As a real estate investor, you may want to unload one property and replace it with another. Real estate prices have surged in many areas. You may hold a property that you think has topped out and want to move on to what you think are greener pastures. Fair enough. But selling an appreciated property will result in a current tax hit — maybe a big one. That’s a suboptimal outcome if you intend to use the sales proceeds to buy replacement property.
What to do? Section 1031 exchange to the rescue. Here’s what you need to know.
What are Section 1031 exchanges, also known as ‘like-kind’ exchanges?
For now, Section 1031 of our beloved Internal Revenue Code allows you to postpone the federal income tax bill from unloading appreciated real property by arranging for a Section exchange — AKA a like-kind exchange. This time-honored maneuver is one big reason that some real estate investors have struck it rich over the years.
An earlier version of the Biden tax plan would have severely limited your ability to postpone taxes with a Section 1031 exchange. While that tax-raising proposal is now apparently off the table, it could come back sooner rather than later if lawmakers get serious about trying to tame federal budget deficits. So, it could be a really good idea to get Section 1031 exchanges done sooner rather than later while the current taxpayer-friendly rules are still in place.
Section 1031 exchange tax basics
You can arrange for real property swaps as long as the relinquished property (the property you unload in the swap) and the replacement property (the property you receive in the swap) are of like-kind. While that sounds like it could be a potential problem, it’s not, because anything that’s defined as real property can be swapped for anything else that’s defined as real property.
What constitutes real property?
Good question. Thankfully, IRS regulations use a very broad brush to define real property for Section 1031 exchange purposes. The starting point is that real property includes land, improvements to land, unsevered natural products of land, and water and air space superjacent to land.
If interconnected assets work together to serve a permanent structure (for example, systems that provide a building with electricity, heat, or water), the assets, may qualify as a structural component of real property. For example, a gas line that fuels a building’s heating system counts as real property.
The regulations also list examples of intangible assets that can count as real property — such as options, leaseholds, easements, and land development rights.
The regulations also stipulate that any property that’s considered real property under applicable state or local law counts as real property for Section 1031 exchange purposes.
Finally, the regulations allow you to receive an “incidental” amount of personal property in a Section 1031 exchange. Incidental personal property can comprise up to 15% of the aggregate fair market value of the property. For example, say you’re acquiring a small hotel worth $30 million in a Section 1031 swap. The swap can include personal property worth up to $4.5 million (15% of $30 million), and the whole package will qualify for favorable Section 1031 treatment.
Key point: Contact your tax adviser for full details about what constitutes real property before pulling the trigger on what you hope will be a 100% tax-deferred Section 1031 exchange.
The impact of ‘boot’
To avoid any current taxable gain on a real property swap, you must avoid receiving any “boot.” Boot means cash and property that’s not defined as real property. When mortgaged properties are involved, boot also includes the excess of the mortgage on the relinquished property (the debt you get rid of) over the mortgage on the replacement property (the debt you assume).
If you receive boot, you’re taxed currently on gain equal to the lesser of: (1) the value of the boot or (2) your overall gain on the transaction based on fair market values. So, if you receive only a small amount of boot, your swap will still be mostly tax-deferred (as opposed to completely tax-deferred). On the other hand, if you receive lots of boot, you could have a big taxable gain.
The easiest way to avoid receiving any boot is to swap a less-valuable property for a more-valuable property. That way, you’ll be paying boot rather than receiving it. Paying boot won’t trigger a taxable gain on your side of the deal.
In any case, the untaxed gain in a Section 1031 swap gets rolled over into the replacement property where it remains untaxed until you sell the replacement property in a taxable transaction.
Deferred Section 1031 exchanges
As you might imagine, it’s usually difficult, if not impossible, for someone who wants to make a Section 1031 swap to locate another party who owns suitable replacement property and who also wants to make a Section 1031 swap rather than a cash sale. The saving grace is that deferred exchanges can also qualify for tax-deferred Section 1031 exchange treatment.
Under the deferred exchange rules, you need not make a direct and immediate swap of one property for another. Instead, you can in effect sell the relinquished property for cash, park the sales proceeds with a qualified intermediary who effectively functions as your agent, locate a suitable replacement property later, and then arrange for a tax-free like-kind exchange by having the intermediary buy the property on your behalf. Here’s how a typical deferred swap works.
* You transfer the relinquished property (the property you want to swap) to a qualified exchange intermediary. The intermediary’s role is simply to facilitate a Section 1031 exchange for a fee which is usually based on a sliding scale according to the value of the deal. In percentage terms, intermediary fees are generally quite reasonable.
* Next the intermediary arranges for a cash sale of your relinquished property. The intermediary then holds the resulting cash sales proceeds on your behalf.
* The intermediary then uses the cash to buy suitable replacement property which you’ve identified and approved in advance.
* Finally, the intermediary transfers the replacement property to you to complete the Section 1031 exchange.
Voila! From your perspective, this series of transactions counts as a tax-deferred Section 1031 swap. Why? Because you wind up with the replacement property without ever having actually seen the cash that greased the skids for the underlying transactions.
Key point: See the side bar for the basic requirements for making a deferred Section 1031 exchange.
What if you still own the replacement property when you die? Under our current federal income tax rules, any taxable gain would be completely washed away thanks to another favorable provision that steps up the tax basis of a deceased person’s property to its date-of-death fair market value. So, under the current rules, taxable gains can be postponed indefinitely with like-kind swaps and then erased if you die while still owning the property. Wow.
Your heirs can then sell the property and owe zero federal income tax or just a little tax based on post-death appreciation, if any. What a deal. Real estate fortunes have been made in this fashion without having to share with Uncle Sam.
Warning: An earlier version of the Biden tax plan would have greatly reduced the date-of-death basis step-up break. While that tax-raising proposal is now apparently off the table, it could come back sooner rather than later. If it does come back, we can hope that it will only affect those who are truly rich. Fingers crossed.
The bottom line
While Section 1031 exchanges can get pretty complicated, the tax advantages can be huge, which makes all the complications well worth the trouble. As stated earlier, doing Section 1031 exchanges sooner rather than later may be highly advisable. Finally, get your tax adviser involved to avoid missteps. Arranging a Section 1031 exchange is not a good DIY project IMHO.
Side Bar: Requirements for deferred Section 1031 swaps
In order for your deferred real property exchange to qualify for tax-free Section 1031 swap treatment, you must meet two important requirements.
1. You must unambiguously identify the replacement property before the end of a 45-day identification period. The period commences when you transfer the relinquished property. You can satisfy the identification requirement by specifying the replacement property in a written and signed document given to the intermediary. In fact, that document can list up to three different properties that you would accept as suitable replacement property.
2. You must receive the replacement property before the end of the exchange period, which can be no more than 180 days. Like the identification period, the exchange period also commences when you transfer the relinquished property. The exchange period ends on the earlier of: (1) 180 days after the transfer or (2) the due date (including extensions) of your federal income tax return for the year that includes the transfer date. When your tax return due date would cut the exchange period to less than 180 days, you can simply extend your return. That restores the full 180-day period.