1031 Exchange ABCs

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When an owner of investment or business use property sells the property, the sale often creates an obligation for payment of capital gains taxes. Did you know that the recognition of capital gain on the sale of an investment property can be deferred? IRC 1031 provides that no gain will be recognized on the sale of property held for investment if the taxpayer reinvests in other investment property that is "like kind". Technically, a third party, who is called a Qualified Intermediary, is inserted into the transaction to actually facilitate an "exchange" by the taxpayer of one deed for another deed. This exchange is deemed to be a continuation of the original investment that does not trigger a taxable event, with the taxpayer's basis in the old property carried forward to the new property: the new asset is substituted for the old asset that makes up the investment. Like a lot of people in real estate, you may have some experience with exchanges - but want to know more to help your clients invest more efficiently.

The Market
While Section 1031 is available for all investors in real estate to consider, the market conditions over the last 12 to 24 months, with historically low interest rates and a stock market that has performed so poorly, there has been a flight of capital from the equity markets to hard assets, and particularly real property. This has been a boon for sellers of real property but it has also put a significant pressure on the supply of property that is attractive for re-investment.

In a Section 1031 Exchange there is a continuation of an existing investment with a substitution of an existing asset for a new asset, it is understandable that there be a requirement that the new asset be "like kind" to the old asset. As it relates to real property this definition is extremely broad. It requires that the nature of the asset be determined and be like the nature of the new asset. The inherent nature of real property is that it is ground. Accordingly, any new ground is like any existing ground; the use to which the ground is put, whether there are improvements on the ground, or if there is actually income from the ground and immaterial in determining "like kind". Therefore farm ground can be exchanged for an industrial building, a duplex can be exchanged for a retail store, or an apartment building can be exchanged for an office building.

If properly used, 1031 can be an incredibly powerful planning tool for real estate investors. It allows for an investor to reposition the geographic location of his or her portfolio; it allows the investor to replace a property devoted to one use with a property devoted to another use (which can dramatically alter the amount of management that is devoted to the investment); it allows him or her to either consolidate or diversify the composition of the portfolio; it can be an effective tool in estate planning; it is effectively an interest free loan from Uncle Sam.

Repositioning a Portfolio
For any number of reasons, an investor may conclude that an existing investment has matured, is located in a changing neighborhood and will no longer appreciate, or has received an attractive offer to purchase. In these cases the investor may wish to dispose of that asset but continue his investment through the purchase of another asset in different location. In the case of investment real property this is possible and the reinvestment will be with 100% of the net sale price; since Section 1031 allows for the deferral of the recognition of the realized gain, no part of the sale proceeds need be reserved to pay any gain tax. The only restriction on the geographic location of the replacement asset is that it be located within the United States. Otherwise, the investor can select property anywhere.

Adjusting the Management Responsibility for a Portfolio
Because the use of an investment property is irrelevant to determining "like kind", it is possible to use Section 1031 to transition a portfolio that is highly management intensive, such as rental residential, to something much less management intensive, such as triple net leased retail property. This kind of a transition can be an important lifestyle planning decision as an investor considers a retirement situation.

The Effect of Deferring the Recognition of Gain
Section 1031 can also be considered as one of the most powerful tool we have available to build personal wealth. Through Section 1031, the appreciation of an investment can be realized through its sale, but since the recognition of the gain is deferred, 100% of the appreciation can be utilized to acquire new assets, and with the utilization of leverage available through traditional real estate lending sources, the realized appreciation can be used to substantially enhance a portfolio's value. The following example will demonstrate this concept: Assume a property was acquired for $200,000, with an 80% loan and equity of $40,000. Assume that the property can now be sold for $300,000. Ignoring the impacts of depreciation and transactional costs for purposes of this example, the realized gain is $100,000 and the net equity available for reinvestment is $140,000 ($300,000 less a mortgage of $160,000 - again ignoring the impact of principal repayment). With a conventional 80% loan, this $140,000 would permit the investor to acquire a $700,000 property, with no current obligation for capital gains tax or depreciation recapture. The investor has transitioned an investment worth $300,000 into an investment worth $700,000!

Section 1031 is the Exception
The general rule under the tax code is that upon the sale of a capital asset, any realized gain or loss is recognized in the year of sale. Section 1301 is the exception to this general rule, and as such, the rules and regulations that govern this section must be strictly followed. Failure to follow all the rules and regulations will disqualify the exchange and result in the transaction falling under the general rule.

The Application of Section 1031
Therefore, it is important to understand the limitations that exist to this Section. It applies to property that is held for a productive use in a trade or business or held for investment. It does not apply to property held primarily for sale or held for personal use. The Statute also specifically excludes several specific types of capital assets, including stocks, bonds, notes, and partnership interests.

Section 1031 has been a part of the Internal Revenue Code since 1921. Initially, all exchanges were done simultaneously, then, in the case of Starker vs. U.S., the U.S. Ninth Circuit Court of Appeals upheld the first exchange when the purchase of the replacement property occurred at a later point in time from the sale of the relinquished property. The concept of the delayed exchange was then codified into Section 1031 in 1984 amendment to the Code. Since that time, this has been the most popular structure for an exchange, which allows the investor 45 days to identify potential replacement properties and 180 days to complete the purchase of a property that was identified.

This Section of the Code is not as "all or nothing" provision. It is possible to have a partially tax deferred transition, with the balance being taxable. If non-like kind property is received in the exchange it is called "boot" and is the part of the transaction on which gain is recognized (to the extent of the gain). However, for investors to obtain the full tax deferral, it is necessary for them to acquire a replacement property of equal or greater value than the relinquished property, invest the net equity from the relinquished property into the replacement property, and receive nothing but like kind property in the exchange.

The Qualified Intermediary
In order for the investor's transaction to be structured as an exchange rather than a sale, it is essential that the investor never actually or constructively receive any cash. The Treasury Regulations that provide guidance for these transactions set out procedures for the use of an independent third party who serves to insulate the investor from receiving the cash. This party is called a Qualified Intermediary. Because this industry is unregulated by any level of government, the selection of a Qualified Intermediary deserves the utmost care and attention. It is imperative for the investor to fully evaluate the security that is provided by inquiring about the level of insurance and bonding that are carried for the benefit of the investor, and the guarantees that are given to the investor by the Qualified Intermediary. The investor should also inquire about the size, expertise and resources of the Intermediary.

Investment Property Exchange Services, Inc.
Investment Property Exchange Services, Inc. is the largest Qualified Intermediary in the U.S. and is a subsidiary of Fidelity National Financial (FNF:NYSE), the parent holding company for Chicago Title Insurance Company (IPX1031). IPX1031 has provided its clients with superior Qualified Intermediary Services for over two decades. Each year, IPX1031 assists thousands of clients and their legal and tax advisors by providing proven exchange solutions that best achieve the client's goals of enhancing their business portfolios and preserving equity. IPX1031 specializes in every type of exchange transaction. Our company is prepared to assist you in implementing the most appropriate exchange structure for your clients' transactions.

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