What is a 1031 exchange?
Under section 1031 of the Internal Revenue Code, a real property owner can sell his property and then reinvest the proceeds in ownership of like-kind property and defer the capital gains taxes. To qualify as a like-kind exchange, property exchanges must be done in accordance with the rules set forth in the tax code and in the treasury regulations. The 1031 exchange can offer significant tax advantages to real estate buyers. Often overlooked, a 1031 exchange is considered one of the best-kept secrets in the Internal Revenue Code.
Who should consider a 1031 exchange?
If you have real property that will net you a gain upon sale (generally property that has been substantially depreciated for tax purposes and/or has appreciated in fair market value), then you are exactly the person who should consider a 1031 exchange.
There are 5 tax classes of property:
1) Property used in taxpayers trade or business.
2) Property held primarily for sale to customers.
3) Property which is used as your principal residence.
4) Property held for investment.
5) Property used as a vacation home.
Section 1031 applies to the first and fourth categories, and potentially the fifth category. Business use is defined as, "To hold property for productive use in trade or business." Property retired from previous productive use in business can be qualifying property. Investment purpose defined as real estate, even if unproductive, held by a non-dealer for future use or increment in value is held for investment and not primarily for sale. Investment is the passive holding of property, for more than a temporary period, with the expectation that it will appreciate. Property held for sale in the immediate future is not held for investment.
Why should you consider a 1031 exchange?
- Defer paying capital gains taxes.
- A properly structured exchange can provide real estate investors with the opportunity to defer all of their capital gains taxes. By exchanging, the investor essentially receives an interest-free, no-term loan from the government.
- Relief from property management. The lessee takes the responsibility to sublet and maintain the property allowing real estate buyers to avoid most of the day-to-day management headaches.
- Upgrade or consolidate property.
- Diversify. Own multiple properties rather than just one.
- Relocation to a new area.
- Differences in regional growth or income potential.
- Change property types among residential, commercial, retail, etc.
What are the 1031 exchange rules?
The real property you sell and the real property you buy must both be held for productive use in a trade or business or for investment purposes and must be like-kind.
The proceeds from the sale must go through the hands of a qualified intermediary and not through your hands or the hands of one of your agents or else all the proceeds will become taxable.
All the cash proceeds from the original sale must be reinvested in the replacement property - any cash proceeds that you retain will be taxable.
The replacement property must be subject to an equal level or greater level of debt than the relinquished property or the buyer will either have to pay taxes on the amount of the decrease or have to put in additional cash funds to offset the lower level of debt in the replacement property.
Identification Period: Within 45 days of selling the relinquished property you must identify suitable replacement properties. This 45 day rule is very strict and is not extended should the 45th day fall on a Saturday, Sunday, or legal holiday.
Exchange Period: The replacement property must be received by the taxpayer within the "exchange period," which ends within the earlier of . . . 180 days after the date on which the taxpayer transfers the property relinquished, or . . . the due date for the taxpayer tax return for the taxable year in which the transfer of the relinquished property occurs. This 180-day rule is very strict and is not extended if the 180th day should happen to fall on a Saturday, Sunday or legal holiday.
Replacement property identification
3-property rule: You may identify any three properties as possible replacements for your relinquished property. More than 95% of exchanges use the 3-property rule.
200% rule: You may identify any number of properties as possible replacements for your relinquished property as long as the aggregate value of those properties does not exceed 200% of the value of your relinquished property.
95% exemption: You may identify any number of properties as possible replacements for your relinquished property as long as you end up purchasing at least 95% of the aggregate value of all properties identified.
In a 1031 exchange you can exchange any real property for any other real property within the United States or its possessions if said properties are held for productive use in trade or business or for investment purposes. Examples of like-kind property include apartments, commercial, condos, duplexes, raw land and rental homes*. As used in IRC 1031(a), the words "like-kind" mean similar in nature or character, notwithstanding differences in grade or quality. One kind of class of property may not, under that section, be exchanged for property of a different kind or class. Examples of qualified like-kind exchanges:
- apartment building for farm/ranch
- office building for hotel
- raw land for retail space
- unimproved property for commercial property
- airplane for airplane
Examples of non like-kind properties include primary residences, stocks and bonds, notes, partnership interests, developed lots held primarily for sale and property to be resold immediately after initial purchase or completion of improvements.
