Do you remember Wimpy from the Popeye cartoons? “I’ll gladly pay you Tuesday for a hamburger today.” Wimpy was on to something with this deferred payment idea. How great would it be if you could do that with capital gains taxes from investment real estate? Well…
Exactly such an opportunity exists in the form of a 1031 exchange (or tax deferred exchange). Exchanges let an owner sell the real estate and buy a different, generally better performing property, while carrying the basis — and the tax bill — forward. In the simplest terms, a 1031 exchange is just capitalizing on the principle of time value of money—you can invest the proceeds otherwise allocated for taxes, gain a return (ideally), and pay the IRS later. There are some rules to follow, but the gains usually make it worth the trouble.
Like many areas of commercial real estate, a tax deferred exchange is a complex topic. You’ll find the basics outlined here, but it’s wise to talk to an attorney or an accountant that is experienced. Otherwise, you could find yourself with an unwelcome letter from the IRS.
1031 Exchange (Tax Deferred Exchange) Basics
It’s always been legal to swap one property for another at the same instant and carry your basis forward. The innovation of the tax-deferred exchange, which was made officially legal by a 1979 Tax Court federal court ruling in favor of T.J. Starker, is that it lets an owner sell, wait, then buy. Under a 1031 exchange, there are three basic rules that have to be followed:
- The proceeds have to be invested into a like-kind property.
- The replacement property must be identified within 45 days of closing, and the purchase of one or more must be settled within 180 days of closing of the relinquished property.
- Money cannot be taken out or it’ll be taxable as “boot.”
Don’t be Fooled by “Like-Kind” Properties
If you don’t buy the same kind of property that you sell, the IRS won’t consider it a valid 1031 exchange. Fortunately, when it comes to investment real estate, the IRS defines like-kind very broadly. For example, if you sell a 40-unit apartment building in Harrisonburg, which of the following investments do you think would be like-kind for an exchange?
- A 50-unit apartment building in Winchester, VA
- A 200-unit apartment building in Corvallis, OR
- An office building in Harrisburg, PA
- A NNN Chipotle in Phoenix, AZ
- A beach-front rental condo in Naples, FL, a vacant industrial facility in Anchorage, AK, and a rental ski chalet in Vail, CO
If you answered “all of the above,” you’d be correct. Like-kind property is any real estate in the U.S. that is held for investment purposes or for use in a business. This gives you broad latitude in choosing your replacement property. Your house and personal vacation cottage don’t qualify as a property held for investment purposes.
1031 Exchange (Tax Deferred Exchange) Timing
The IRS has two key timing rules that apply to 1031 exchanges. Violating either of them could invalidate your exchange and leave you liable for all of the taxes that you would have paid if you didn’t exchange. The first is that you have to create an identification list of properties within 45 days of when the sale of your “downleg” or “relinquished” property closes. The IRS limits how many properties you can identify (most investors choose to list three) and will only let you buy the properties that are on that list. You also must close on the purchase of your “upleg” or “replacement” property within 180 days of when your downleg closes.
Pulling Out Money
Part of what makes an exchange an exchange is that you don’t get any money out of it. When you sell, the proceeds go to a special third party, called a qualified intermediary that holds the funds and disburses them to buy the replacement property. Any funds that you take out of your exchange is called “boot” and gets taxed as a capital gain.
To avoid receiving boot, you have to spend all of the money that came out of the sale of your replacement property. You must also replace the previous debt on your replacement property with a mortgage that is at least as big as the one that existed on the property sold. To do this, the replacement property generally has to cost as much or more than the property sold. If you want to pull money out of the exchange, a cash-out refinance after the transaction closes can be a strategy. Talk to a CPA before you do this, though, since you could end up invalidating your exchange.
You might be scared by the IRS’ rule that you have to sell your property before you buy a property. If you can’t find anything to buy, or if your identified properties sell to someone else, you could get stuck paying taxes or scrambling to buy something you don’t want. As you can imagine, sometimes bad decisions get made in an effort to avoid or defer taxes, especially when there are time constraints. As is the case with many difficult situations, they can largely be avoided through proper research and planning…and sometimes with safe harbor guidelines from the IRS.
If you can afford to buy before you sell, the reverse exchange could solve that problem. Unlike a regular 1031 exchange (tax deferred exchange) that requires you to sell, then buy, the reverse exchange flips it around and lets you buy before you sell. Reverse exchanges are complicated and expensive to set up, but many real estate investors find the piece of mind that they offer to more than justify the inconvenience.
Whether you do a regular or a reverse 1031 exchange (tax deferred exchange), the tax savings can be considerable. If you’re thinking about selling real estate due consideration should be given not only as a tax deferral strategy, but also as a means to leverage those deferred taxes over time. Wouldn’t you gladly pay the IRS in 30 years for a property sold today?
Tim Reamer provides commercial real estate brokerage and consulting services with Cottonwood Commercial and specializes in investment property (multifamily | commercial | NNN), retail/restaurant site selection, and commercial buyer/tenant representation. Learn more at www.timreamer.com.