Published in the May 20-26, 2031 Real Estate Focus Issue of
The Enterprise, Utah’s Business Journal
By Kevin Dwyer
After years of lurking underneath the rubble of the financial, economic and real estate collapse that commenced in 2008, conditions may be ripening for the reemergence of the 1031 exchange. Prior to the collapse, the 1031 exchange was the darling of the real estate investment world and allowed investors to defer, if not ultimately avoid, taxation upon their bloated gains which accrued during the inflation of investment bubble. But the collapse ended all that and the 1031 exchange became a relic, along with many others, of the carnage of the collapse. But that may be changing.
For those who may have forgotten, section 1031 of the Internal Revenue Code permits taxpayers to defer, if not avoid, taxable gain from the sale of property held for use in a trade or business or for investment, provided they reinvest the sales proceeds in similar “like-kind” property to be held for use in a trade or business or for investment. For example, if an investor purchased one acre of Utah blackacre for $100 in 2005 and then sold it in 2012 for $200 he would have a $100 capital gain subject to a twenty percent tax rate (15% federal plus 5% state) or $20 leaving him with only $180 to reinvest. But if the same investor completed a 1031 exchange and purchased whiteacre he could retain the $20 in tax and reinvest the entire $200 for his benefit. That $20 of deferred gain is like an interest-free loan from the government that the taxpayer will only have to repay if, and when, he elects to divest himself of his real estate investment.
Prior to the financial collapse, 1031 exchanges were routinely used in rising markets, coupled with relative low lending rates and an expanding economy. That environment came to an abrupt halt in 2008 primarily for three reasons. First, prices collapsed and the associated gains evaporated. Second, credit markets dried up making reinvestment difficult and risky. Third, investors suffered sufficient losses to shield any lingering gains without the need of a 1031 exchange. Consequently, the 1031 market as well as its sister market, the Tenant in Common market both cratered.
But 2013 may be the year of the 1031 revival and, again for three reasons. First, the economy and the markets, after 4 years of waiting, are finally starting to revive. Savvy investors with the means and fortitude to invest in the down times are starting to see handsome returns which will need to be shielded from tax. Second, effective capital gain tax rates are on the move. The Obamacare regime added a new 3.8% Medicare Surtax on “net investment income” This Surtax applies to all taxpayers whose taxable income exceeds $200,000 for single filers or $250,000 for married couples filing jointly. Additionally, as of January 1, 2013, capital gains rates have been increased from 15% to 20% for taxpayers whose taxable income exceeds $400,000 for single fliers and $450,000 taxpayers married filing jointly. For Utah investors, effective capital gains rates could soar from 20% to 28.3%. Returning to the prior example, the tax bite without an exchange just increased from $20 to $28.30 – a 40% increase for affected taxpayers. Finally, credit markets, and the associated qualification requirements are beginning to relax thus lubricating the economic wheels of trade which are so essential for 1031 exchanges. There is less risk and uncertainty in reinvesting. The combination of these three factors fosters the economic environment in which a 1031 exchange makes a lot of sense. Given the option to pay Uncle Sam 28.3% of each dollar of gain or retain such amount for direct personal benefit, most taxpayers would elect to retain the cash
But these tax benefits are not without cost or consequence. Statutory and regulatory compliance is mandatory. Both the relinquished property and the replacement property must be “held for use in a trade or business or for investment.” Personal use property such as personal residences and vacation cabins as well as “dealer” property held primarily for resale does not qualify for like-kind deferral. No specific holding period is identified but IRS publications seem to contemplate a 2-year holding period to place a taxpayer’s qualified use of the property beyond question.
With certain limited exceptions, the same taxpayer, be it an individual or entity, who sells the relinquished property must purchase the replacement property. This may present some issues if a taxable entity sells the relinquished property but the lender on the replacement property is only willing to lend on property owned by the principal individual.
From the date of sale of the relinquished property, the taxpayer has 45 days to identify potential replacement properties and 180 days, again from the date of sale, to close on one or more of the identified properties. The Taxpayer can identify three properties of any value, or four or more properties provided the aggregate fair market value of the 4+ properties is less than twice the fair market value of the relinquished property. The taxpayer, from the onset must enter into a written agreement with a qualified intermediary. The qualified intermediary is essentially a tax-wise escrow service who holds the sales proceeds away from the taxpayer until they can be applied toward the purchase of the replacement property. In theory, the taxpayer never receives or is entitled to the benefit of the sales proceeds, and the exchange agreement expressly limits such access, thus avoiding actual or constructive receipt of the taxable proceeds. Since, the taxpayer never technically receives the proceeds he cannot incur a taxable gain.
To completely defer gain, a taxpayer must purchase replacement property of equal or greater value and with an equal or greater amount of debt. All exchange proceeds must be expended as well. To the extent any one of the foregoing tests are not satisfied, “boot” or taxable gain will be recognized to the lesser of the amount of such shortfall or the recognized gain. However the recognition of boot does not invalidate the entire exchange. Referring back to the original example, if the taxpayer only reinvested $190 of the $200, he would recognize gain on the $10 shortfall but would still defer tax on the remaining $90 of gain.
In times past, savvy real estate professionals have utilized the 1031 exchange as a means of tax deferral, but also as a means of financing new real estate acquisitions. As real estate markets recover, and frankly normalize, those same professionals and investors alike should revisit and reacquaint themselves with the benefits of this old tax planning friend. The 1031 exchange is rapidly becoming one of the last legitimate means of deferring taxable gains, especially as the folks in Washington seem to be focusing on taxing capital gains and net investor income.
This article is not intended to constitute legal or tax advice and cannot be used for the purpose of avoiding penalties under the Internal Revenue Code or promoting, marketing or recommending any transaction or matter addressed herein.
Contact Ray M. Beck at ray@crslaw for more information.
- On June 18, 2013