Overcoming Client Reluctance to Enter into a 1031 Exchange Transaction
By S.H. Spencer Compton
Senior Vice President and Special Counsel
First American Title Insurance Company of New York
Section 1031 of the Internal Revenue Code provides that no gain or loss will be recognized when property held for productive use in trade or business, or for investment, is exchanged for like-kind property which will be held for productive use in trade or business, or for investment. Most states allow such an exchangor to defer state capital gains tax as well. Put simply, in a 1031 exchange transaction, the seller of qualified property can use the entire equity in the property to purchase replacement property. Federal and state capital gains taxes are deferred. It’s no wonder that many real estate advisors regard the 1031 exchange mechanism as one of the few “free lunches” available to real estate investors, yet, so often, sellers of investment property are reluctant to avail themselves of its benefits. Why?
Despite the availability of information on 1031 exchange transactions, certain common misconceptions linger:
- I can turn my sale into the first leg of a 1031 exchange by directing the closing agent to hold my sales proceeds in an escrow account until I later direct him to use the proceeds to purchase my replacement property.
Wrong. The transaction is taxable because the taxpayer has constructively received the sales proceeds and still has control over their disposition. He has the right to change the escrow instructions and to withdraw the monies. Furthermore, in the transaction above, the taxpayer is not transferring property to a person and getting property back from that person in exchange. To withstand IRS scrutiny and qualify as a 1031 exchange, the two transactions must be interrelated and interconnected with each other. There must be an intermediary or buyer/seller cooperation.
- I have to find a seller of replacement property who wants to buy my relinquished property so we can trade them.
Wrong. The majority of 1031 transactions are three parties (e.g. a buyer, a seller and an intermediary) involved in the exchange of two properties. Real estate brokers and consultants serve as matchmakers, bringing buyers and sellers together on demand. Today’s 1031 exchange marketplace is a fluid one.
- I have to sell my relinquished property and buy my purchased property simultaneously.
Wrong. The logistics of coordinating the various parties to a simultaneous transaction would chill (if not kill) most exchange transactions. The exchange must be interdependent but need not occur simultaneously. This is one of the benefits of using an intermediary.
- I can only exchange a buggy whip manufacturing facility for another buggy whip manufacturing facility. The 1031 exchange like-kind requirement is restrictive and hard to satisfy.
Wrong. For real property, the like-kind standard is very broad. All real property is like-kind property to all other real property. Vacant land can be exchanged for developed property. One property can be exchanged for two or more properties. The rule is highly accommodating.
- The 1031 exchange rules are so complex that the cost of professional fees in consummating the transaction will eat up any capital gains tax savings I might realize.
Wrong. A plain vanilla 1031 exchange transaction where a seller of relinquished property uses an intermediary to exchange for a replacement property is a relatively simple proposition and the deferred capital gains tax can be significant. It is where the exchanger adds a complication--like the need to cash out a partner--that complexities arise. In many instances, such complexities can be accommodated by careful planning with a tax advisor. Depending on the facts, it may be possible to convey the property to each of the owners of the property-owning entity, individually as tenants-in-common, or to refinance the replacement property post-closing to cash out the departing partner. Consultation with a tax advisor should be part of structuring any 1031 exchange transaction.
- I just found out about the benefits of structuring my real property sale as a 1031 exchange, but it’s too late. I’m at the closing.
It’s not too late. As long as the buyer will cooperate, a brief contract amendment can be executed at the table transforming the sale into a 1031 exchange. As long as the net sales proceeds are not be paid over to the seller or its agent, but to a qualified intermediary, federal and state capital gains tax can be deferred, provided the exchanger identifies replacement property within 45 days thereafter and closes on its purchase within 180 days from the sale of the relinquished property.
Too many potential 1031 exchange transactions go unrealized, and capital gains taxes paid, due to real estate investors’ lack of information or misapprehensions about the wealth-building benefits of these transactions. Real estate and tax advisors owe it to their clients to advise them fully of the advantages of the 1031 exchange.