* Qualification for Section 1031 exchanges depends upon the extent of personal use.
1031 exchange formats
- Two-party swap
- Alderson exchange
- Delayed exchange (most common)
- Safe Harbor
- Multiple sales/acquisitions
- Reverse exchange
- Improvement exchange
History of 1031 exchange
1918 - First income tax law
1921 - Section 202 of Internal Revenue Code states that gain or loss not recognized on exchanges of like-kind property
1924 - Non like-kind exchanges excluded from Section 202
1928 - Code section changed to Section 112(b)(1)
1954 - Section 1031 enacted
1975 - Starker exchange; Tax court approves delayed exchange
1977 - Tax court reverses prior ruling, invalidating delayed exchanges
1979 - 9th Circuit reverses, reinstating initial ruling and creating delayed exchange
1984 - Congress amends Section 1031; 45 day identification period and 180 day exchange period and partnerships excluded
1991 - Regulations 1.1031 passed
2002 - Revenue Procedure 2002-22 issued by IRS; 15 points to clarify TIC interests
The role of the Qualified Intermediary (QI)
The QI is a person or entity that can legally hold funds to facilitate a 1031 exchange. To be qualified, the intermediary must not be relative or agent of the exchanging party. As an exception, a real estate agent may serve as an intermediary if the current transaction is the only instance in which the agent has represented the exchanging party over the past two years.
The use of a QI is essential to completing a successful 1031 exchange. The QI performs several important functions in the 1031 exchange process including creating the exchange of properties, holding the exchange proceeds and preparing the legal documents.
What is Tenants-in-Common (TIC)?
A TIC is a form of real estate asset ownership in which two or more persons have an undivided, fractional interest in the asset, where ownership shares are not required to be equal, and where ownership interests can be inherited. Each co-owner receives an individual deed at closing for his or her undivided percentage interest in the entire property. Through TIC ownership, the average person is able to enjoy ownership in an institutional-type property with a minimum investment.
What are the benefits of TIC ownership?
The TIC structure has various features that make it attractive to the real estate buyer.
Access to Higher Grade Properties - The typical entrance in whole commercial building begins at $1 million, but through TIC ownership, the average person is able to enjoy ownership in an institutional-type property with a minimum purchase. Besides reliable income and growth potential, these properties are able to attract tenants with greater financial strength and stability than possible for the individual landlord.
Combined Real Estate Experience - As an alternative to sole ownership of real estate, a 1031 buyer can take ownership in a large commercial property along with other unrelated buyers, not as limited partners, but as individual owners. Each of the TIC owners brings their previous real estate knowledge to the group. Thus, each decision of the TIC ownership will be backed by many years of real estate experience.
Lessee with an established history of 1031 experience in Real Estate - Most of the day-to-day property operations are handled by the NNN PLUS lessee. The lessee has extensive experience in real estate. Thus, situations that arise in day-to-day operations will be addressed quickly and efficiently, and the TIC owner will enjoy the freedom from property management.
Simple Management - The TIC owner avoids the time and frustration of dealing with multiple tenants. You no longer deal with "toilets, tenants and trash," and simply receive your monthly rental income from your mailbox. Enjoy "tennis, travel and time with family."
Exact Dollar Matching - In a TIC property, you can purchase any amount above the minimum. For example, if you have $152,479 of equity from the sale of a previous property you can purchase $152,479 of equity in a TIC property.
Low Minimums - Revenue Procedure 2002-22 issued by the IRS allows up to 35 TIC owners in any one property. Minimum purchase requirements are structured to meet this limitation and can range as low as $150,000 equity.
Non-recourse Financing - The mortgages on most of the TIC properties offered by FOR 1031 are non-recourse. The TIC debt structure generally allows for the debt financing to assumed. Assumption usually occurs without the need for qualification or loan assumption fees.
