Another sign the real estate market in West Michigan is bouncing back: 1031 tax-deferred exchanges are on the rise.
Long favored by real estate investors who buy and hold property, 1031 exchanges allow you to “swap” one parcel of property for another while pushing tax liability further down the road. In essence, you can enhance and update a real estate investment portfolio without triggering capital gains in the eyes of the IRS.
A 1031 exchange works this way: If you were to buy a piece of property for $75,000 and sell it a few years later for $100,000, that $25,000 would be taxed at the capital gains rates. But if you take that $100,000 and purchase another piece of investment property, it could qualify as a 1031 exchange under the IRS tax code, allowing you to defer payment of taxes.
There’s no limit to the number of 1031 exchanges you can do, allowing an investor to shelter profits from transactions until the property is finally sold for cash.
The IRS does impose strict time requirements around the 1031 exchange, requiring an investor to identify the new property within 45 days of the sale of the original parcel and to close on the new property within 180 days. Additionally, investors must use a qualified intermediary, or QI, to hold the proceeds from the original sale.
The use of 1031 exchanges all but disappeared during the real estate bust — as did many QIs. But good ones like Margo Rosenthal of Investment Property Services Inc. survived the shakeout and are looking forward to a busy year.
“We attribute the sharp increase in the number of 1031 tax-deferred exchanges last year to a combination of rising real estate values, higher tax rates and the advent of new taxes,” said Rosenthal, vice president of IPS. “As investors and owners seek ways to defer taxes, we anticipate 2014 will be another strong year for 1031 exchanges.”
In order to qualify for a 1031 exchange, in broad strokes, the real estate investor must:
- Acquire “like kind” replacement property that will be held for investment or used in a trade or business.
- Purchase replacement property of equal or greater value.
- Reinvest all of the equity from the sold property into this replacement property.
- Obtain the same or greater debt on the replacement property.
In order for all of these elements to come together in a timely fashion, most like-kind exchanges require multiple parties: the investor, the buyer of the old property, the seller of the new property and the QI. In accordance with the tax regulations, the investor does not take actual receipt of the exchange funds – the QI does.
The tax regulations, including the time rules and sequence of events, are critical. Prior to closing the sale of the old property, the taxpayer arranges for the QI to acquire the old property and transfer it to the buyer. The QI also acquires the new property and transfers it to the investor. Naturally, there are a host of guidelines to adhere to, so a detailed exchange agreement is used to spell out the process and safeguards for it.
With the closing, the proceeds from the sale of the old property are held by the QI for the benefit of the investor to be used for the purchase of the new property. That 45-day clock begins ticking with the transfer of the old property. This is when the investor needs to identify specific properties as its new property to purchase. If no replacement properties are identified, the funds are delivered to the investor, who is unable to defer taxes.
With the new property selected, the investor then assigns rights to the QI to purchase the new property. When it’s time for the closing, the QI handles the transfer of the funds to the seller of the new property, and the seller transfers the new property directly to the investor. This transaction must be completed within 180 days from the sale of the old property.
Like-kind exchanges are quite beneficial and can be convenient. But they do require proper planning and structuring. Real estate investors should always consult with their financial and legal advisors before undertaking such a transaction to ensure that all appropriate tax liability can truly be deferred.
Robert J. Nolan is a partner at Warner Norcross & Judd LLP. He concentrates his practice in both real estate and corporate mergers and acquisitions. He can be reached at email@example.com.