1031 Exchanges

Final Paper "1031 Exchanges - Insight for the real estate investor"

This paper is written to provide a reasonably comprehensive overview of Section 1031 of the IRC as it pertains to real estate transactions, and to offer some thoughts on the wealth-creation advantages that 1031 Exchanges offer.

For the greater part of the last decade, we in the United States have been witness to a consistently appreciating real estate market. Sometimes it seems that almost anyone who has purchased a house, piece of property, or other real estate type investment has done very well. I personally can point to a few examples where friends of mine have made several hundred times their first home equity investment. In sales of primary homes there is a tax advantage that the IRS permits, as long as the proceeds are invested into another home, the capital gains on your existing home sale are exempt from taxation. However, if the property in question is an investment, a capital gain tax is assessed every time there is a sale that includes a gain. A tax strategy that investors can employ in such situations is to transfer their investment property for another investment of "like-kind", this is a Section 1031 Exchange. Under Section 1031, if all its guidelines are met, the exchange is not a taxable event. Also, similar to tax rules regarding reorganizations - in a 1031 Exchange there is no taxable event and therefore no step-up in basis.

The wealth-creation advantage of a 1031 Exchange can be viewed in the chart below. The example depicts two sales of real estate, the initial assumption is that the property has been completely depreciated and the entire $100K of initial equity is a capital gain.

Event 1 Event 2

Typical Sale 1031 Exchange Investment experiences 20% appreciation Typical Sale 1031 Exchange

Equity 100,000 100,000 160,000 200,000

Tax 20,000 0 16,000 0

Net Equity to Invest 80,000 100,000 144,000 200,000

New Investment (20% Down payment) 400,000 500,000 720,000 1,000,000

By the end of event two, the investor who utilizes 1031 Exchanges is able to invest in a property that is 39% greater in value than the investor who sells his (her) real estate investments in a typical manner.

Section 1031 of the IRS tax code can be viewed in Exhibit 1 at the end of this paper, for practical reasons I would like to offer a basic example in which an investor(s) can benefit from the tax advantages of Section 1031.

John and Jane own and rent out a duplex in Atlanta. They are getting older now and are planning to retire and to move to Miami. John and Jane would like to sell the Atlanta Duplex and purchase a small commercial building next to the lovely condo they bought on the beach. The main issue is John and Jane can only afford to buy this building if they are able to capture all of the existing equity in their Atlanta duplex. To avoid (defer) a taxable event when they sell their duplex John and Jane can utilize Section 1031 of the IRC. There are, however, a few hoops that John and Jane must jump through to qualify.

First, the properties being exchanged must be "like-kind", " this criteria is defined by its use, not its characteristics. For example, land may be exchanged for rental property such as a house, condo, or commercial real estate." In addition to "like-kind" both properties must be located within the United States. It is important to identify the investment because once the initial property is sold, the investor has 45 days in which the acquisition property must be identified, failure to due so and the capital gains tax will apply to the sale of the initial investment. The investor now has 180 days, from initial sale to purchase the target real estate investment. There is some flexibility in the 45-day replacement property rule, namely two options the investor has when identifying his (or her) replacement property.

1. The three-property rule will allow the investor the flexibility of identifying up to three properties they are interested in exchanging for, the fair market value of the properties identified is not considered here.

2. A 200% rule will the allow the investor to identify any number of properties as long as the market value of the individual identified properties does not exceed 200% of the market value of the property being exchanged.

A 1031 Exchange must pass through an intermediary, in theory you are exchanging assets, it is necessary to have a third party to the transaction "to maintain the fiction that you aren't buying and selling" . Of course the investor can simply trade (exchange) properties with the owner of the target property, however, it is unlikely that the other investor wishes to exchange and extremely unlikely that both properties will be equal in value. If the properties are mismatched in value the addition of "boot" in an exchange will expose an investor to the capital gains tax - at least equal to the boot portion of the sale. These situations, and for situations in which the two parties do not wish to trade property at all, an intermediary is a requirement to execute a 1031 Exchange. "The duties of the qualified intermediary are to act as a principal for the exchanger in relinquishing property, to hold exchange proceeds, and to disburse these proceeds to the seller of the replacement property." The intermediary can be an accountant, an attorney, a broker, or an investment banker. However, the intermediary is limited to only performing 1031 services to that client. This is one reason that many professions either specialize in 1031 services or avoid them altogether.

Section 1031, in one from or another, has been a part of the IRC for over 70 years. Recently the section has been expanded to 'loosen' the requirements for exchanges that involve Tenants in Common (TIC). Here is a brief timeline of Section 1031's history:

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 -