§1031 Tax Deferred Exchanges
§1031 of the Internal Revenue Code provides an effective mechanism for deferring the capital gains tax that you may incur when selling your business/investment properties. By exchanging the property with like-kind real estate, property owners may defer their tax and use the proceeds from the sale to purchase replacement property. 1031 Exchanges are tax efficient ways for real estate owners to preserve and build their wealth.
The tax deferred exchange, as defined in §1031 of the Internal Revenue Code, offers taxpayers way to defer paying capital gains tax on the sale of real estate. To fully defer the capital gain and recapture taxes, the Exchanger must (a) acquire “like kind” Replacement Property that will be held for investment or used productively in a trade or business, (b) purchase Replacement Property of equal or greater value, (c) reinvest all of the equity into the Replacement Property, and (d) obtain the same or greater debt on the Replacement Property. Debt may be replaced with additional cash, but cash equity cannot be replaced with additional debt. Additionally, the Exchanger may not receive cash or other benefits from the sale proceeds during the exchange.
IRC §1031 applies to a broad spectrum of real assets, but it does not apply to exchanges of stock in trade, inventory, property held for sale, stocks, bonds, notes, securities, evidences of indebtedness, certificates of trust or beneficial interests, or interests in the partnership.
An exchange is rarely a swap of properties between two parties. Most exchanges involve multiple parties: the Exchanger, the buyer of the Exchanger’s old (Relinquished) property, the seller of the Exchanger’s new (Replacement) property, and a Qualified Intermediary. To create the exchange of assets and obtain the benefit of the “Safe Harbor” protections set out in Treasury Regulations 1.1031(k)-1(g)(4) which prevent actual or constructive receipt of exchange funds, prudent taxpayers use a professional Qualified Intermediary.
A typical 1031 exchange has three basic steps.
Exchanger (investor) determines they want to sell a property (the relinquished property), identifies a buyer, and engages a Qualified Intermediary Prior to the close of the sale.
Proceeds from sale are transferred to Qualified Intermediary and exchanger identifies a replacement property
Qualified Intermediary transfers funds to seller of replacement property and exchanger closes on new property.
Some Basic 1031 Exchange Rules
The Exchanger had 45 days, from the date the Relinquished Property is transferred, to identify potential Replacement Properties. Identification must be specific and unambiguous, in writing, signed by the Exchanger, and delivered to the Qualified Intermediary or another party to the transaction as permitted by Treas. Reg §1031(k)-1(c)(2) prior to the end of the 45 day Identification Period. The list of identified potential Replacement Properties cannot be changed after the 45th day. The Exchanger may only acquire from the list of indentified properties.
Purchase of Replacement Property must be completed by the earlier of the 180th day after the transfer of the first Relinquished Property or the due date (including extensions) for filing Exchanger’s tax return.
Exchangers have flexibility to identify multiple and alternative Replacement Properties.
- Three Property Rule: The Exchanger may identify as potential Replacement Property any three properties, without regard to their fair market value.
- 200% Rule: The Exchanger may identify as potential Replacement Property any number of properties, provided the aggregate fair market value (as of the end of the Identification Period) of all of the identified properties does not exceed 200% of the aggregate fair market value of all of the Replacement Properties.
- 95% Exception: If the Exchanger identifies more potential Replacement Properties than allowed under the Three Property or the 200% Rules, the Exchanger will be treated as if no Replacement Property was identified unless the Exchanger actually receives the Replacement Property by the end of the Exchange Period worth at least 95% of the aggregate fair market value of all of the identified Replacement Properties. For this purpose, fair market value of the aggregate Replacement Property is determined as of the earlier date the property is received by the Exchanger or the last day of the Exchange Period.
How Can We Help
KWM can help you find the right type of Replacement Property!
Given the time-sensitive manner of 1031 Exchanges, and the frequency with which we handle these requests, KWM has accumulated a variety of resources to help ensure that the process is executed efficiently.
We work with various institutional Real Estate Sponsors that create Real Estate Partnerships thru Delaware Statutory Trusts (DSTs) that allow our clients to invest in high quality Replacement Properties. Depending on market availability, we may be able to offer you access to multifamily apartment complexes, CVS or Walgreen deals, Healthcare Real Estate, and other types of real estate.
Why You Should Consider Investing In DSTs
- Relieve the burden of active real estate ownership.
- Obtain ownership in multifamily, triple-net lease, medical office, student housing, office, self storage and industrial property in good locations.
- Diversify your real estate portfolio by geography and property type.
- Invest in single asset and/or multiple asset offerings.
- Choose from highly leveraged, moderately leveraged, or no leveraged offerings.
- Facilitate Estate Planning
- Low minimum investment amounts allow portfolio diversification
- Benefit from professional real estate expertise, including acquisition, financing, property management and asset management.
- Eliminate the burden of hands-on management.
- Tax reporting information is supplied by the institutional sponsor.
KWM helps investors select 1031 Exchange Programs designed to achieve each client’s personal risk, growth, and income goals. We can recommend a Qualified Intermediary (QI), which plays an instrumental role in a successful 1031 exchange.
1031 Exchanges can also be a useful estate planning technique for real estate owners who want to pass on their assets. Using our estate planning knowledge, KWM can design a plan to minimize taxes owed on gains in property value.
Things To Consider When Investing In DSTs
- Like all real estate, investor’s are subject to risk and return of capital is not guaranteed.
- There are costs and fees associated with DST investment and management. The tax benefits of 1031 investments must be balanced with the costs of investing.
- Tax laws are subject to change, which may negatively impact a DST investment.
- Investors do not maintain management control over DST properties.
- DST investments are not freely transferable and restrictions apply to the transfer of interests. There are no public markets for a client to buy or sell a DST interest.
For 35 years, our primary concern has been to provide sound financial guidance based on our firm’s three pillars- independence, long-term guidance and industry knowledge. We rely on this foundation to guide you through the complicated process of 1031 Tax- deferred exchanges.