I. What is a 1031 Exchange?
When a taxpayer sells investment property for a gain, she may incur taxes at both the federal and state levels. Section 1031 of the Internal Revenue Code (“IRC §1031”) provides a mechanism for deferring federal capital gains tax and depreciation recapture when a taxpayer disposes of business or investment property and acquires “like-kind” property, allowing a taxpayer to fully reinvest all his equity into the new property. Most (but not all) states with a capital gain tax offer a similar tax deferral under state code.
II. What is “Like-Kind” Property?
In order to qualify for deferral under IRC §1031, both the relinquished and replacement properties must be (1) held by the taxpayer for productive use in a trade or business or for investment and (2) be “like-kind” to one another. The term “like-kind” refers to the nature or character of the property, ignoring differences of grade or quality. For example, unimproved real property is considered “like-kind” to improved real property. The lack of improvements is a distinction of grade or quality, but the basic real estate nature of both parcels is the same. In general, all real property in the United States is “like-kind” to all other domestic real property. Therefore, a taxpayer may generally exchange any domestic real property for any other U.S. real estate provided it will be used in a trade or business or held for investment.
III. Spotting a 1031 Exchange Opportunity
Now that you know most sales of commercial real estate qualify for tax deferral under IRC §1031, what should you do when you, your employer or your client is selling commercial real estate? First, determine is if the seller is looking to purchase other real property within the next 180-days. If so, the seller should consider a 1031 like-kind exchange. Not only will it benefit the seller, but it may mean additional business for you if you assist them in locating, negotiating or closing the purchase of the replacement property.
A second consideration is whether the sale of the relinquished property will result in a taxable gain for the taxpayer. Section 1031 is a gain deferral provision. If the taxpayer is selling relinquished property for a loss, she cannot do an exchange. Even if the taxpayer is selling for a gain, she needs to make sure that deferring the gain will benefit her bottom line. For example, if gain associated with the sale of the relinquished property is offset by a loss on the sale of another property, it may be more beneficial to her overall tax picture to recognize the gain now.
IV. Be Aware of the 45-Day Identification Period
IRC §1031 requires that the replacement property be identified within 45 days of the closing of the sale of the relinquished property. Therefore, you and your client should begin looking for potential replacement property immediately!
V. Replacement Property Must Close within 180 Days
The 180-Day Exchange Period runs concurrently with the Identification Period and requires identified replacement properties be acquired within the earlier of (i) 180 calendar days after the date on which the Exchanger transferred the first Relinquished Property, or (ii) the due date (including extensions) for the taxpayer’s tax return for the tax year in which the transfer of the first relinquished property occurs. The 45-day Identification Period and the 180-day Exchange Period are strict, calendar days and are not extended if the deadline date falls on a Saturday, Sunday or legal holiday. The deadlines can only be extended if the taxpayer qualifies for a disaster extension under Rev. Proc. 2007-56.
VI. Do I Need to Use a Qualified Intermediary?
Clients often ask if using a Qualified Intermediary (“QI”) is really necessary. The answer is YES! In most circumstances, the use of a QI is required to successfully complete a tax-deferred exchange. Moreover, the QI cannot be the taxpayer or a family member. The QI facilitates the reciprocal trade by entering into a written exchange agreement with the taxpayer under which the QI: (i) acquires the relinquished property from the taxpayer and transfers it to the buyer, and (ii) acquires the replacement property from the seller and transfers it to the taxpayer.
Typically, the QI drafts the exchange documents including the exchange agreement which must expressly limit the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain benefits of money held by the QI as sellers cannot touch the money in between the sale of their old property and the purchase of their new property. Remember, the use of an experienced QI can significantly reduce the complexity of an exchange by ensuring the proper execution of required documentation and proper handling of funds.
Dana R. Sobrado, Esq. is Chief Executive Officer and Secretary of National Exchange Titleholder 1031 Co. (“NExT1031”). During her 14-plus year tenure in the 1031-exchange industry she has processed or directly supervised over 1,000 exchanges including numerous complex parking transactions. Sobrado has been accredited as a Certified Exchange Specialist (CES®) by the Federation of Exchange Accommodators and is a member of AZCREW