Springfield Business Journal Articles


1031 Exchanges

Assume you hold income producing real property that has gone up in price. You want to sell the property, but don't want to sacrifice a significant portion of your profit to the capital gains tax. Is there anything you can do? Thankfully, the answer is yes.

Section 1031 of the Internal Revenue Code allows taxpayers to sell certain real and personal property while deferring tax liability by exchanging the current property (relinquished property) for qualified use "like-kind" property (replacement property). To put it another way, a taxpayer who wants to sell an old piece of property and use the proceeds to buy a new property will be able to defer taxes otherwise payable on the sale of the old property as long as the new property is purchased to replace the existing property. The process is called a 1031 exchange or a "like-kind" exchange.

For example, assume Joe bought a strip mall for $300,000 in a soft market, and sells it today for $500,000. Joe must pay capital gains on the profit of $200,000. However, if Joe takes the proceeds of the sale and buys another strip mall worth $500,000 or more, he has completed a like-kind exchange and has deferred the capital gains tax until he profits from the new investment. Joe, therefore, gets the immediate benefit of his entire profit which allows him to "trade up" to a better property.

Joe doesn't have to invest all of the proceeds from the sale in the replacement property. However, the portion not invested will be subject to capital gains tax.

Not all property can be subject to a like-kind exchange. For example, your primary residence doesn't count. Instead, only property held for productive use in trade or business, or property held for investment, benefits from this IRS rule. This is called "qualifying use" property.

Assuming you have qualified use property, you must also satisfy the "like-kind" test. For example, real property is "like-kind" to other real property. Property eligible for 1031 exchange treatment includes raw land, commercial office buildings, shopping centers, farmland, leases of more than 30 years, rental houses, factories and the like.

The rules are a bit more restrictive for personal property. Aircraft, automobiles, trucks, office equipment, furniture, machinery, billboards, franchise licenses, and copyrights are just a few permissible examples. Inventory, stocks, bonds, notes and other securities, however, are excluded from the scope of 1031 exchanges.

The IRS imposes stringent timelines for this process. Replacement property must be identified within 45 days of the initial sale. Multiple properties can be identified, but special rules apply that are beyond the scope of this article. Accordingly, the savvy investor already has his or her replacement property in mind before offering the relinquished property for sale. Finally, the acquisition of the replacement property must be completed within 180 days of the initial sale. These deadlines are inflexible, and if violated the benefits of this exemption evaporate. Keep in mind that the time limits are calculated to include weekends and holidays.

It's also possible to acquire the replacement property before selling the relinquished property. This is called a "reverse exchange." Slightly different rules apply, but the benefits are the same.

If the tax payer personally receives the proceeds from the sale of the relinquished property, the IRS will not defer the capital gains tax. Rather, the proceeds must be received by a "qualified intermediary." The qualified intermediary must be an independent entity who is not the tax payer or a related party. The tax payer enters into an "exchange agreement" with the qualified intermediary. That exchange agreement limits the tax payer's access to the proceeds and also directs the qualified intermediary to acquire the relinquished property from the tax payer, to transfer it to the buyer, to acquire the replacement property, and then to transfer the replacement property to the tax payer.

"It sounds complicated," says Dana Lyons of the Illinois Real Estate Title Center, "but it's actually a turn key service we can provide to our customers for a modest price." Most title companies offer such services, complete with all of the necessary paperwork, for a fee that is based on the value of the transaction. Make sure your qualified intermediary is bonded and that the funds will be held in an interest bearing bank trust account.
Although the process may sound daunting, it's quite common place. According to Rod Egizii of Aspen Real Estate Company "many commercial real estate transactions in Central Illinois are driven by the need to acquire replacement property - it's something we are quite familiar with."

A like-kind exchange is an excellent way to avoid capital gains taxes on a transaction if your ultimate goal is to reinvest the funds anyway. However, because of the many rules, it's best to contact your tax or legal counsel before heading down this road.

by Thomas C. Pavlik, Jr.
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