The 1031 Exchange: Traps, Escapes and Opportunities
The 1031, or “Starker” Exchange is often hailed as the be-all and end-all of ways to avoid capital gains taxes. It does not eliminate them, of course, but only defers them, possibly indefinitely. These exchanges are “non-simultaneous,” meaning that you sell one property and exchange it for another that you find later. Simultaneous exchanges are also tax-deferred, but have not suffered the same wrath from the IRS as have deferred exchanges. Simultaneous exchanges take place when two or more properties are swapped. They also include circumstances when a third seller enters the picture, buying a property while allowing another pre-existing seller to buy a property while simultaneously selling his.
The concept of the non-simultaneous exchange arose in 1967 when T.J. Starker transferred encumbered timber property to the Crown Zellerbach Corporation in exchange for an unsecured promise by Crown to transfer like-kind property to him sometime during a five-year period.
At the end of this five-year period, Mr. Starker was to receive the outstanding balance in cash together with a six percent growth factor. The Ninth Circuit Court found that Section 1031 did not contain any requirement that the transactions be simultaneous and that an exchange for like-kind property five years later was permissible. Further, the court found that the six percent growth factor was just interest in disguise and was taxable when received. In addition, the court expressly held that just because Mr. Starker might receive cash in the future didn’t disqualify the transaction as a 1031 exchange.
The IRS was outraged, and appealed to Congress, which in 1984 passed an amendment to Section 1031 that set time limits of forty-five days to identify a replacement property and one hundred and eighty days (or the due date of Federal Income Tax, whichever comes first) to close on this property.
Is the 1031 Exchange the be-all and end-all of transferring property? Of course not. The ideal situation would be if capital gains taxes didn’t exist all; however, the 1031 Exchange provides a way to keep from paying capital gains taxes on the sale of rental property. Still, it has hidden within it some pitfalls to trap the unwary. You see, the IRS strongly opposes this provision of the Tax Code, so they insert several nominal hoops through which to jump. We need to be careful with some procedural items just to make sure we have everything worked out with the person who is buying or selling the property. Finally, there are some opportunities and little-known provisions that can help make a deal. We’ll discuss several of these points now.
Watch out for exchanges with a “related party.” We can exchange with anyone we want, but if we do it with a related party (we talk more about this later in the article) we encounter some problems. If the related party sells the property within two years, the IRS assumes it was just a ruse to cover up what was really a sale, and declares any capital gains tax that we would have owed to be owing.
Thus, as a precaution, add appropriate language to the Earnest Money agreement. Always make the buyer of our property aware that it is involved in an exchange. The fact that the transaction is an exchange will probably not affect the buyer in any way, as it is nothing more than a sale with a third party involved. Insert the following language, or something similar, in the sales agreement.
“Buyer hereby acknowledges that it is the intent of the Seller to effect an IRC Section 1031 tax-deferred exchange which will not delay the closing or cause additional expense to the Buyer. The Seller’s rights and obligations under this agreement may be assigned to XYZ Exchange, a Qualified Intermediary, for the purpose of completing such an exchange. Buyer agrees to cooperate with the Seller and XYZ Exchange in any manner necessary to complete the exchange.”
The reason for this clause is two-fold. First, it lets buyer know that we are exchanging the property. It simply states the fact that the sale that affects them. Second, the language of the clause can serve to allay fears of a buyer who has never even heard of a 1031 Exchange.
We must be careful when we use this clause if we anticipate there being a need for any delay in the closing of our property. Remember, we have forty-five days to identify one or more replacement properties and 180 days to close. What happens if we can’t identify a suitable property in this period of time? We lose the exchange and become liable for any capital gains taxes that would be owing.
We can delay closing of the relinquished property (the one we are selling or exchanging out of), in order to give ourselves more time to either identify or close on a new property.
If we are dealing with an experienced investor, we should have no problem in working things out. But if we are dealing with a potential owner-occupant and real estate novice, we will have to be as explicit and reassuring as possible in order to keep the deal intact. Too many of the uninitiated would suspect wrongdoing and assume that this contract couldn’t possibly be legal, especially after they ask someone’s advice who has a less than thorough real estate background. Strange things happen in the minds of people in the middle of a real estate transaction and they become worried when there is no need to be.
The solution: Spell out everything in as much detail as possible.
Sometimes we have to close on a property sooner than 180 days. The law says that we have 180 days to close on a new property unless the tax year intervenes. So any property sold with a 1031 Exchange in mind after about October 15 will not have 180 days to close. We see that April 15 is about 180 days from October 15. If we cannot close before April 15, we need to file an extension. That should give us plenty of time.
The IRS audit period can be longer than normal. Generally the IRS has three years to audit a tax return. However, the statute of limitations is extended if a taxpayer fails to report more than 25% of his or her gross income. The tax savings from a deferred exchange is often enough to activate this extension.
The 1031 Exchange isn’t always a good idea. Specifically, in the following three scenarios:
1. The 1031 Exchange is a bad idea if we’d lose money upon selling the property. Some markets have lower property values than they did two or three years ago. Especially if we have made capital improvements on the property, we would simply be exchanging to move a loss forward onto our new property. Should we feel as if we are close to that situation, use the calculation form in this issue to determine where it stands.
2. The 1031 Exchange is a bad idea if the gains would be less than the cost of the exchange. In other words, if the accommodator fees would be more than the taxes we would pay.
Both of those situations involve calculating the property basis. The basis of the property is usually the amount we paid for it plus any capital improvements, less any capital gains carried forward from exchange of a previous property. However, if we inherited the property, the basis is its value when the estate closed. It makes no difference how much the person from whom we inherited it paid for it.
