1031 Property Exchanges

Property exchanges go by several names. The Internal Revenue Service calls them 1031 exchanges, or more formally, real estate transactions that comply with Section 1031 of the Internal Revenue Code. They are also frequently referred to as like-kind exchanges, delayed exchanges or Starker exchanges (named for the owner/investor whose case first reached the U.S. Supreme Court, both legitimizing and clarifying such transactions).

Without 1031 exchanges, any real estate investor who wants to sell property after owning it for at least one year will owe capital gains taxes on any profits from the sale. Currently, federal capital gains are taxed at 15 percent. In strong real estate markets, not unlike those experienced in recent years throughout many parts of the U.S., capital gains taxes can be quite significant. For example, an investor who purchased property for $250,000 then sold it for $500,000 would be subject to $37,500 in federal taxes (15 percent of the $250,000 profit).

But assume that this same investor also plans to purchase a different investment property. In this case, they could defer paying the capital gains tax by “exchanging” one property for another, so long as the transaction complied with strict IRS guidelines. The original $250,000 basis would be applied to the new property, regardless of what the investor paid for it. In effect, the philosophy behind a 1031 tax exchange is that as long as a real estate investment remains intact, capital gains taxes should not be assessed.

The Advantages of 1031s

Delaying tax payments is much like receiving an interest-free loan from the government. After factoring in the time value of money, it becomes even more apparent that the longer the payment can be delayed, the larger the benefit of deferring it. But the benefits don’t stop there. By keeping more money in their pockets, investors have additional proceeds to reinvest from the original property, or may opt to reinvest in a higher-priced property.

Basic Qualifications

What types of properties qualify for a like-kind exchange? Real property held for business or investment must be exchanged for other like-kind real property. Beyond this, however, investors have a great deal of latitude. For example, an apartment building can be exchanged for a farm; or a condo unit for vacant land. But while 1031s offer considerable flexibility, there are very clear and strict time parameters and other restrictions placed on deferred-tax exchanges.

To “exchange” one property for another, investors should work with a qualified 1031 intermediary who handles the transfer of funds and properties between the parties. Of course it is rare that the two properties involved in an exchange will be equal in value and equity. Therefore, to balance the transaction, one party typically pays in additional funds or assumes a larger amount of the underlying debt. If the investor seeking the exchange receives this money, or reduces his debt, then the offsetting amount is called boot. Any gains received in the form of boot would taxable, regardless of whether it was received in actual funds or in the form of debt relief.

Are there disadvantages?

The primary disadvantage of 1031 exchanges is that they are complex transactions that must be properly structured and documented, utilizing third-party experts to manage certain aspects of the deal. Beyond this, it is important to consider the fact that future taxes, while deferred, may be higher, particularly after a succession of tax- deferred exchanges, all built upon the original, low basis.

Part of the complexity of 1031 exchanges stems from the fact that tax laws change periodically, with clarifications and interpretations modifying many subtle transaction details. This is an area of real estate that truly requires the involvement of tax and legal experts. While it is perfectly appropriate for a buyer’s (or seller’s) agent to intro duce 1031s to clients and discuss his or her knowledge and involvement in past transactions, you must never cross over the line of pro viding legal or tax advice.

Assuming you understand where this line is drawn, however, 1031 property exchanges can offer you and your real estate-investing clients very significant tax advantages. Once you’ve developed your knowledge of this important area, you’ll find yourself in an excellent position to tap into new opportunities for both personal and professional gain.

Four Basic Rules of 1031 Exchanges

1. Property must be held for investment or productive use in trade or business.

2. Property must be exchanged for like-kind property.

3. Replacement properties must be identified within 45 days after the relinquished property is transferred.

4. The exchange must be completed (replacement property received) by the earlier of 180 days or the tax return due date.

Source: Tax Deferred 7031 Real Property Exchanges course materials. Reprinted with permission from the REALTORS® Land Institute.

1031s Offer More than Just Tax Advantages

Tax-deferred property exchanges provide a powerful tool for real estate investors. But even if you don’t personally invest in real estate, it can work to your advantage to take time to learn more about them. Why? Because knowledge of 1031s places you in unique company and allows you to cultivate a new base for clients and referrals.

When looking for new clients, don’t limit yourself to wealthy investors. Smaller investors, especially in areas where property values have soared, also make great prospects. Additionally, consider assisting landlords with rental listings. While the lease arrangements themselves aren’t very lucrative, it can be a great opening for future 1031 exchanges on rental proper ties held by the landlord, plus it places you in direct contact with tenants who may become future buyers or investors.

After developing your knowledge of 1031s, promote your
niche position by:

• Offering seminars that feature CPAs, attorneys and other 1031 experts.
• Including tips and articles on 1031s in your communications with past clients and prospects.
• Locating non-owner occupied properties and sending the owners information on the benefits of 1031 exchanges and how you can assist them.
• Promoting your knowledge to other practitioners, improving your opportunities for referral business.

How to expand your knowledge of 1031s?

One excellent way to develop your knowledge is to attend the 2-day course, Tax Deferred 1031 Exchanges, offered by the REALTOR® Land Institute, or RLI. Developed specifically for real estate practitioners, this course will help you:

• Understand how the rules governing 1031 tax-deferred real property exchanges are applied and how transactions are put together.
• Explain the tax deferral benefits of a 1031 exchange.
• Recognize and evaluate situations in which a 1031 tax deferred exchange could be to the client’s advantage.
• Work with intermediaries and other experts to structure the transaction.

A complete description of the Tax Deferred 1031 Exchange course, as well as dates and registration details, can be found at www.coursecalendar.com.

Also the Field Guide to 1031 Exchanges, offered by NAR’s Information Central at http://www.realtor.org/libweb.nsf/ pages/fg408, is another great resource for learning more about 1031 tax-deferred property exchanges. Filled with basic background information, IRS guidelines, links to 1031-related Web sites and other valuable resources, this is an excellent source for information specifically tailored to the needs of real estate professionals.

An Important Caveat

Always remember that while 1031 knowledge can be a powerful marketing tool, you should never provide your clients’ specific advice on tax strategies or legal matters. The actual details of their property exchanges must be handled by qualified experts, including attorneys, tax advisors, and qualified intermediaries.