Section 1031 Tax Deferred Exchanges
We serve as Qualified Intermediary in Section 1031 tax-deferred exchanges, and provide legal support and consultation services for Qualified Intermediaries.
What’s a Section 1031 Tax-Deferred Exchange?
A Section 1031 Tax-Deferred Exchange is a technique that allows owners of appreciated real estate that is held for investment or used in a trade or business to sell the property and invest the proceeds in a replacement property without paying capital gains on the sales proceeds.
For example, a taxpayer bought real property A for $100,000 two years ago and it is now worth $200,000. He would like to sell this property and purchase real property B, also worth $200,000. If he simply sold property A, he would owe approximately $20,000 in capital gains taxes (actually more if the property had been depreciated). He would also have to come up with $20,000 out of pocket to purchase property B!
With a 1031 exchange, this tax is deferred. No tax is paid on the exchange, assuming that the purchase price of the replacement property (or the total purchase price of multiple properties) equals or exceeds the sale price of the property (or total price of the properties) sold. The taxpayer in the example pays no tax on the sale of property A, but instead has a tax basis of $100,000 in real property B. When he does sell property B, he will pay capital gains tax on the difference between the sale price of property B and his $100,000 basis (assuming he does not do another 1031 exchange!)
Over the course of several years and exchanges, the tax savings can be phenomenal. Assume that the taxpayer in our example does this every two years for the next ten years (and being a real estate genius, is able to double his investment every two years). Here’s a comparison of how much he would have made at the end of the 10 years with or without using 1031 exchanges, assuming a 20% capital gains tax rate applies:
|Year||Without 1031 Exchange||With 1031 Exchange|
|0||Buys $100,000 property||Buys $100,000 property|
|2||Sells property for $200,000, pays $20,000 tax, purchases $180,000 property with after tax proceeds||Sells property for $200,000, pays no tax, purchases $200,000 property with proceeds.|
|4||Sells property for $360,000, pays $36,000 tax, purchases $324,000 property with after tax proceeds.||Sells property for $400,000, pays no tax, purchases $400,000 property with proceeds.|
|6||Sells property for $648,000, pays $64,800 tax, purchases $583,200 property with after tax proceeds||Sells property for $800,000, pays no tax, purchases $800,000 property with proceeds.|
|8||Sells property for $1,166,400, pays $116,640 tax, purchases $1,409,760 property with after tax proceeds.||Sells property for $1,600,000, pays no tax, purchases $1,600,000 property with proceeds.|
|10||Sells property for $2,099,520 and pays $209,952 tax, leaving about $1,889,568 after taxes.||Sells property for $3,200,000, pays capital gains tax of $620,000, leaving $2,580,000 after taxes.|
|End of 10 years||$1,889,568||$2,580,000|
It is no wonder that savvy investors have used tax-deferred exchanges to help them build vast real estate empires!
To the extent that depreciation recapture, which is taxed at higher ordinary income rates, is deferred by doing tax-deferred exchange(s), the tax savings can be even higher! The tax savings are also much higher if the real property owner is a C corporation, due to the higher capital gains tax rate applicable to these entities.
Furthermore, if the taxpayer dies before finally “cashing out” of his real estate investments, the step up in tax basis under Internal Revenue Code Section 1014 will apply so that the accumulated capital gain on his death will never be taxed.
What does the Qualified Intermediary do?
Before the sale of the property being sold, the client enters into an Exchange Agreement with the Qualified Intermediary, and assigns the sale contract to the Qualified Intermediary, who then becomes the (technical) seller of the property at the closing. The proceeds from the closing are held in an escrow account by the Qualified Intermediary.
The replacement property or properties must be identified within 45 days of the first closing, and the closings on the replacement property or properties purchased must occur within 180 days of the first closing. The purchase contract is assigned to the Qualified Intermediary, and at the closing on the replacement property, the funds held by the Qualified Intermediary are forwarded to the title company handling the closing to be used towards the purchase.
Because the client has not had access to the funds during this period, he or she is not taxed on the proceeds on the sale.
Who can serve as Qualified Intermediary?
Your “regular” attorney or accountant cannot serve as Qualified Intermediary, because under the tax laws they are considered your agents and are therefore disqualified. Certain other persons and entities are disqualified as well.
Obviously, because the Qualified Intermediary is holding your money for you, make sure that the company you use is reputable and can provide references.
How does the Qualified Intermediary hold the proceeds from the property sale?
The proceeds will be held in an interest-bearing “Qualified Intermediary” account at a local bank. If the proceeds exceed the FDIC insurance limit of $250,000, they may be held in a repurchase account that invests in short-term government securities. Alternatively, the funds can be split into accounts at different banks.
If you have a different financial institution in mind with which you feel more comfortable and/or will give you a favorable interest rate, the Qualified Intermediary account can be established there.
The interest earned on the Qualified Intermediary account is added to the account balance and can be applied toward the purchase price of the new property. You will receive a 1099 from the financial institution for the interest earned on the account and will have to report it on your personal income tax return.
I have a replacement property I wish to purchase, but don’t have a buyer for my existing property yet. Can I still do a Section 1031 exchange?
Yes! In September 2000, the IRS issued Rev. Proc. 2000-37, 2000-40 I.R.B. 308, which provides a roadmap for doing a 1031 exchange in this situation (it’s called a “reverse” exchange). It’s more complicated than a regular exchange, so the recommendation is still to try to sell the existing property first, if possible, but a reverse exchange can be done!
I own the existing property individually, and am concerned about possible environmental contamination liability and other liability issues with respect to the replacement property I will be purchasing. How can I limit my liability on the new property?
Instead of taking title to the property individually, you can establish a single-member limited liability company (LLC) to receive title to the replacement property. Because the LLC is considered a “disregarded entity” under the federal tax law, this will not disqualify the exchange.
Potential liability issues are especially a concern with respect to environmental contamination. Under the federal Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) (also known as the “superfund” law), passed in 1980, not only the current owner but every person or entity who has ever owned a parcel of real property is potentially jointly and severally liable for cleanup costs. If you ever owned the property individually and are unable to show that the contamination didn’t happen during the time that you owned it, you could possibly be held personally liable, even if you later transferred the property to a corporation, LLC, or other limited liability entity.
I am in the process of executing a Contract for Sale and Purchase on real property I am selling, and am considering doing a Section 1031 exchange. Is there any particular wording that should be included in the Contract?
We recommend that the following language be added to the Contract to ensure the buyer’s cooperation with a Section 1031 exchange:
“Buyer acknowledges that Seller intends to accomplish a tax deferred exchange under Section 1031 of the Internal Revenue Code and agrees to cooperate with the performance of this exchange, including the execution of such additional documents as may be necessary, at no additional cost to Buyer.”