Section 1031 Tax Deferred Exchanges

When an owner of investment-use or business-use property sells the asset, the sale will trigger capital gains recognition and a resulting tax obligation. However, the recognition event can be deferred through the use of IRC §1031, which provides that no gain will be recognized if the taxpayer reinvests in other investment property that is “like kind”. Technically, a third party, who is called a Qualified Intermediary, is inserted into the transaction to actually facilitate an “exchange” by the taxpayer of one deed for another deed. For Federal tax purposes, the new asset is deemed to be a continuation of the original investment, with the taxpayer’s basis in the old property carried forward to the new property: the new asset is substituted for the old asset that makes up the investment.

Like Kind. For there to be a continuation of an existing investment, it is understandable that the new asset be “like kind” to the old asset. As it relates to real property this definition, which focuses on the nature of the asset, is extremely broad. The inherent nature of real property is that it is ground. Accordingly, investment in any new ground is like an investment in any existing ground; the use to which the ground is put, whether there are improvements on the ground, or if there is actually income from the ground is immaterial in determining “like kind”.
Therefore, farm ground can be exchanged for an industrial building, a duplex can be exchanged for a retail store, or an apartment building can be exchanged for an office building.

If properly used, §1031 can be an incredibly powerful planning tool for real estate investors. It allows for an investor to (a) reposition the geographic location of the portfolio, (b) replace a property devoted to one use with a property devoted to another use, or (c) either consolidate or diversify the composition of the portfolio.

Repositioning a Portfolio. For any number of reasons, an investor may conclude that an existing investment should be sold. In these cases the investor may wish to dispose of that asset but continue his investment through the purchase of a like kind asset in a different location. Through the use of an exchange, the reinvestment can be at 100% of the net sale price since no part of the sale proceeds need be reserved to pay any gain tax. The only restriction on the geographic location of the replacement asset is that it be located within the United States. Otherwise, the investor can select property anywhere.

Adjusting the Management Responsibility for a Portfolio. Because the use of an investment property is irrelevant to determining “like kind”, it is possible to use Section 1031 to transition a portfolio that is highly management intensive, such as rental residential, to something much less management intensive, such as triple net leased retail property. This kind of a transition can be an important lifestyle planning decision as an investor considers potential retirement.

The Effect of Deferring the Recognition of Gain. Section 1031 is one of the most powerful tools we have available to build personal wealth. Through Section 1031, the appreciation of an investment can be realized through its sale, but since the recognition of the gain is deferred, 100% of the appreciation can be utilized to acquire new assets, and with the utilization of leverage available through traditional real estate lending sources, the realized appreciation can be used to substantially enhance a portfolio’s value. The following example will demonstrate this concept: Assume a property was acquired for $200,000, with an 80% loan and equity of $40,000. Assume that the property can now be sold for $300,000. Ignoring the impacts of depreciation and transactional costs for purposes of this example, the realized gain is $100,000 and the net equity available for reinvestment is $140,000 ($300,000 less a mortgage of $160,000 – again, ignoring the impact of principal repayment). With a conventional 80% loan, this $140,000 would permit the investor to acquire a $700,000 property, with no current obligation for capital gains tax or depreciation recapture. The investor has transitioned an investment worth $300,000 into an investment worth $700,000!

Section 1031 is the Exception. The general rule under the tax code is that upon the sale of a capital asset, any realized gain or loss is recognized in the year of sale. Section 1301 is the exception to this general rule, and as such, the rules and regulations that govern this section must be strictly followed. Failure to follow all the rules and regulations will disqualify the exchange and result in the transaction falling under the general rule.

The Application of Section 1031. It is important to understand the limitations that exist to this Section. It applies to property that is held for a productive use in a trade or business or held for investment. It does not apply to property held primarily for sale or held for personal use. The Statute also specifically excludes several specific types of capital asset classes, including stocks, bonds, notes, and partnership interests.

Section 1031 has been a part of the Internal Revenue Code since 1921. Initially, all exchanges were done simultaneously. In 1984, Section 1031 was amended to permit a delayed exchange when there is a gap in time between the sale of the old property and the purchase of the new property. Since that time, this has been the most popular structure for an exchange, which allows the investor 45 days to identify potential replacement properties and 180 days to complete the purchase of a property that was identified.

This Section of the Code is not an “all or nothing” provision. It is possible to have a partially tax deferred transition, with the balance being taxable. If non-like kind property is received in the exchange it is called “boot” and is the part of the transaction on which gain is recognized (to the extent of the gain). However, for investors to obtain the full tax deferral, it is necessary for them to acquire a replacement property of equal or greater value than the relinquished property, invest the net equity from the relinquished property into the replacement property, and
receive nothing but like kind property in the exchange.

The Qualified Intermediary. In order for the investor’s transaction to be structured as an exchange rather than a sale, it is essential that the investor never actually or constructively receive any cash. The Treasury Regulations that provide guidance for these transactions set out procedures for the use of an independent third party who serves to insulate the investor from receiving the cash. This party is called a Qualified Intermediary. Because this industry is totally unregulated, the selection of a Qualified Intermediary deserves the utmost care and attention. It is imperative for the investor to fully evaluate the security that is provided by inquiring about the level of insurance and bonding that are carried for the benefit of the investor, and the guarantees that are given to the investor by the Qualified Intermediary. The investor should also inquire about the size, expertise and resources of the Intermediary.

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