Regarding Section 1031 of the Tax Code, the tax reform laws enacted in the beginning of 2018 kept the use of 1031 Exchanges for tax deferral when commercial and investment real estate properties are sold but eliminated the use of 1031 Exchanges to obtain tax deferral when personal property is sold. Despite that change, 2018 was a record year for 1031 Exchanges. As we start this New Year, here are some of the trends, issues and key points to remember regarding 1031 Exchanges.
Trends / Market Update
What is in store for commercial real estate in 2019? Many are predicting that the market will continue to transition from a Seller’s market towards of a Buyer’s market, or at least move closer to an equilibrium. Why? Properties are expected to remain on the market longer, meaning that prices may begin to decrease. Couple that with the fact that interest rates have risen, and it is at least plausible the market will begin to balance out.
What we do know is that we have seen investment and commercial real estate transactions remain stronger than owner occupied houses. Because of this, we expect 1031 Exchanges to remain a commonly used and valuable tool for those involved in the real estate market in 2019.
Planning Ahead for a Successful Exchange
Obtaining tax deferral via a 1031 Exchange transaction requires planning, expertise and support. Although we, as a Qualified Intermediary, do provide a lot of information about like kind exchanges, we do not provide legal or tax advice. We also prepare the documentation for the 1031 Exchange, and, most importantly, safeguard the exchange funds. Laying the proper groundwork before entering into an exchange will avoid unnecessary obstacles and lead to a smooth transaction.
STEP 1. Instruct your real estate agent or attorney to include a “1031 Exchange Cooperation Clause” in the purchase and sale agreement. IPX1031 can provide the necessary language.
STEP 2. IPX1031 encourages you to engage your legal and tax advisors to determine if you would benefit by structuring your transaction as a 1031 Exchange.
STEP 3. After the contract is signed contact IPX1031 and we will answer your questions and prepare the documents that need to be signed prior to closing.
STEP 4. Inform IPX1031 if you plan to 1) use Exchange Funds to make improvements to the new Replacement Property, or 2) acquire the new Replacement Property before you sell your old Relinquished Property.
STEP 5. Start searching for Replacement Property! Once you close on your old Relinquished Property the clock starts ticking and you only have 45 days to identify your new Replacement Property.
Tax Straddling: Pay Taxes in 2019 or 2020?
If your transaction closed at the end of 2018 and you are unable to find new property to identify or purchase the property that you have identified, you may still be able to defer paying taxes on your capital gains until 2020. Since you will receive your 1031 funds back in 2019, in certain circumstances, since you did not have control/possession of your funds until 2019, the IRS may allow you to pay taxes on your 2019 tax return, which are due in 2020. This is in accordance with IRC Section 453(d) and requires your accountant to file specific tax forms. Ask your accountant if you are eligible to take advantage of this “mini” tax deferral.
1031 Refresher – Commonly Asked Questions
As the New Year begins, it is a good time to review some commonly asked 1031 Exchange questions.
1.) What property type can be purchased to complete a 1031 Exchange?
2.) How much time do I have to purchase new Replacement Property after I sell my old property?
3.) What should be the sales price of the new property in order to defer my capital gains taxes?
1.) What type of new property can be purchased to complete a 1031 Exchange?
The answer to this question is what makes a 1031 Exchange advantageous to real estate investors. To successfully complete a 1031 Exchange the taxpayer must sell real property that is held for investment or productive use in a trade or business (no primary residence or second homes), and must purchase a Replacement Property that is to be held for either investment or productive use in a trade or business.
Individual property type does not matter. Meaning, an investor can sell a single-family rental property and buy an industrial building as their Replacement Property:
Common property types we see in exchanges:
- Office Buildings
- Apartment Buildings
- Raw Land (Note, to qualify as investment property, it does not need to be income producing)
- Retail Shopping Center
- Single- Family Rentals
- Industrial Buildings
- And many more
2.) How many days does an investor have to identify and purchase their Replacement Property?
The IRS timelines are strict. Once the Relinquished Property is transferred, the investor has 45 calendar days to identify their Replacement Property and an additional 135 calendar days (180 calendar days total) to close on the new Replacement Property. Note that these dates do include weekends and holidays.
These timelines are important to understand for the following reasons:
- If your exchange is not set up with a Qualified Intermediary (IPX1031) before the Relinquished Property is transferred, a 1031 Exchange will not be an option.
- After the 45 day identification period ends, the properties on the investor’s identification form cannot be modified, and they will only be able to purchase from that list (the identification form can be amended without limit during the 45 days);
- The IRS does not provide extensions, unless there are very special circumstances (for example, some presidentially declared natural disasters or military deployment).
3.) What is the dollar amount that needs to be purchased in order to defer all capital gains taxes?
In order to fully defer the investor’s capital gains, the taxpayer will need to purchase a replacement property which is equal or greater than the value of the property they are selling, spend all of their equity and replace the value of any debt that encumbered the relinquished property..
Example: The taxpayer owns a property with an adjusted basis of $600,000 and sells it for $1,050,000. Let’s assume that they have $50,000 in closing costs (commissions, title & escrow etc.), leaving them with a $1,000,000 net. They would need to purchase a Replacement Property for at least $1,000,000 to defer all of their potential capital gains.
Let’s assume they bought a Replacement Property for $900,000. They would still defer $300,000 of capital gains, but would be potentially liable to pay taxes on the un-reinvested $100,000 (read about Boot here) . This is what is known as a “partial-exchange”.
Remember that the investor will need to work with a Qualified Intermediary, such as IPX1031, to complete a successful 1031 Exchange. The Qualified Intermediary must be engaged prior to the closing of the old Relinquished Property.