Can you name one person that actually enjoys paying taxes? We all enjoy the liberties of living in this country but it doesn’t seem to make it any easier to write a big check to Uncle Sam. This is especially true in the real estate investment world, where large gains are not uncommon and along with those gains, come large tax payments. The IRS has blessed a method of deferring tax payments and investing those dollars back into like-kind real estate. Section 1031 of the Internal Revenue Code allows an owner of investment property to exchange property and defer paying federal and state capital gain taxes (up to 15 percent federal, 25 percent depreciation recapture and applicable state taxes) if they purchase a like-kind property following the rules and regulations of the code. This allows the investor to use all of the sale proceeds to invest into more real estate.  

HOW IT WORKS

Investors have a maximum of 180 calendar days from the closing of relinquished property to complete the exchange. Within the first 45 days of this period, an investor must designate candidate replacement properties and identify them properly to the IRS through the services of a Qualified Intermediary (QI). A QI is the professional provider of the mandatory mechanics of an exchange. Like-kind property can include, but is not limited to, any of the following, provided it is held for investment, single family rental, duplex, apartment, commercial property and raw land. A personal residence does not qualify as like-kind property. The investor may target up to three properties regardless of value or a group of properties with a combined value that does not exceed 200 percent of the value of the initial property sale. From this point, the investor must pursue the identified replacement properties and decide which of them he will purchase. The investor must assign all Purchase Agreements to the QI and must remain cognizant of the exchange timeline when coordinating third party reports like appraisals, structural studies and Phase I environmental reports. When the seller engages the services of a QI, pursuant to an exchange agreement, the IRS does not consider the seller to be in receipt of the funds generated by the sale of the relinquished property. A QI tracks the exchange timeline and compliance, receives the funds from the initial sale and wires funds for the subsequent purchase of the replacement properties. 

After the due diligence timeline has expired, parties move forward with closing. The investor can use traditional financing to close on the properties but must be sure that all of the proceeds being held by the QI are applied to the purchase and that no cash is left over. Many investors hold the replacement properties for a long time. John Rodney, tax attorney and partner at Thorp Reed & Armstrong in Pittsburgh comments, "In some cases, investors exchange one property for another for many years and defer taxes indefinitely.  In fact, if the investor holds an exchanged property at his death, he can avoid the entire tax on the deferred gain."

REASONS TO EXCHANGE

A 1031 exchange allows real estate investors to defer 100 percent of both federal and state capital gains taxes. This preservation of equity is one of the main reasons that investors will elect to go through the exchange process. Investors will also exchange for leverage purposes. An investor can exchange out of a property that is owned “free and clear” and into a property that is a much larger and more valuable property. This provides the investor greater depreciation benefits and greater cash flow, which increases their return on the investment.
Investors may exchange for diversification purposes. Often times, investors build portfolios of similar properties. Investors may have a large percentage of office investment properties in their portfolio and will exchange out of a few of those properties into something else, like retail or industrial properties. This diversification will protect the investor from any downturn in one of these real estate sectors. Investors may also elect to diversify geographically, moving some of their portfolio from the Midwest to hotter markets like California or Florida.
Investors may also use a 1031 exchange to help in their estate planning. To avoid a family squabble regarding what to do with one large property, the investor may exchange into multiple smaller properties, designating a different property for each heir.

REVERSE EXCHANGE

It is possible, though much more complicated, to complete an exchange in reverse order. Revenue Procedure 2000-37 provides guidelines for the taxpayer to acquire the replacement property before the sale of the relinquished property is completed. The “reverse exchange” can be the ideal solution if the investor cannot delay the closing of the replacement property. It also may help the investor seize the moment and take advantage of a great deal on a replacement property and eliminate the pressure filled problems presented by the 45 day identification period. 

CASE STUDY: DIVERSIFICATION

An investor owned a 300,000 SF distribution center in the Southwest. Trying to take advantage of the hot sales market, the investor began to shop the building for sale. A 1031 exchange buyer out of California made an aggressive offer and ended up buying the building. The investor, who sold the property, now had 180 days to identify and close on the replacement properties. Seeking to diversify his portfolio, the investor identified properties including oceanfront lots, retail stores and smaller industrial facilities. The investor ended up acquiring property in seven states, including: West Virginia, North Carolina, South Carolina, Texas, Alabama, Florida and Kentucky. Instead of paying $450,000 in taxes, this investor was able to invest those dollars into his new properties.

EFFECT ON INVESTMENT MARKET

The increasing number of exchange buyers has had a significant impact on the net leased real estate investment market. These buyers, often with a large sum of cash, are willing to be aggressive because they are subject to the IRS regulated timeline. Due to their need to find something fast and put it under contract, exchange buyers may tend  to overpay for replacement property. These higher prices ripple through the investment community and many sellers raise their prices hoping to land an exchange buyer who will pay full price. When the prices go up, the yield on investment compresses and the margins for all buyers are squeezed. This makes it particularly tough for buyers in an environment when interest rates are rising. 

Even though a 1031 exchange is a great way to defer taxes, there are a couple of downsides. First, once you start a 1031 exchange you are committing yourself to the process for the foreseeable future and you cannot stop the process without payment of back taxes. Second, you are a bit limited in the way you can participate. Rodney adds, "One problem with doing a 1031 exchange is that the ownership of the property has to be direct.  For example, an individual can't exchange property owned directly for an interest in a partnership that owns a different property.  In some cases, however, multiple ownership of property can be accommodated using a so-called "tenant in common" or "TIC" structure."
Most failed 1031 exchanges happen because suitable replacement property is not identified in the 45 days allowed. Most often this is a result of waiting until the last moment to identify the replacement property or identifying replacement properties that do not have a high certainty of closing. Plan ahead and make your tax dollars work for you.

_______________________________________________________________________

Information for this article obtained from: www.tm1031exchange.com