by Michael Selinfreund, President/General Counsel of Cherry Creek Title Services, Inc.
This article is intended for educational purposes only and not as legal advice
December 23, 2015
To review the basic requirements of a 1031 Exchange discussed in Part 1 of this 3 part series; the Exchangor must purchase like kind property; identify the replacement property within 45 days; close on the replacement property within 180 days; purchase property of equal or greater value; reinvest all the funds from the relinquished property; procure debt equal to or greater than the relinquished property (or pay the difference out of other cash assets) and be very diligent in selecting the Qualified Intermediary (QI).
The taxes sought to be deferred using a 1031 exchange are capital gains taxes. To qualify for capital gains tax treatment, the Exchangor must have owned the relinquished property longer than a year. Presently, federal capital gains taxes are 15% for individuals with annual Adjusted Gross Income (“AGI”) under $400,000 and couples under $450,000. The rate is 20% if the taxpayer exceeds these thresholds. In calculating the taxpayer’s gain, depreciation must be recaptured. In addition, most states also impose capital gains taxes. Finally, since the enactment of The Affordable Care Act (Obamacare), there is an additional Net Investment Income Tax of 3.8% for individuals earning over $200,000 AGI and couples earning over $250,000 AGI. Hence, the combined taxes deferred are significant creating an incentive to defer the tax liability for the reasons in part 1 of this 3 part article sequence: the time value of money (cheaper to pay with future dollars) and the expectation of being in a lower tax bracket years later when the gain is realized.
In order for the Exchangor to avoid any present tax liability, the Exchangor must not receive any financial benefit through the exchange as such benefits are considered boot and immediately taxable. So, to defer all taxes, an Exchangor must reinvest all proceeds from the sold property into the replacement property, and, the Exchangor must also procure debt on the replacement property equal to or greater than the debt from the relinquished property unless they replace that difference with fresh cash.
To qualify for like kind in a real property 1031 exchange, the relinquished property is real property and so must be the replacement property. So, a rental home can be exchanged for raw land; an apartment building can be exchanged for a retail center; and an office building can be exchanged for a warehouse. Examples of what isn’t like kind is replacing any of the above relinquished property with: a personal residence, securities, interest in a partnership, stock, LLC member interests; personal property, inventory or goodwill. Multiple real properties are fine as long as the total value of the properties acquired doesn’t exceed 200% of the value of the property relinquished.
It is worth being aware of title parking exchanges whereby the QI takes title for a period of time prior to the Exchangor going into title. Two examples are reverse exchanges and improvement exchanges. In a reverse exchange, the Exchangor acquires the replacement property prior to selling the relinquished property. In an improvement exchange, the QI acquires and holds title temporarily (up to 180 days) and makes pre-approved improvements out of the relinquished property proceeds to the replacement property. Both reverse exchanges and improvement exchanges are significantly more complex and expensive than traditional exchanges; both are more likely to raise the possibility of the exchange being challenged in part or in whole by the IRS; and having the QI in title to the property for any length of time may create title issues for the Exchangor beyond the scope of this article.
In the 3rd and final part, I will discuss vacation homes; strategies involving the conversion of investment property into primary residences thereby using an exchange along with IRC code section 121 (exclusion of 250/500k of gain on primary residence); and finally a simple summary of the steps involved in a 1031 exchange.