DISCLAIMER AND RISKS: THE FOLLOWING DISCUSSION OF DST 1031 EXCHANGES SHOULD NOT BE CONSTRUED AS LEGAL OR TAX ADVICE. THERE ARE RISKS AND COMPLEX TAX CONSEQUENCES INVOLVED IN A 1031 EXCHANGE. FOR A SUCCESSFUL EXCHANGE, STRICT ADHERENCE TO SECTION 1031 IS IMPERATIVE. IT IS IMPORTANT THAT YOU UNDERSTAND THE RISKS AND RULES ASSOCIATED WITH A 1031 EXCHANGE AND SEEK GUIDANCE FROM YOUR OWN INDEPENDENT COUNSEL, QUALIFIED INTERMEDIARY, ACCOUNTANT, OR BUSINESS ADVISOR AS TO LEGAL, TAX, AND RELATED MATTERS CONCERNING 1031 EXCHANGES. SUCH RISKS INCLUDE THE POSSIBLE FAILURE TO QUALIFY FOR SECTION 1031 TREATMENT AND THE SUBSEQUENT NECESSITY TO PAY TAXES ON THE EXCHANGE. NEITHER RK PROPERTIES OR ITS AFFILIATES MAKE ANY REPRESENTATION OR WARRANTY OF ANY KIND WITH RESPECT TO THE ACCEPTANCE BY THE IRS OR ANY OTHER TAXING AUTHORITY OF YOUR TREATMENT OF ANY ITEM ON YOUR TAX RETURN, INCLUDING THE TAX CONSEQUENCES IF YOU ARE INVESTING IN AN RK PROGRAM TO ACQUIRE AN INTEREST IN A REPLACEMENT PROPERTY IN A LIKE-KIND EXCHANGE OF REAL PROPERTY UNDER SECTION 1031 OF THE INTERNAL REVENUE CODE OF 1986, AS AMENDED.
What is 1031 Exchange?
A 1031 exchange is a tax-deferred exchange that allows you to defer capital gains taxes as long as you are purchasing another “like-kind” property. A 1031 Exchange offers the opportunity to purchase fractional interest ownership. When a property owner exchanges into fractional interest ownership, the owner is relieved of personal management and the hassle of dealing with tenants, maintaining the facilities, paying property taxes and other costs of the property. Instead, the property is professionally managed, with the potential to generate steady income, tax benefits and appreciation. Income from your replacement property could potentially be greater than what you were receiving from your original property. Thus, through fractional ownership you can sell your property and exchange into a high quality professionally managed property without the tax consequences.
How does a 1031 Tax Exchange work?
A 1031 Exchange is a three-way exchange in which an intermediary, usually a title company or escrow agent, is used to facilitate the transaction.
What are the basic steps of a 1031?
- Facilitate sale of your property (downleg)
- Assure proper contract and escrow language
- Transfer sale proceeds to qualified intermediary
- Meet 45 day identification requirement
- Open acquisition escrow (upleg)
- Complete exchange within 180 days
DST/1031 Q & A
What is a 1031 tax-deferred exchange?
It is a legal technique utilized to avoid taxes on the sale of investment real estate by re-investing in another “like-kind” investment property under specified IRS regulations.
How does A 1031 exchange work?
A property owner will sell the relinquished property and acquire a replacement property, from an unrelated third party, within 180 days. The third party is known as the Qualified Intermediary or Accommodator. Buyer and Seller have nothing to do with the exchange process.
Are reinvestment options limited because of the like-kind requirement?
There are many options. “Like-kind” is a broad category under which many types of investment real estate may qualify. Examples are rental houses, condominiums, duplexes, apartment buildings, shopping centers, retail and commercial buildings, trailer parks, storage facilities, hotels and motels, parking lots, and factories. Even raw land, if held for investment or business purposes, may qualify.
Aren’t 1031 exchanges used primarily by wealthy corporations in large commercial transactions?
Approximately 60% of exchanges are residential rental properties, one to four units in size. The 1031 Exchange is an integrated vehicle of wealth accumulation for both large and small investors.
What is the IRS position on 1031 exchanges?
In 1991, the IRS published its Safe Harbor regulations giving real estate entrepreneurs the greenlight on using the tax-deferred exchange. Assuming that the investor adheres to the guidelines, including utilization of a Qualified Intermediary (Accommodator), there should be no IRS problems. Safe Harbor regulations resolved much of the mystery of the 1031 Exchange.
Is the gain on the sale of investment property simply the profit difference Between the acquisition and subsequent resale prices?
