Published in the Greater Salt Lake City Edition of Attorney at Law Magazine, Vo1. No. 2.
Before the economic collapse of 2008, the 1031 exchange was the darling of the real estate investment world and allowed investors to defer, if not ultimately avoid, taxation upon their gains. But with the economic collapse, the need to defer capital gains through exchanges disappeared. That may be changing with a reviving economy.
For those who have forgotten, §1031 of the Internal Revenue Code permits taxpayers to defer taxable gain from the sale of property held for use in a trade or business or for investment. If an investor realized a $100 gain from the sale of his Utah property in 2012 he would typically pay 20 percent or $20 in taxes. If that investor completed a 1031 exchange he could retain and reinvest the $20 for his benefit. That $20 literally becomes an interest-free loan from the government.
With the economic collapse, use of the 1031 exchange dropped dramatically for three reasons. First, prices collapsed and the associated gains evaporated. Second, credit markets dried up making reinvestment difficult. Third, investors suffered sufficient losses to shield any lingering gains.
But 2013 may be the year of the 1031 revival, again for three reasons. First, real estate markets are starting to revive. Second, effective long term capital gain tax rates have increased by as much as 8.8 percent – or 40 percent for affected taxpayers. Finally, credit markets are beginning to relax.
But, these tax benefits are not without cost or consequence. Both the relinquished property and the replacement property must be “held for use in a trade or business or for investment.” Personal use property and property held primarily for resale do not qualify.
The taxpayer must engage a qualified intermediary who essentially acts as a tax-wise escrow service and holds the sales proceeds away from the taxpayer until they are applied toward the purchase of the replacement property. In theory, the taxpayer never receives the sales proceeds and therefore does not incur the tax.
After the sale of the relinquished property, the taxpayer has 45 days to identify potential replacement properties and 180 days to close on one or more of the identified properties. The taxpayer can identify three properties of any value, or four or more properties whose aggregate fair market value is less than twice the fair market value of the relinquished property.
To completely defer gain, a taxpayer must purchase replacement property of equal or greater value and with equal or greater amount of debt as the relinquished property. All exchange proceeds must be expended as well. Failure to satisfy each of those tests results in taxable “boot.”
In times past, savvy real estate professionals have utilized the 1031 exchange as a means of tax deferral and financing new acquisitions. As real estate markets recover those same professionals should revisit the benefits of an old tax-planning friend – the 1031 exchange.
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.