Practical Tips for 1031 Exchanges

by Jeff Peterson

CPEC1031 — Commercial Partners Exchange Company, LLC

www.cpec1031.com

1031 exchanges are extremely popular, as enthusiasm for paying unnecessary taxes appears to be reaching an all-time low. Businesspeople and investors are interested in saving money in taxes by exchanging investment or business real estate for other real property investments.

Both state and federal tax rates are high, which has increased investors' motivation to explore their options for saving money.

Here are some 1031 tips you can use to implement successful 1031 exchanges.

The Cash is Radioactive

A basic premise for a delayed exchange is that you cannot ‘receive’ or hold the net proceeds from the sale of your relinquished property in the interim between the sale of your relinquished property and the purchase of your replacement property. Typically, but not always, taxpayers have the forethought to engage a qualified intermediary and to enter into a written exchange agreement that expressly limits the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the qualified intermediary. This is called the G(6) limitation, which states that if the taxpayer has receipt or controls the proceeds, they must recognize the gains as if it were a typical taxable sale transaction because, just like in a sale, they had the cash.

Use a Qualified Intermediary

A qualified intermediary should hold the net proceeds and insulate the taxpayer from receiving any cash during the exchange period. The qualified intermediary then applies the money toward the purchase of designated replacement properties, which are identified in writing by the taxpayer within 45 days of the closing of the sale of the relinquished property and received within 180 days. Both the 45-day identification period and the 180-day exchange period run concordantly from the day after the benefits and burdens of ownership shifted at the close of the sale.

Know Your Deadlines

Multiple replacement properties may be designated in writing. The most often used rule is called the “Three Property Rule,” as it permits taxpayers to list any three replacement properties without regard for the value of the properties. An alternative rule, the “200 Percent Rule,” permits taxpayers to list any number of replacement properties, provided that the total aggregate value of all the designated properties is not more than 200 percent of the value of the relinquished property.

Avoid Seller-Back Financing

The primary rationale for allowing taxpayers to defer all their gains into a 1031 exchange is that they are expected to continue their investment in like-kind property of equal or greater value and equal or greater equity. In other words, the taxpayer will reinvest the net proceeds from the sale in a bigger property. Taking back a note or contract for deed may short-change one’s chance to defer all gains. This is because if you agree to carry back the financing for your buyer out of the proceeds that would otherwise have been paid to you as the seller in cash, then you may have insufficient funds available to reinvest — equivalent to the amount of net proceeds that would have been available in an all-cash transaction — and thus, you not satisfy the requirement of reinvesting all of their equity into their replacement property. Moreover, the receipt of boot, such as cash, notes, or other non-like-kind property, may trigger the recognition of gain.

Cash is king, and if you have enough cash — or even temporary access to credit — so that you can directly loan the money to the buyer without having to reduce the amount of net proceeds available for reinvestment into replacement property, then there is a workaround for this problem.

Defer, Defer, Defer, Die!

Imagine a hypothetical taxpayer who has a plan to exchange like-kind property throughout her entire adulthood, never unnecessarily recognizing gains and continually reinvesting her hard-earned equity over and over again. Perhaps she will start with a single-family rental home, then exchange it for a fourplex, then on to a ten-unit apartment building, followed by an exchange into a 30-unit mixed-use property, and finally into a 64-unit apartment complex. What happens to all of her accumulated gain when our hypothetical taxpayer dies?

Normally, when you sell appreciated property for a profit, you both “realize” a gain (a profit is logged) and “recognize” this gain (the profit becomes taxable); however, under §1031 of the Internal Revenue Code, people are given a free pass on their “recognition” of the gain, allowing them to put off being taxed on their profits indefinitely. This can be repeated again and again throughout your lifetime, allowing you to parlay your gains into bigger and bigger like-kind investments — compounding and building your wealth over time. Your basis in the replacement property is the cost of that property, minus the deferred gains from your preceding like-kind exchanges that have been reinvested. This stimulates the economy and keeps properties churning in the marketplace.

• 1014 of the internal revenue code gives people a step up in basis for property that they receive from a decedent through inheritance. This means that when our hypothetical taxpayer dies, she may be able to pass her low basis property on to her heirs, and they will receive the property — without the deceased hypothetical taxpayer’s low basis — but with a basis that is stepped up to the fair market value of the property at the date of the decedent’s death.

