CALIFORNIA REAL ESTATE PRIMER – 1031 Tax-Deferred Exchanges

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This article is intended to be a general discussion only and should not be considered legal advice. Your use of it does not create an attorney-client relationship. Any liability that might arise from your use or reliance on this article or any of its links is expressly disclaimed. This blog is not legal, accounting or tax advice, is not to be acted on as such, it may not be current, and is subject to change without notice.

What Is A 1031 Tax-Deferred Exchange?

“1031” refers to Internal Revenue Code section 1031 which details a method of transferring the equity from one real property into one or more like-kind properties without incurring the tax burden associated with the gain on the investment.

A common misconception is that a 1031 trade is tax free, but this isn’t true. 1031 exchanges are not tax exempt, they are tax deferred. Even so, if performed correctly 1031 exchanges can provide considerable benefits by allowing taxes to be paid by tomorrow’s dollars instead of today’s dollars. (Tomorrow’s dollars are usually cheaper than today’s dollars.)

A properly executed 1031 exchange can result is significant savings in terms of today’s dollars. For example, in a given exchange the potential tax burden which might be deferred is seen below: (note: the rates cited are subject to change)

15.0 % Long Term Federal Capital Gains

+ 9.2 % California State Tax

= 24.2 % Tax Deferral

Plus 25 % Federal Depreciation Recapture, and potential 26 % Federal Alternative Minimum Tax

 

Types of 1031 Exchanges

There are a number of different types of 1031 exchanges which are recognized:

(1) Simultaneous Exchange – When an exchange between the relinquished property and replacement property occurs concurrently.

(2) Delayed (“Starker”) Exchange – The delayed exchange is the most common of all exchanges. Once a the relinquished property is sold, the delayed exchange allows a property owner a set deadline to identify and close on the replacement property while maintaining the ability to continue deferring any capital gains. Just the calculation of the correct deadline can be a complex matter involving not only the deadlines stated in the code, but also a calculation based on the taxpayer’s filing date for the tax year in which the relinquished property is transferred.

(3) Build-To-Suit – This exchange allows the exchanger to construct a new replacement property or renovate an existing property. (Note: Renovations after the owner takes title are considered “goods and services” and will taxed as boot.)

(4) Reverse Exchange – The opposite of the delayed (Starker) exchange, a reverse exchange occurs when an investor identifies and closes on a replacement property prior to the sale of the relinquished property.

 

Who Can Effectuate A 1031 Exchange

A third party must act as a qualified intermediary to accommodate the exchange. (The qualified intermediary is known as an Accommodator or Facilitator.) Since the facilitator may be holding significant funds on your behalf. It behooves you to inquire about such things as errors and omissions insurance, bonding, and interest etc. Remember, you’re looking for safety, as well as, experience. It’s not unreasonable to ask for references from past clients.

 

1031 Exchange Requirements

(1) “Like-Kind” Exchange – To be considered “like-kind” the relinquished property and the replacement property must both comply with the definition of investment property. The general rule is that real estate is “like-kind” to all other real estate. Provided like-kind property is initially acquired and held for either business or investment purposes. (Held for productive use in a trade or business, or property that is held for investment.)

Examples of “like-kind” exchanges include:

Raw land for commercial property

Residential rental for tenants in common interest

Single-family rental for multi-family rental

(Note: The qualified intermediary or facilitator and/or your accountant or tax attorney must be consulted to be sure the exchange will qualify.  For example, a partnership may exchange property for other property of “like-Kind”, but IRC section 1031(a)(2)(D) specifically prohibits exchanges of partnership interests.  The reason is partnership interests are considered to by personal property which isn’t “like-kind” property with real estate. )

(2) The replacement property or properties must be of equal or greater value than the relinquished property.

(3) The Exchanger must reinvest all net equity in the replacement properties.

(4) The exchange must result in equal or greater debt.

(5) Retain a Qualified Intermediary (Facilitator) – To effect a 1031 exchange and defer the capital gains liability due, you must not take possession of the proceeds from a sale.

(6) 45-Day Rule – The exchanger must identify the potential replacement property or properties within the first 45 days of the 180 exchange period. Once you have closed your relinquished property and placed your proceeds with your Accommodator, the 45 day clock starts ticking to identify a replacement property.

(7) 180-Day Rule – The Exchanger must acquire the replacement property or properties either within 180 days or the date when the Exchanger must file the tax return (including extensions) for the year of the transfer of the relinquished property, whichever occurs first.

You may choose among 3 types of identifications:

3 Property Rule (most common): The Exchanger may identify up to three properties of any value.

200% Rule: The Exchanger may identify more than properties if the total fair market value of what is identified does not exceed 200% of the fair market value of the relinquished property.

95% Exception: If the Exchanger identifies properties in excess of Rule 1 and Rule 2, then the Exchanger must acquire 95% of the value of all properties identified.

Important Notes:

There is no extension of deadlines for Saturdays, Sundays or Holidays.

The time limits begin to run on the day the Exchanger transfers the relinquished property to the buyer.

The “Date of Transfer” will be the date of recording or transfer of the benefits and burdens of ownership, whichever occurs first.

As you can see, sections 1031 Tax Deferred Exchanges are not for the faint hearted. Not only are the rules less than clear they are subject to change. So, remember, always consult the appropriate, legal, tax and financial advisors and retain the services of an experienced facilitator.

This article is intended as an overview only, and should not be construed as legal, financial, or tax advice. Consult your legal and/or tax professional.

 

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