1031 Exchange

The Internal Revenue Code, Section 1031 Tax Deferred Exchange, outlines a legal strategic method for acquiring or selling “Like-Kind'' or qualified properties in order to defer capital gains tax. If the Taxpayer meets the criteria as established by the Internal Revenue Service (IRS), then capital gains taxes may be 100% deferred by “Exchanging” property. By hiring an Intermediary the funds from the relinquished property are transferred from the sales escrow account to the Intermediary Account. At the time the replacement property has been identified and it is ready for closing the Intermediary will transfer the funds to the new sales escrow.

The IRS has established timelines for the exchange. With the closing of the relinquished property, you have 45 days to identify in writing the properties you intend to purchase and 180 days (or the due date for your tax return–whichever is earlier) to complete the acquisition of one or more of those properties. In addition, the 45 day identification period and the 180 day exchange period are calendar days.

Points to remember:

• In order to defer 100% of the gains you must purchase a replacement property equal to or greater than in value
• To avoid “mortgage boot” any existing loans need to be replaced
• You cannot buy from a related party unless the related party is also doing an exchange
• When selling to a related party, the related party must hold the property for two years or it will disallow your exchange.
• Same Taxpayer who transfers relinquished property must acquire replacement property

Below is a list of properties that are considered to be “Like-kind” property and can be exchanged with one another:

• Single-Family Rentals
• Industrial Buildings
• Golf Courses
• Retail Space
• Farms and Ranches
• Hotels and Motels
• Leases with 30 years +remaining
• Multi-Family Rentals
• Offices
• Land
• Tenant in Common (TIC)

IRC Section 1031 has been in existence since 1921. Over the years, however, numerous modifications have been made to the benefit of the Taxpayer. Initially, a tax break was provided to property owners who were simultaneously trading properties. The theory was that since the nature of the investment for both owners was not changing as a result of the transaction, no taxes should be collected. This method worked well for property owners who wanted to trade their property simultaneously, but this situation was very rare. In 1979, IRC Section 1031 was first questioned. Recognizing that a Simultaneous Exchange was rare, members of the Starker Family brought to court the idea that other methods of property exchange should also qualify for tax-deferred treatment. Historically known as the Starker Decisions, members of the Starker Family vigorously fought to modify IRC Section 1031,making Delayed Exchanges, as well as Simultaneous Exchanges, eligible for tax-deferral. The courts confirmed that an exchange did not need to occur simultaneously to qualify for tax-deferred treatment. This was a monumental decision, but since the courts had made this decision at the state level and not at the federal level, a clear definition of the allowable method of a Delayed Exchange had not been defined nationwide.

Congress modified Section 1031 to provide consistent rules for Delayed Exchanges and in 1991, the Internal Revenue Service finalized regulations, which further clarified the rules under which Delayed Exchanges could be implemented. From these regulations stemmed the Safe Harbor Rules, which Qualified Intermediaries to operate under today.

• Defer both the capital gains tax and depreciation recapture from the sale
• Diversify Your Real Estate Portfolio by Selling One and Buying Multiple Properties
• Consolidate Your Real Estate Portfolio by Selling Smaller Assets and Buying One Larger Asset
• Exchange Into Property Closer to Home for Ease of Management
• Exchange Into Property with Better Cash Flow to Increase Return
• Buy Replacement Property with a New Amortization Schedule
• Buy Up in Value to Obtain a New Depreciation Schedule
• Use Exchanges as an Estate Planning Tool to Set Up Heirs for Future

Delaware Statutory Trusts

A DST (Delaware Statutory Trust) is simply a separate legal entity created under the laws of Delaware to hold title to one or more income producing commercial properties. A DST offering can be any type of commercial property; apartments, retail space, office buildings, industrial parks, etc. Much like a REIT (Real Estate Investment Trust), an individual DST may hold title to multiple properties at one time. Each investor owns a “beneficial interest” in the trust which, in turn, owns the underlying Real Property. This DST interest entitles the investor to his or her pro-rata share of income and appreciation in the DST’s assets.

The DST structure takes management responsibility for the property(s) out of the hands of investors and places it into the hands of a sponsor-affiliated trustee. The rental income generated from the DST properties is distributed on a monthly basis directly to your bank account. Instead of having all your money tied up in one property, DSTs allow you to diversify both geographically and functionally. This is a great option for those looking for passive ownership.

Tax Deferred Cash Out

Instead of having to replace a property with a like-kind property, one can take the proceeds and invest it. You have one of these two options: business or investing in a financial vehicle of choice (mutual funds, CD’s, stocks, annuities, etc). Using the funds to pay off existing debt on other investment properties falls under business use. The investor could choose to buy a much lower priced property in another market and put the balance of the funds in a financial investment vehicle of choice as no replacement loan is needed. With the TDCO strategy, the previous debt is not required to be replaced. That is because the TDCO loan is the replacement

debt. One can simply pay off the debt and invest the balance of the resources as they desire.

In many cases, owners of investment properties no longer want to own those properties and deal with the challenges that come with tenants, laws, and so on. With the TDCO, the owner can sell their investment property and invest it into other financial vehicles that can create passive income from the growth. They might also choose to invest in other passive income business opportunities.

This tool can also be used to rescue a failing exchange. Many 1031 Exchanges fail due to the 45/180 day restrictions not being met, for many reasons. With the TDCO strategy, as long as the 1031 Exchange Accommodator will cooperate and release the funds to the TDCO strategy, then the “failing” exchange can be rescued before it fails. It cannot be used to rescue an already failed exchange. Then, the taxes are deferred for decades as long as the investor follows the TDCO investment guidelines.

Disclosure: While this article provides general information about the two capital gains tax strategies, it does not constitute legal or tax advice. The best way to get guidance on your specific legal issue is to contact a lawyer.