By: Kramer A. Litvak
Even though the real estate market has softened in recent months, many people own real estate with significant inherent gains. Sellers of such properties are keenly interested in finding ways to minimize the tax impact of such a sale. The most common method of minimizing taxes on the sale of appreciated property is to complete a Section 1031 Like-Kind Exchange (“1031 Exchange”).
A 1031 Exchange is a procedure by which the gain from the sale of appreciated property (the “Relinquished Property”) is deferred by rolling that gain into like kind property (the “Replacement Property”). A 1031 Exchange is only available for investment and business use property. A 1031 treatment is not available for the sale of personal residences (or second residences), nor is it available for the sale of real property that would be considered “inventory,” such as lots held by the developer of a subdivision. Both the Relinquished Property and the Replacement Property must qualify as investment or business use property.
There are two basic types of 1031 Exchanges: the simultaneous exchange and the deferred exchange. A simultaneous exchange is one in which the seller trades his or her property for property that another party already owns, i.e., the transfers occur contemporaneously. A deferred exchange is one in which the seller transfers property for the other party’s promise to acquire and transfer property of like-kind to the seller. In reality, simultaneous exchanges rarely occur. As such, I will only be discussing deferred exchanges.
Deferred exchanges must satisfy two timing rules. First, within 45 days of the transfer of the seller’s property, the seller must give the other party written identification of the property the seller wants to receive. There are no exceptions to the deadline. Multiple properties can be identified, but there are complicated rules governing such multiple identifications and tax advice should be consulted. Second, the seller must receive the Replacement Property by the earlier of 180 days after he or she transferred the Relinquished Property or the due date of the seller’s tax return for the year of the transfer. Again, there are no exceptions to this deadline.
As a practical matter, most deferred exchanges utilize the services of a qualified intermediary (the “QI”). This eliminates the purchaser’s participation in the completion of the deferred exchange. The QI may not be a “disqualified person,” which means the QI cannot be related to the seller. When a QI is used, the seller must enter into an exchange agreement prior to or at the closing of the relinquished property. Pursuant to the exchange agreement, the net proceeds from the sale of the Relinquished Property are held by the QI in an escrow account. The exchange agreement must expressly limit the seller’s right to receive, pledge, borrow or otherwise obtain the benefits of the cash or cash equivalent received from the purchaser before the end of the exchange is completed.
When completing a 1031 Exchange of real estate, the rules for determining if property is of like-kind are broad. For example, residential property (such as a residential rental property) is of like-kind to commercial property. Likewise, improved real estate is of like-kind to unimproved real estate. Situations concerning the determination of like-kind do arise, however, and the seller should consult a competent tax attorney or CPA.
In order to defer all of the gain from the sale of a Relinquished Property, the seller must meet two tests: 1) the seller must purchase Replacement Property with a value equal to or greater than the value of the Relinquished property, and 2) the seller must reinvest all of the net proceeds from the sale of the Relinquished Property.
It is important to note that many Qualified Intermediaries only provide the 1031 documentation and escrow services. They do not provide crucial tax advice regarding the transaction. I strongly recommend the engagement of a competent tax professional who will act as intermediary, provide the necessary 1031 documentation, and give tax advice.