At Kolding Commercial Brokerage & Investments we have witnessed the success that some owners have enjoyed and the importance of buying and holding certain assets. However, in certain situations, we strongly believe in taking advantage of the provisions of The Internal Revenue Code Section 1031.
As a result, below is an overview of the 1031, and the role it can play in creating wealth in real estate.
The 1031 Exchange
The delayed exchange is a very special investment technique, which can only be used in real estate transactions. You are allowed to sell your property today and to reinvest the profits as long as six months later without having to pay the taxes due on the sale. Taxes are deferred to a future date that you choose. The 1984 Tax Reform Act provided Congressional approval of the concept of delayed exchanging by requiring that the investor identify his like-kind trade property within 45 days and complete the exchange by 180 days after the sale of his property. The 1986 Tax Reform Act increased capital gains taxes and is responsible for a rapidly growing interest in the use of delayed as well as simultaneous exchanging.
The delayed exchange procedure was brought to the attention of the real estate community when an investor by the name of T.J. Starker and his family attempted to trade timberland to the Crown Zellerbach Corporation in exchange for a promise to deliver suitable trade properties to the Starkers in the future. The I.R.S. challenged this transaction and after a series of tax court trials, the 9th Circuit Court of Appeals ruled in favor of Mr. Starker. The I.R.S was not happy. As recently as March of 1988 they stated that the appellate decision applied only to Mr. Starker and that the widespread use of delayed exchanges may create problems for many investors. However, Regulations issued in 1991 validated the use of the delayed exchange on a national basis. The delayed exchange is entirely legal, defensible, and has been used thousands of times over the years.
What is a like-kind property?
The Internal Revenue Code Section 1031 (a) (1) says, "no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged solely for property of a like kind to be held either for productive use in a trade or business or for investment." What does the code really mean? Property that is held for investment can be exchanged for any other property that is being held for investment and the investor will be allowed to defer paying capital gains taxes.
What are some properties held for productive use in a trade or business or for investment?
The list would include raw land, motels, office buildings, apartments, warehouses, and single family rentals to name a few. The way the code reads, any combination of these properties can be exchanged. That means an apartment can be exchanged for an office building, a warehouse exchanged for a motel, and finally raw land exchanged for a single family rental. In an exchange of real property for real property, the fact that any real property is improved or unimproved is immaterial, because that fact relates only to the grade or quality of the property and not to its kind or class.
Many options are available. Here are a few ideas:
- Exchange from a property that cannot be refinanced to improved property. This will give the exchangor the ability to refinance and perhaps acquire more property.
- Trade from non-productive land for improved property that can generate cash flow.
- Trade from a high appreciation property, such as a house, for a high cash flow property, such as a retail store or an apartment. This can be used to create cash flow for retirement.
- Exchange from a property with a high debt service for a property with lower payments and lower interest rates.
- Exchange to change the lifestyle of a client. For example, exchange for a property requiring reduced management effort for the retiree who desires to travel.
- Trade from multiple properties into one larger property, or trade one property for multiple properties depending on the desires of the client.
Investors buy real estate to earn a profit. Decisions are carefully made to determine the effects of location, potential rents and expenses, financing and a multitude of other important factors in an attempt to realize as much of a profit as possible. Once the profit is made, the typical investor sells his property, pays his taxes and reinvests in other real estate. The vast majority of real estate investors seldom make use of the wealth-building advantages of the tax-deferred exchange.
Every investor knows that leverage creates wealth. A 20% down payment can result in a 50% investment return because of leverage. Tax deferment is also leverage. Just as you use financing to leverage a purchase, you can use tax savings to acquire even greater wealth. The 40% or more of capital gains taxes, which normally would be paid to the Federal and State government, can now be used to acquire larger properties. An investor is able to accelerate his investment program by eight years or more by carefully developing an investment strategy utilizing exchanges.
Exchanges are useful in a wide variety of circumstances. They provide excellent opportunities for resourceful investors to create transactions which would not be possible through a sale/purchase format. The overriding advantage of exchanging lies in the ability to move equity from property to property without having to pay the capital gains taxes. Exchangors can create an entire investment program using the wide variety of benefits available.
The steps of an exchange
- Exchangor finds a Buyer and opens escrow.
- Ownership to the Relinquished property is transferred to a 1031 accommodator
- Ownership is immediately transferred to the Buyer of the Exchangor's
- At the close of escrow the proceeds are wire transferred from escrow to a designated bank.
The funds are held in a separate account set up for each specific transaction. The first half of the transaction is completed at the close of escrow. It is at this time that the Exchangor must locate a replacement property within 45 days, and then complete the exchange within 180 days of the close of escrow of the Relinquished Property.
- Once the Replacement Property is located and is ready to close, exchange credits will be wire transferred from the bank to the escrow handling the closing of the Replacement Property.
- Ownership to the Replacement property is transferred to a 1031 accommodator.
- Ownership to the Replacement property is then transferred to the Exchangor to complete the Exchange.
The exchange is completed with the Exchangor giving property to the Facilitator and in turn receiving a like-kind property.
The most common uses for exchanging are:
- Exchanging from property which cannot be refinanced, such as land, to improved property which will support a new loan gives the client the ability to obtain cash. Trading from non-productive land to improved property can also create cash flow.
- Trade from a high appreciation property, such as a house or apartment, to a high cash flow property, such as a retail store, or from a cash producer to one which generates more capital appreciation.
- Exchange from a property with high debt service payments for property with lower payments or lower interest.
- Exchange for a property that is easier to sell.
- Exchange to change the lifestyle of a client. For example, exchange for a property requiring no management for the retiree who wishes to travel or move.
- Exchange from many smaller properties to a larger building to consolidate ownership benefits or from a larger building to smaller properties to improve liquidity or to divide ownership among several persons.
- Trade to convert the nature of the investment. For example, trade from an investment house to a small medical building for the doctor who wishes to practice in a building he owns.
- Leases of 30 years or more may be traded for real estate. Sale lease/backs have been ruled to be exchanges, if done properly.
The uses of trading are limited to the imagination of the investor and his advisor. Almost any problem can be solved or objective reached more quickly by using the tax-deferred exchange. If you are considering a 1031 Exchange please consult your tax attorney or CPA. In addition, we have included several links which you may find helpful when considering a 1031 Exchange.