Many people think that when you do a 1031 exchange, you are kicking the can down the line and will eventually have to pay the tax when you someday sell the appreciated property in a taxable (non-1031) transaction. With the interplay between §1031 and §1014, however, all of that gain may go untaxed — mindful of the fact that you must die to make this strategy work, dampening its attractiveness.

Although §1031 and §1014 can help with normal taxes, they cannot mitigate the potentially devastating effects of estate taxes. For people with significant wealth in real estate, it is prudent to maintain life insurance so that there is enough cash available upon your death to pay any estate taxes. This is so that one’s real estate assets will not have to be liquidated by their estate, particularly if they die during a downturn in the economy when prices may be depressed. Under §101 of the internal revenue code, life insurance proceeds are tax-free when they are paid out by reason of the death of the insured, so it makes good tax sense to invest in life insurance as you accumulate more real estate.

Planning Opportunities for Partnerships — Drop’n Swaps

To qualify for a 1031 exchange, you must have “held” your real property for investment purposes, for use in your trade, or for business purposes. The exact amount of time that one must hold the property has never been clearly articulated by Congress or the IRS. In 1984, Congress acted to exclude partnership interests from §1031 tax deferral.

Many people own property in LLCs and pass-through entities that are taxed as partnerships. If you have clients that own appreciated property inside of a partnership-type entity, it can be advantageous to talk to your clients early about the most tax-efficient potential dispositions of the partnership's assets.

Oftentimes, partners have differing goals and divergent tax outcomes if partnership assets are to be sold in a taxable (non-1031) sale, particularly if there has been a death of one or more of the partners, causing a step up in basis for the heirs of the deceased partners, while the remaining partners may have a much lower basis. This can cause discord within the partnership.

Option # 1 — Total T-I-C: If you have the luxury of time before a sale, you may want to deed the assets out of the partnership and create a tenancy-in-common arrangement so that each partner now owns their own individual interest in the actual real estate, rather than through the partnership. Determine whether there is a mortgage against the partnership’s assets before deeding out to make sure that you do not violate any due-on-sale provisions. Lenders frequently consent to a transfer if they are asked in advance. The longer that the tenant-in-common co-owners can hold title in their own individual capacity, the better to satisfy the holding requirement of §1031. * Also, make sure that the CPA reports the income and expenses from the real property as a tenancy-in-common rather than filing a 1065 partnership tax return. Further, have your attorney draft a tenancy-in-common agreement to replace the old agreement between the former partners or members.

Option #2 — Partial T-I-C: If only a small minority of the partners want to sell the asset in a taxable (non-1031) transaction, and the remaining majority wants to conduct a tax-deferred 1031 exchange, one option is to redeem out the non-1031ing partners creating a partial tenant-in-common arrangement so that they become tenant-in-common co-owners of the property together with the surviving partnership or entity (such as an LLC taxed as a partnership), and the new tenant-in-common co-owners can take their proportionate share of the net sale proceeds and pay taxes; allowing the rest of the owners in the surviving partnership to continue deferring the gains under the umbrella of the partnership. * Again, work with your CPA and attorney for the housekeeping issues.

Conclusion

The tax benefits of using 1031 exchanges of real property are tremendous, although the rules and regulations may seem daunting. The best way to help navigate the process is to spot the 1031 opportunities early and begin planning well before the sale is to occur in order to best educate yourself about the opportunity and options to re-structure ownership to take the best advantage of tax deferral.

Jeff Peterson is a Minnesota attorney and former adjunct tax law professor. He serves as the president of Commercial Partners Exchange Company, LLC. He works exclusively in the facilitation of 1031 exchanges, reverse exchanges, and build-to-suit construction exchanges for both real property and chattel personal property. Jeff frequently answers questions from lawyers about how to best utilize the services of a qualified intermediary. Jeff can be reached at 612 643 1031 or jeffp@cpec1031.com.

Important Disclaimer:

No attorney-client professional relationship shall be created by this article.

Investors are encouraged to seek the counsel of their attorney or accountant. This material is provided for informational purposes only and does not establish, report, or create the standard of care for attorneys, nor does it represent a complete analysis of the topics presented. Readers should conduct their own appropriate legal research. The information presented does not represent legal advice.