For example, Owner A bought a fourplex in 1970 for $15,000. When he died, the market value of the fourplex was $200,000, a gain of $185,000, not counting improvements. He left it in his will to Owner B. But the new basis of the property is $200,000, not the $15,000 Owner A paid for it. If Owner B were to sell the fourplex for market value, the costs of paying the accommodator would create a loss. Thus it would be counterproductive to exchange the property, and better to sell it outright, take the money and to buy another property.
3. Finally, the 1031 Exchange is a bad idea if we’re selling on a real estate contract. The property title must change hands in a 1031 Exchange. It usually doesn’t when property is sold on a contract. Furthermore, very little gain is recognized for the first several years, because the amount paid on principal is infinitesimal. Most of the income from the sale is interest. So there would be essentially no capital gains tax to pay in the first few years, because there has been almost no gain.
Be careful if the exchange pays off the mortgage.
Anything we receive in the exchange other than like-kind property is considered “boot” and is taxable. Cash and paid off mortgages are not like-kind property. So if we exchange a property with a balance owing of $50,000 for another property with no balance, ending up with a free-and-clear property, we are going to have to pay capital gains taxes on $50,000, even though we didn’t receive any money.
There are two ways around the problem:
1. We can have the seller of the property we are acquiring refinance the property and we assume the debt, or we could finance it, either through a lender or on a land-sale contract.
2. We can add cash to the deal. Cash “added in” offsets debt relief on the “relinquished” property. Ask the accommodator how this works.
The rule of thumb is that we must end up owing at least as much as we did when we began the exchange.
Be careful taking title. Title on the new property has to be the same as that on the old. If our old property was owned by XYZ Corp., then XYZ Corp. has to hold title to the new one, not Joe Doakes or the XYZ Partnership. This consideration is extremely important because many times property is sold to liquidate a company or partnership.
If the 1031 Exchange is to be valid, the liquidation will have to be done after the exchange is completed. Alternately the property could be sold outright, the capital gains tax paid and the net proceeds divided appropriately. An accountant would have to determine what the best tax strategy would be.
We can exchange a share. Tenants in common, joint tenants, tenants in the entirety and any other kinds of common owners can exchange their undivided interest. We don’t have to exchange a whole property, just our share of it.
There are no “business days.” When we count the days, 45 to identify or 180 to close, it is actual days. If the 180th day falls on a Sunday, we have to close by that Sunday, not the next business day. (And note: it is 180 days, not six months.) If the 180th day is Christmas, we have to close by then. The regulations state parenthetically that Section 7503—which states that if the time for performance ends on a weekend or legal holiday, then the performance date is extended to the next business day—does not apply to deferred exchanges.
There is no justification for interpreting the 45-day and 180-day requirement that way. Section 7503 of the Tax Code applies to any act under the authority of internal revenue laws and has no language to the effect of “unless otherwise provided in the regulations.” According to the Tax Code all deadlines fall to the next business day if they fall on a weekend or holiday. Section 1031 is the only one excepted. Remember, the IRS hates 1031 Exchanges.
Don’t use a “related party” to do the exchange. The IRS doesn’t want a “related party” to act as an escrow holder, a trustee, an intermediary or accommodator in a tax-deferred exchange. The IRS wants no access to the cash from the sale, but to have it go directly to the new property. They figure that if we use someone with whom we have a business or personal relation- ship to handle the exchange for us that we really have access to the money.
What is a “related party?” Obviously it includes brothers-in-law and first cousins, but it also includes lots of other people whom we would not immediately suspect. In fact, IRS regulations are so unclear that we can’t always be sure just who it does include.
The regulations define a related party as someone who bears a relationship to the taxpayer as defined under Section 267(b) and Section 707(b) of the Tax Code except that 10% replaces 50% wherever it appears. For example, under Section 267(b)(2) an individual owning (directly or indirectly) more than 50% in value of the outstanding stock of a corporation and that corporation are considered to be related parties; under the exchange regulations an individual owning just 10% of the stock is considered a related party to the corporation.
A party who “acts as an agent” (note present tense) of the taxpayer is a related party. People who perform services for the taxpayer, such as an employee, broker or attorney are considered agents. Even though the regulations don’t specifically mention them, accountants, financial advisors or other professionals would probably fit the definition of acting as an agent.
A major exception is if the person or entity performing services for the exchanger does so just for exchanges intended to qualify under Section 1031, or if the agent is a financial institution performing routine services. Those people or entities would not be considered agents and thus would not disqualify the exchange.
We can probably think of a number of “what ifs” as well: What if we hire an attorney to do a 1031 Exchange and the attorney acts as the accommodator? Two years from now we or our spouse ask the attorney to look at a sale agreement for another property for us. Would the fact that the attorney acted for us two years later invalidate the exchange?
What if an accountant prepared a tax return for us two years ago. Now we hire an Exchange Accommodator to handle a 1031 Exchange for us that is more than 10% owned by that accountant. Would that invalidate the exchange?
These situations are unclear. And where are they ultimately clarified? In the courts, unless, of course, we just want to pay the IRS when they demand back taxes and penalties for an improper exchange.
We are safest using a company that does nothing but exchanges, and there is an entire industry that has grown up around the 1031 Exchange. Pick a real estate exchange company with a solid reputation and history. Ask a Realtor or someone who has done an exchange to recommend a company.
Have an accountant help first. Don’t jump right into an exchange without investigating tax consequences. Remember, an exchange is not necessarily always in our best interests. An accountant can tell us the various ramifications. An exchange company could, too. But once we hire an accommodator, that is a neutral party and cannot advise us as to the best strategy. Even if we asked the company before we began the exchange, their having given advice could be construed as making them a “related party.”