Industry History
In 1921, the United States Congress amended the tax laws to permit the deferral of taxation based on the sale of property if the property was instead exchanged for like kind property of equal or greater value. This was viewed at the time as a critical step in protecting the growing U.S. economy. Congress understood that it would be crucial for U.S. persons and companies to own the majority of real estate in order to control our economy. This new tax law created an incentive for Americans to reinvest in the country and not take their money abroad.
This provision, which later became known by the Internal Revenue Code (IRC or Tax Code) section that it was given §1031 also served to increase the asset base and wealth of U.S. real and personal property owners. The purpose of tax-deferral versus tax abatement is that the government, by not taxing today, has in a sense given the taxpayer a no interest loan to roll the sale proceeds into a new, larger piece of property. This encourages economic growth through transactional frequency and stabilizes the markets by discouraging the withdrawal of equity from properties.
As IRC §1031 evolved, so did the regulatory definitions for its use. In 1979, the Starker family of Washington state sued the IRS, and their landmark case paved the way for delayed (non-simultaneous) exchanges, which expanded the practical use of this tax benefit significantly. In 1984 and 1986, the IRS amended §1031 to comply with tax code revisions passed in those years. In 1991, regulations were released to address non-simultaneous exchanges. Among the regulatory issues that now define the use of §1031 were the strict timeframes that structured its use.
Qualified Properties for an Exchange
Any property held for productive use in a trade, business or for investment can be exchanged for like-kind property.
Like-kind refers to the nature of the investment. Any type of investment property can be exchanged for another type of investment property, such as: a single-family residence exchanged for a duplex; raw land for a shopping center; and an office building for apartments. Some examples of properties that do not qualify for an exchange may include a personal residence, stock in trade (i.e., developed lots), and partnership interest.
Assets other than real estate can be exchanged. IRC §1031 allows tax deferral on personal property such as planes, boats, trucks, and equipment.
Reinvestment Requirements for an Exchange
Real property that is sold must be replaced with real property, and as a rule of thumb, the value of what is bought must at be least equal to or greater than the value of what is sold, less closing costs. It is possible to sell one property and buy multiple replacement properties and vice-versa. All proceeds from the sale of the old property must be re-invested in the new property. If any proceeds are left over or used for other purposes they are subject to taxes. If there was a mortgage on the old property there must be equal or greater mortgage on the new property. A lesser mortgage balance on the new property would result in taxable ‘boot’ unless the exchanger commits additional cash to the deal. It is a common misconception that the relinquished property must be exchanged with similar type and use property - this is not true for real estate. Quite simply, investment real estate must be exchanged for investment real estate and whether it’s a farm, shopping center, distribution facility or undeveloped land is irrelevant to the exchange.
Timing Requirements for an Exchange
The exchanger must close on the replacement property within 180 days of the close date of the property he sold. During the first 45 days of the 180-day exchange period the exchanger must identify, in writing, what property or properties he will buy. Should the identified property not be available for acquisition after the 45-day period, the burden falls on the taxpayer and they must pay capital gains taxes. Like many tax benefits this one is quite strict; there are no extensions or exceptions permitted. Therefore, in order to use this benefit, one must work diligently to identify suitable replacement property within one and half months and insure that it can be acquired within the 180 day timeframe.
Current Industry Developments
In 1991, IRC §1031 was modified to require the use of a Qualified Intermediary (”QI”) in performing a non-simultaneous tax deferred exchange. A QI is defined as a person who is not related to the taxpayer, and who does not fulfill a role as the taxpayer’s accountant, attorney, or real estate broker. One of the most critical elements of the exchange process is that the taxpayer/exchanger may not receive or control any of the cash proceeds resulting from the sale of his property; otherwise, an actual or constructive receipt of proceeds will destroy an exchange. This issue is so important that the regulation contains a definition of who can or cannot act as a QI. The regulations provide that use of a QI can result in a “safe harbor” from constructive receipt. The QI will hold the proceeds in a qualified escrow or “trust” account until such time as the exchanger purchases replacement property. The documentation prepared by a QI also creates a paper trail that will characterize the sale of a property as a tax deferred exchange as opposed to a taxable sale.
In March 2002, the IRS and Treasury Department issued safe harbor guidelines (Rev. Proc. 2002-22) for the structuring of undivided fractional interest transactions. TSG is proud to have provided the model for which these guidelines were based.