' - a simultaneous deeding of properties between parties to prevent either investor from receiving cash (and triggering taxes as a result). However, this turned out not to be very practical if the investor needed time to find a suitable replacement property to swap for a property he was seeking to relinquish.
The Emergence of Delayed 1031 Exchanges
In the late 1970's, the famous Starker court case paved the way for new regulations that now allow for non-simultaneous "Starker" or delayed exchanges under IRC Section §1031. But even with the changes that evolved from this legal decision, many people are still misled by the term “exchange”. They erroneously think that it requires a simultaneous swap or trade. In fact, with the evolution driven by the Starker decision, an exchange now simply allows for a non-taxable or §1031 tax deferred rollover of sale proceeds into new investment property.
The post Starker regulations provided for two major innovations:
1. The establishment of a Qualified Intermediary (QI) - a neutral third party whose role is to create 'safe harbor' procedures for the tax-deferred sale of a real property asset.
Much like the concept of the Individual Retirement Account (IRA), where taxes are deferred until cash is received by the taxpayer, the Qualified Intermediary (QI) acts like an "IRA holder". They prevent the seller/exchanger from receiving sales proceeds (cash).
The QI becomes a part of the transaction by acting as the 'substitute seller' - arranging for the cash to be forwarded from the Relinquished property to purchase the Replacement property. The QI also provides the documentation that is required for the tax deferral. When these procedures are carefully followed, the IRS treats the transaction as part of one continuous investment, and not as a taxable sale.
2. Providing the investor with a period of time to find and acquire a suitable Replacement property
The exchanger must identify possible Replacement property(s) within 45 days of the sale of their Relinquished property. They also have up to 180 days from the original sale to purchase a Replacement property. This new delay from sale to purchase with an exchange has made the possibility of finding suitable Replacement property much more likely, dramatically increasing the popularity of IRC §1031.
Summing It Up - Why Exchange Property?
The reason investors exchange property is simple: they want to legally defer paying tax on gains incurred by the sale of a property. Capital gain taxes are triggered upon the sale of either appreciated or depreciated assets.
This 1031 method of conserving capital assets is available to all taxpayers. Just as the IRA account protects investor's savings from unnecessary taxation until the savings are converted to income, the IRC §1031 exchange can act as a shelter for those investors' who use real estate as their retirement vehicle.
Please keep in mind that if there is no gain, there is no reason to do an exchange of properties under Section 1031. However you also need to keep in mind that taxes are paid on capital gains, not just on cash profits.
Even with no profit, there are often many circumstances where there are significant taxes owed on a gain with the sale of an asset. Many times these transactions produce no cash with which to pay those taxes.
For example, we often see this when:
1) the gain from an earlier property exchange was deferred into a current property that is being sold or,
2) depreciation benefits have substantially reduced the basis of a current property – leaving a situation where selling it even at a small loss could still trigger 15% - 25% or more after combined federal and state taxes.