Tips & Insights

The 411 on 1031s

There are many aspects of the tax code that favor investing in rural and recreational properties. Specific ones such as agricultural exemptions and general ones such as deprecation immediately come to mind. Recently, however, more and more property owners are making use of a well regarded vehicle to limit their taxable exposure. Called a 1031 Exchange, it takes its name from Section 1031 of the Internal Revenue Code:

“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”

Translated into everyday English, this legalese means that under certain circumstances you can trade ownership of a particular property (known as the Relinquished Property) for ownership in a second property (known as the Replacement Property) and defer payment of federal taxes on your capital gain. Although you are in effect buying and selling properties, the economic gain on the Relinquished Property is not realized – at least in the eyes of the IRS - because you are exchanging ownership, not pocketing the profits.

“The awareness of 1031s is much higher in the marketplace than it was five years ago,” says Dan McCabe of Investment Exchange Group in Denver. “It used to be that the average user of a 1031 Exchange was a big real estate player. Now it’s more mom-and-pop types. An added factor is that more money is flowing into real estate as opposed to the stock market,” says McCabe.

In the early years of the Section 1031 era, the rules for an exchange necessitated simultaneous closings, a bear of a requirement that severely limited the number of qualifying transactions. Treasury regulations were eventually changed, and Delayed Exchanges were created. Delayed Exchanges are the most common type of exchange today; they allow for a time gap between the transfer of the Relinquished Property and the acquisition of the Replacement Property.

This time gap, however, means that a property owner could possibly receive the funds from the sale of the Relinquished Property, and the moment actual or constructive receipt of the proceeds occurs the exchange disappears according to Uncle Sam.

Thus was born a new type of financial professional, the Qualified Intermediary (QI). A QI is an independent third party that facilitates a 1031 Exchange. The IRS regards a QI as the safe harbor for the funds involved in a 1031 Exchange. This is vitally important. By holding the proceeds from the sale of the Relinquished Property and then applying them to the purchase of Replacement Property, a QI makes sure that actual or constructive receipt never occurs. No taxable liability is therefore generated.

A QI is also well-versed in the intricacies of the tax code and how it applies to each case so that an exchange qualifies for 1031 status. Here’s the short list of those specs, according to the professional trade association of QI’s, the Federation of Exchange Accommodaters:

Qualifying Property. In general, most real estate is allowed. Certain types of property are specifically not allowed to be exchanged, including stocks and bonds, inventories, article of indebtedness, and partnership interests.

Proper Purpose. The taxpayer’s primary residence will not qualify. Neither will property acquired for immediate resale. Only property “held for productive use in a trade or business or for investment” is allowed to be exchanged.

Like Kind. All qualifying real property located in the U.S. is like-kind. Property in another country does not qualify for a 1031 Exchange.

Exchange Requirement. Since it’s the heart of the procedure, this one should be obvious. You can’t sell a property, stick the cash in the bank, and then go buy another one the next day. The properties must be exchanged, which is where a QI typically comes in.

“As real estate prices appreciate, we are seeing more and more 1031 exchanges. Probably half of our transactions involve an exchange of some sort,” says Kenneth Wendland, a Texas real estate broker who specializes in farms and ranches in the Southwest and Western U.S.

So who should consider at 1031 exchange?

“Anyone who has real property that has appreciated,” says Jule Herbert, partner in the firm of Herbert and Harrell. “That gain might be because of the market, or it could be because they’ve depreciated the property,” he adds.

“Say you own a condo in Naples, Florida. You paid $700,000 for it, it’s worth $1.2 million, and you’re getting tired of all these hurricanes. Somebody in that situation would definitely benefit by using a 1031 Exchange. Not only could they defer the capital gain on the $500,000 profit, but they could roll the entire $1.2 into three cabins, put them in a rental program, and get something that cash flows. A properly structured 1031 not only allows an investor to hold on to profits, but it allows people to diversify geographically,” Herbert adds.

Anyone who plans on selling a piece of property for a gain and buying a replacement would be well advised to take a closer look at this effective tool. In order to defer taxes the acquisition cost of the Replacement Property needs to be equal or greater than the cost of the Relinquished Property, and all the equity from the first property must go into the second. In other words, don’t expect a 1031 exchange to be a vehicle to pull out tax-free cash from a property.