Diversification - Due to the low minimums in TIC properties, the buyer can decrease risk by diversifying into different properties in various different marketplaces.
Speed and Simplicity - Speed and simplicity are achieved due to the efforts of the FOR 1031 team. The negotiation process is complete, and survey, rent rolls, etc. are already completed and available for your review. After your review of all the due diligence used to acquire your property, and upon your approval, you are ready to close. The closing can be completed in days, not months.
No Closing Costs - Absent seller default or other items outside the control of FOR 1031, closings are met within the agreed upon time frame. FOR 1031 does not charge the TIC owners any closing costs.
Deeded Interest - The TIC owners buy the property and receive a deeded interest. You can transfer this interest by gift, sale, inheritance, assignment, etc. Such transfer does not need to coincide with the transfer of all TIC interests in the property. DBSI Housing, if requested to do so by the TIC owner, will assist in the marketing of any TIC interest.
No Special Allocations - All the TIC owners receive monthly rental payments, sale proceeds and the depreciation tax benefits in proportion to their percentage ownership in the property.
Impasse Resolution Procedure - On a decision requiring unanimous vote, such as a sale decision, a 60% - 75% (depending on your TIC agreement) vote by the TIC owners will be sufficient to initiate the impasse resolution procedure. This procedure allows the TIC owners with 60% - 75% (depending on your TIC agreement) or more of the property to make an offer to buyout the dissenting owner with 25% or less of the property. The dissenting TIC owners can either: (1) accept this offer, (2) buy out the 60% - 75% (depending on your TIC agreement) TIC owners at the same price per percentage ownership, or (3) change their dissenting vote to a consenting vote.
Disclaimer: The above brief description is not to be construed as legal or tax advice and is qualified in its entirety by the actual closing documents. In case of any discrepancy, the actual closing documents will control.
Question: In a nutshell, what is TIC ownership? Answer: TIC ownership combined with NNN leases provide the real estate buyer with the advantages of ownership in a larger property, revenue and annual depreciation benefits without many of the day-to-day management problems associated with individually-owned rental property.
Question: What purchase amounts are ordinarily required for TIC ownership? Answer: Revenue Procedure 2002-22 issued by the IRS allows up to 35 TIC owners in any one property. Minimum purchase requirements are structured to meet this limitation and can range as low as $150,000 equity. The typical entrance in whole commercial building begins at $1 million, but through TIC ownership, the average person is able to enjoy ownership in an institutional-type property with a minimum purchase. Besides reliable income and growth potential, these properties are able to attract tenants with greater financial strength and stability than possible for the individual landlord.
Question: What happens if fail to close on my 1031 exchange? Answer: You will have to pay your capital gains taxes. Failure to close is the top reason clients reveal as to why they pay capital gains. By identifying a TIC property, you can reduce your potential tax risk, and avoid a failed closing. If you fail to close on other identified properties, you are able to move all your proceeds into the TIC property you identified.
Question: Is there any liability exposure associated with TIC ownership? Answer: The mortgages on most of the TIC properties offered by FOR 1031 are non-recourse. The TIC debt structure generally allows for the debt financing to assumed. Assumption usually occurs without the need for qualification or loan assumption fees.
Question: What if I want to sell my TIC ownership? Answer: On a decision requiring unanimous vote, such as a sale decision, a 60% - 75% (depending on your TIC agreement) vote by the TIC owners will be sufficient to initiate the impasse resolution procedure. This procedure allows the TIC owners with 60% - 75% (depending on your TIC agreement) or more of the property to make an offer to buyout the dissenting owner with 25% or less of the property. The dissenting TIC owners can either: (1) accept this offer, (2) buy out the 75% TIC owners at the same price per percentage ownership, or (3) change their dissenting vote to a consenting vote.
Question: What happens to my TIC ownership if I die? Answer. Your ownership interest will pass to your heirs pursuant to your will just like any other asset. Currently, the estate tax code provides that they will also receive a stepped-up tax basis to fair-market value, but you should check with your CPA or tax adviser because not all circumstances are alike. The income taxes which were deferred because of your 1031 exchange are potentially forgiven forever.