The computation of taxable gain on the sale of investment property must be done in accordance with IRS guidelines and includes certain adjustments that could still result in a taxable gain even if there were no property appreciation For example, all tax depreciation deductions taken must be added to gain. Postponed gains from any prior tax-deferred rollovers must also be added to gain. Realtor commissions and other costs of sale, capital improvements and certain loss carryovers will reduce taxable gain.
If a property owner owes mortgages or other dept that exceed the gain, would there then be no gain and no need for A 1031 exchange?
The mortgage balance or any other property debt does not reduce the taxable gain. This is why it is possible to have negative equity in a property but still have a taxable gain.
Upon the sale of investment property, is the taxpayer subject only to capital gains tax?
The gain in the sale of a property can result in other hidden tax liabilities. For example, most states, and even some locales also tax gains. Additionally, all or part of a gain may be treated as ordinary income if depreciation recapture is necessary. In a non-1031 sale, the gain can substantially increase adjusted gross income which, in turn, can create tax liability. Utilizing the 1031 Exchange can eliminate all of the above taxes.
Must the amount of the capital gain be reinvested in a rollover property in order to defer all of the takes?
In order to completely defer tax on the gain, the seller must invest in like-kind replacement property, the cost of which must equal or exceed the net selling price of the relinquished property. Net selling price is the total sales price less commissions and other selling expenses, not to include the mortgage payoff.
Can an investor withdraw cash from A 1031 exchange?
One of the requirements of a 1031 Exchange is that a seller may not receive constructive receipt of the proceeds from sale of the relinquished property. The proceeds must be held in a qualifying escrow account until a like-kind replacement property is acquired. However, an investor may choose not to reinvest all his equity into a replacement property. He may take part of it as taxable income and reinvest the remaining portion into the replacement property. Another method of taking cash from a move-up exchange is to refinance before or after the exchange.
Are 1031 exchanges limited to the selling of only one property and the acquisition of only one replacement property?
An investor is not limited to exchanging or acquiring just one property. Several properties can be exchanged/acquired in one 1031 transaction.
Can a qualifying 1031 exchange be effected by allowing a title company to escrow the funds from settlement?
Escrow and Intermediary are two separate IRS requirements. An Escrow deposits and holds proceeds from the sale of the relinquished property. An Intermediary acts as a middleman in the transaction by managing the exchange; that is, processing and filing the required 1031 documentation so the investor is assured of proper tax treatment.
Are there advantages, other than saving capital gains taxes, in utilizing a tax-deferred exchange?
There are multiple advantages. In addition to the taxes saved, an investor should consider what can be done by combining the saved dollars with leveraging and compounding. Because of the 1031 Exchange, the investor reduces or eliminates capital gain tax. Taxes saved along with leverage increases buying power. Increased buying power compounds wealth. The benefits of a 1031 Exchange are not just the dollars saved, but also the additional wealth which can be attained with the saved tax dollars.
Do 1031 exchanges merely postpone the payment of taxes or can the tax liability be eliminated?
When a property is rolled over via a 1031 Exchange, the untaxed gain remains and will become taxable if a property is ever sold outright. This is why the term “tax-deferred” exchange is appropriate. That is, by continuing to exchange property until death, the gain is permanently eliminated. This is because under current law the death of the property owner effectively eliminates gain by a “step-up” in the tax basis of the property to its fair market value. Therefore, as a result of employing IRS Code Section 1031, heirs will have a larger estate, not only from the taxes saved, but also from years of compounded earnings on the saved dollars.
Are there situations wherein an exchange should not be utilized?
When the adjusted tax basis of a property exceeds the net selling price, a realized loss will occur on the sale of the relinquished real estate. Under Section 1031, losses are deferred as well as gains; therefore, to recognize and deduct a loss there should be a sale and not an exchange. Also, it may not be cost effective to employ Section 1031 if only a nominal amount of taxes are due upon a sale.
Summary of 1031 Exchange
The following are objectives of 1031 programs. There are no assurances that any of these objectives will be achieved in any particular transaction.
- Deferral of capital gains tax
- Professionally managed property
- Ability to retire from day-to-day management
- Income that may be greater than income from original property
- Potential for greater appreciation from investment
- Properties selected by an experienced professional real estate company
- Ability to do another exchange after sale of your interest
Real estate investment intent
Both the property sold (Relinquished Property) and the property purchased (Replacement Property) must be held for investment or productive use in a trade or business. None of the properties exchanged can be your personal residence.
1031 tax exchange time frames
Replacement Property(ies) must be identified within 45 days of the sale of the Relinquished Property and must be purchased within 180 days of the sale of the Relinquished Property.
Identification of replacement properties
You can identify up to three Replacement Properties of any value during the Identification Period, or more, subject to certain conditions.
What is “like-kind” in a DST or 1031 exchange?
