1031 Exchange: Tips & Pointers

By Jeff Peterson

CPEC1031 — Commercial Partners Exchange Company, LLC

  www.cpec1031.com

 

1031 exchanges are a hot topic. Investors want to save money in taxes by exchanging real estate and other assets for like-kind property to keep hard-earned equity working for them.

The trend at the executive level has been to increase taxes. Minnesota increased its highest rate to 9.85 percent and the federal capital gains tax rate increased to 20 percent, not to mention recapture of deprecation at 25 percent plus the 3.8 percent net investment income tax. This has pushed people to explore their options for saving money by exchanging for like-kind property.

Here are some tips you can use to help successfully save money through 1031 exchanges.

You Can’t Touch the Cash in a 1031 Exchange

A basic principle of 1031 exchange is that the seller cannot hold their net proceeds from the sale of their relinquished property during the time between the sale of their old relinquished property and the purchase of their new replacement property. Investors need to bring in a qualified intermediary (QI) and to enter into a written exchange agreement that expressly limits the investor’s rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by their QI. The QI holds the proceeds and insulates the investor from having actual or constructive receipt of the proceeds.

Role of the Qualified Intermediary

Your QI will draft your 1031 documents and closing instruction to escrow the proceeds from your sale. Next, the QI applies this escrowed cash toward the purchase of your identified replacement properties, which need to be designated in writing by you within 45 days of the closing of the sale of the relinquished property, and received by you [1] within 180 days. Both the 45-day identification period and the 180-day exchange period run simultaneously from the day after the benefits and burdens of ownership shifted at the close of the sale.

1031 Deadlines are Hard & Fast

You can designate numerous replacement properties in writing to your QI. The most simple and commonly used rule is called the “Three Property Rule.” It allows you to designate up to three replacement properties without regard for the value of the properties.

An alternative rule, the “200 Percent Rule,” allows you to list any number of replacement properties provided that the total aggregate value of all of the designated properties is not more than 200 percent of the value of the relinquished property. You can pick either rule and only need to satisfy one of these rules to have a valid designation of replacement property.

There is also a fall back rule for identification called the “95 Percent Exception”[2]  that allows you to designate any number of replacement properties, but you have to actually receive 95 percent of the value of these specified properties. This rule is seldom used.

Cash on the Barrelhead — Stay Away From Seller Financing

The point of 1031 exchanges is to let investors defer their gains if they 1031 exchange into like-kind replacement property (or properties) of equal or greater value, and equal or greater equity. In other words, you should reinvest 100 percent of your net proceeds from your sale into a more expensive replacement property.

If you accept a note or contract for deed, you may end up recognizing some of your gains because you are loaning your buyer money that would normally have gone into your 1031 escrow account. In this case, you may come up short on cash in your exchange escrow account to reinvest an equivalent to the amount of equity into your replacement property, unless you add cash out-of-pocket. What’s more is the receipt of non-like property such as cash, notes, contract for deeds, or other seller-back paper may trigger some recognition of gain.

Keep on Deferring — Don’t Stop Until You Drop

Typically, when you sell appreciated property for a profit, you both realize a gain (a profit is logged) and recognize this gain (the profit becomes taxable); but when you do a 1031 exchange, you defer the recognition of the gain, which allows you to indefinitely put off being taxed on these gains. This can be repeated over and over again throughout your lifetime, allowing you to parlay your gains into larger and larger like-kind investments, compounding and building your wealth over time. The basis in your replacement property is the cost of that property, minus the amount of deferred gains from your prior exchanges that rolled into the property.

Dying to Save Money in Taxes

Another important tax code section is IRC § 1014, which says that when a person inherits property from a decedent’s estate, the basis in the inherited property is stepped-up to the fair market value [3] of the property at the time of the decedent’s death. This means that when an investor dies, they may be able to pass along their low basis property to their heirs, and the heirs will receive the property — without the deceased investor’s basis — but with a new basis that is stepped up to the fair market value of the property at the date of the decedent’s death.

Death and Not Taxes

Some people think that the deferral of gains is temporary and that tax will eventually have to be paid, which is true if you sell your appreciated property in a taxable — non-1031 — transaction. But because of the way § 1031 and 1014 work together, if you hold on to your properties until you die, all of that gain may go untaxed. The downside is that you actually need to die to make this plan work.

1031 Exchange Benefits

The tax benefits of using 1031 exchanges are significant. You have to jump through some administrative hoops to comply with the regulations, but smart investors begin planning their 1031 moves well before their sales occur, and they line-up replacement properties early to insure tax savings.

Jeff Peterson is a Minnesota attorney and former adjunct tax law professor. He serves as the president of Commercial Partners Exchange Company, LLC (www.cpec1031.com), and works exclusively in the facilitation of 1031 exchanges, reverse exchanges and build-to-suit construction exchanges for both real property and chattel personal property. Jeff frequently answers questions from investors about how to best utilize the services of a qualified intermediary. Jeff can be reached at 612 643 1031 or Jeffp@CPEC1031.com.