To 1031 or not to 1031…that is the question. Back in the real estate boom of 2005-2008 the 1031 exchange was an often used tax strategy by real estate investors looking to avoid the tax when selling highly appreciated properties. However, due to the “Great Recession” at the end of the boom, the 1031 strategy got put on the back burner of most taxpayers minds as worries of job security, declines in retirement accounts, and economic instability became the soup de jour.
However, Americans are known for their resilience and now, almost a decade after that near-fatal collapse of the economy, the sun has come back out again. Property values are up and again investors are looking for creative ways to get around the state and capital gains tax.
Bottom line, the 1031 exchange has proven to be one of the most effective ways to save tax dollars today!
Most simply put a 1031 exchange occurs when a taxpayer sells a property and buys another piece of real estate of equal or greater value. Sounds simple right? Well, this is where it get’s fun.
- You can sell one property and buy 3 (or more actually), so as long as what you buy in total is equal to or greater than what you sold.
- You can sell 3 (or more actually) and buy one property, so long as it’s equal to or greater than the sum of what you sold.
- You can only do it with Real Estate, and
- Both properties you sell and purchase must be in the U.S.
If you noticed, the law is call the 1031 “exchange”. Well, where in the world are you going to find a seller that wants your property and is willing to ‘exchange’ it and help you with your 1031? You have a better chance of winning the lottery- right?
So to help smooth the way for a qualifying exchange, the IRS allows for a something called a Qualified Intermediary (“QI”). This is a third-party that must be used to ‘hold’ the money the seller receives from the sale of the property, until the buyer pulls the trigger and buys the ‘replacement’ property.
Here is an image of what a proper exchange looks like:
The QI acts as the “referee” in the 1031 exchange, making sure all the rules are followed.
Just like in sports there are good refs and bad refs. A bad QI can blow up the whole transaction causing you to pay tax you would not have otherwise planned on paying, similar to the no call when Michael Jordan pushed off Bryon Russell to get open and score the championship winning points in game 6 of the 1998 NBA finals. Unfortunately, the 1998 Utah Jazz squad didn’t have a referee looking out for their best interest. Make sure you have a good QI on your side when completed a 1031.
Nuts and Bolts
In the diagram above, it shows a seller finding a buyer to pay the highest price for their property and the QI ‘holding’ the cash as they wait for the ‘exchange’ to unfold.
Then the Seller must act within 45 days to identify what property or properties it hopes to buy in the exchange. This is called the “Exchange Period”. The Seller doesn’t have to ‘close’ on the purchase within 45 days, but just let the IRS know what the plan is. The QI documents this process for you if the IRS was to come knocking on your door.
After the Exchange Period is over, the Seller must close on the purchase of the new or replacement property within 135 days (essentially 180 days from the date of the sale). This is called the “Replacement Period”. The IRS doesn’t mind allowing for the exchange, but it doesn’t want you to drag it on…thus it creates these two timing rules so you move it along and close.
A good QI will be very clear about what needs to happen by what dates. Second, you have 180 days to close on the new property. Anything that occurs outside these 2 dates will result in a disqualified 1031 exchange.
What about taxes?
There are no taxes- for now. That’s the beauty of the 1031. However, what you did do is ‘defer’ the taxes. The gain you didn’t have to pay taxes on is allocated to the property or properties you purchased. Thus, you have to come up with another 1031 or strategy to avoid the tax someday in the future.
When you successfully complete a 1031 exchange your tax accountant will fill out a special form with the IRS and attach it to your tax return. This form will give the appropriate dates and the appropriate amounts of your “carryover basis” of the new property. It will also show any amount of taxable gain from the transaction.
As you might expect there are many pitfalls in a 1031 exchange which will cause unintended consequences. We’ll note a few of them here:
- Not using a QI. Having the QI set up is essential for the transaction because the IRS requires that the Seller does not touch the money from the sale to Buyer. If the Seller touches the money, the 1031 is blown up. You cannot achieve a successful 1031 exchange without a QI. Furthermore, a QI cannot be just any Joe Blow off the street. They have to be a company that deals specifically with 1031 exchanges.
- Missing the dates. The IRS form that shows your 1031 exchange has the relevant dates printed on lines 3 through 6 of the FIRST page. The IRS will not miss them. If your dates are not in line with the rules, you are out of luck
- Your 1031 exchanges straddles two years and you fail the exchange. Say you sell your old property on Dec 1, 2017. Your 180 days ends after the April 15 due date of your 2017 tax return, what happens? The IRS rule states that the 1031 exchange is to be reported in the year that the 1031 exchange BEGINS. In this case if you don’t close on your new property until after April 15, which is likely, you will have to file for an extension of time to file your tax return because the 1031 must be reported on your 2017 tax return. Take precautions by paying an estimate tax payment if you think there is a chance the 1031 could fail.
- The purchase price of the exchange property or properties isn’t equal to or greater than what you sold. If the new property isn’t as valuable as the old property you’ve defeated the purpose of deferring the gain.
- Beware of State rules. The “1031 exchange” comes from code section 1031 of the Internal Revenue Code aka the tax code. It is the federal tax code. Much to the dismay of tax accountants everywhere, not all states follow all rules of the federal tax code. If you’re seeking to do a 1031 exchange take a moment to find out what your state rules are. If you’re in Pennsylvania, you’re out of luck as they are the only state that doesn’t recognize the 1031 exchange rules in some form or another.
- Beware of “Boot.” In a 1031 exchange you actually have an interesting choice. You can choose to take some money out when you sell the original property. If you choose to do so you will have to pay tax on the amount of cash you receive. This, by itself, doesn’t blow up the 1031 exchange.
- Your gain is deferred, not exempt! This means if you sell the 1031 property at a later date you will pay tax on that sale as if the original 1031 didn’t take place. There is potentially one exception to this rule. If you successfully complete a 1031 exchange and subsequently die, the new property will receive a “step-up” in basis. At the sale of the property your heirs will enjoy the benefit of that step up and may potentially pay zero tax from the sale.
The 1031 exchange can be a great tax strategy and is available to everyone who has the right property in place. Especially since the economy is currently in an upswing now is the best time to consider “upgrading” your portfolio through a 1031 exchange.
Pay attention to the rules and avoid the pitfalls. The best piece of advice I could give is that you contact your tax advisor prior to starting the 1031 exchange transaction. Press them for information to ensure you are doing things correctly, and even get a referral for a good QI.
Rick Taylor is a Tax Manager and Certified Public Accountant (CPA) at the home office of Kohler & Eyre CPAs, LLP. Rick’s practice areas include small business and individual tax planning with an emphasis on entrepreneurship and real estate. Rick previously worked in the tax department at Barlow & Douglas, LLP in Las Vegas, Nevada, and is currently married with 7 children living in Cedar City, Utah.