The Replacement Property must be “Like-Kind” to the Relinquished Property. Any type of real property is Like-Kind to other real property. For example, a shopping center is like-kind to an investment condominium and a warehouse is like-kind to raw land.
Common property ownership
The party selling the Relinquished Property must be the same party purchasing the Replacement Property or a disregarded entity with respect to that party.
Real estate property value
You must purchase a property of equal or greater value to the property sold or pay tax on the difference.
1031 exchange value
You must use all of the cash proceeds from the sale of your Relinquished Property toward the purchase of Replacement Property or pay tax on the difference. If you offer seller financing on your Relinquished Property, you may be subject to tax as the principal is repaid.
Qualified intermediary for tax deferral
To qualify for safe harbor tax deferral, sale proceeds must be held by a Qualified Intermediary between the sale of the Relinquished Property and the purchase of the Replacement Property.
Failure to close on replacement property
In order to complete a 1031 exchange and close on the replacement property in a subsequent tax year to the year in which the relinquished property is sold, it is absolutely necessary that the taxpayer file a Form 4868 Application for Extension to File Tax Return. Otherwise, the intended exchange will not qualify for tax deferral, but will instead be treated as a taxable sale made on the installment method. In the event that the taxpayer fails to close within the 180-day deadline, in effect the taxpayer has underreported his income in the year of disposition, and thus would owe interest and penalties. One benefit of the §1031 Regulations is that they provide that if the taxpayer intended in good faith to complete an exchange, the taxpayer is treated as receiving the consideration for the sale of the relinquished property under the installment method (i.e. on the date that the taxpayer received a refund of his money held by the Qualified Intermediary). There may not be automatic interest or penalties imposed if the taxpayer intended the property to be exchanged.
1031 tax exchange timeline – 45 days
You have 45 days from the sale of your Relinquished Property to identify your potential Replacement Properties. You can generally identify up to 3 properties or more, subject to the Rules of Identification. You do not have to have the identified property or properties under contract in order to identify them.
Real Estate Property Holding Periods – General Rules
Holding period
The words “held for” are a key element of the definition of property qualifying for exchange under§1031. Property acquired for an exchange is not “held for” the prescribed purpose and cannot be exchanged tax free.
How long must one “hold” property before an exchange is uncertain?
Some commentators have believed that the taxpayer should hold each exchange property for at least two (2) years. In such case, the relinquished property should have been held as an investment or for business purposes prior to the exchange, and the replacement property should likewise remain as investment or business use property for two years following its acquisition. The Internal Revenue Service has granted a private letter ruling (PLR 8429039) that permitted an exchange to qualify under Section 1031 where the taxpayer held the replacement property for a minimum holding period of two (2) years. Private letter rulings only apply to the taxpayer who applies for them, but many tax practitioners believe that private letter rulings often represent the Internal Revenue Service’s interpretation of a particular issue.
Relinquished property holding period
In Rev. Rul. 84-121, the Internal Revenue Service asserted its position that relinquished property acquired and exchanged soon after its acquisition will not qualify for a Section 1031 exchange, because the taxpayer is deemed to have acquired the property with the intent to dispose of it, rather than to hold it for investment or business purposes. The courts may permit a holding period of as little as three (3) months to qualify for a 1031 exchange where the taxpayer satisfied the holding and intention requirements by owning the property without the intent to liquidate the investment or to use it for personal pursuits.
Replacement property holding period
The courts have not been so liberal when examining a quick disposal of replacement property, or a speedy conversion of replacement property to the taxpayer’s personal use. Treasury Regulation01.1002-1(c)states that the Internal Revenue Service may consider subsequent dispositions of replacement property by the taxpayer to be evidence that the replacement property was not acquired to be “held” for business or investment purposes.
Is boot taxable in a 1031?
Property the taxpayer receives in the exchange which does not qualify as “like-kind property”.Cash proceeds are the most common form of boot. Boot is subject to taxation.
What is the 1031 exchange napkin rule?
You must buy a Replacement Property of equal or greater value to the Relinquished Property in order to completely defer the applicable capital gains tax. If you purchase a property of lesser value, you will be responsible for any tax on the difference. You must also use all the cash proceeds from the sale on your purchase in order to completely defer the applicable capital gains tax. If you do not use all your proceeds on the purchase, you will be responsible for any tax on the difference.
Original basis
The purchase price of a property. It is used to calculate capital gains or losses for tax purposes.
Three real estate property rule
The Exchanger may identify up to three properties, without regard to their value.
200% percent rule in 1031 exchanges
The Exchanger may identify more than three properties, provided their combined fair market value does not exceed 200% of value of the Relinquished Property.
95% percent rule
The Exchanger may identify any number of properties, without regard to their value, provided the Exchanger acquires 95% of the fair market value of the properties identified.