If you’ve been in the real estate business for even a short amount of time, you’ve probably heard of Section 1031 exchanges. This transaction allows you to sell property and then buy a different property — known as a “like-kind” exchange — as part of what the IRS calls a nonrecognition transaction. Let’s take a deeper look at what you need to know.
What’s a 1031 exchange?
Internal Revenue Code Sec. 1031 allows you to exchange business or investment property (the relinquished property) for business or investment property of a like kind (the replacement property) without recognizing any gain or loss until the disposition or liquidation of the replacement property occurs. The simplest type of exchange is a simultaneous swap of one property for another. Deferred exchanges are more complex but allow for additional flexibility.
The provision allows a deferred, or “forward,” exchange where you transfer the relinquished property before acquiring a “replacement property.” You must identify the replacement property within 45 days of when you transfer the relinquished property. You also must acquire the replacement property within 180 days of the transfer or by the due date of the applicable tax return (including extensions) for the year in which you transfer the relinquished property, if sooner (the exchange period).
The same time limits apply to “reverse” exchanges. In a reverse exchange, you acquire the replacement property first, and then “park” it with an exchange accommodation titleholder (the accommodator) before transferring the relinquished property.
What about some guidance?
In a memo from the Office of Chief Counsel (Memo No. 200836024), the IRS considered a scenario in which a taxpayer structured two separate exchanges. In the first, a reverse exchange, the replacement property was acquired and parked with the accommodator, and the taxpayer identified the relinquished property in a timely manner (within 45 days).
The relinquished property had a much higher value than the replacement property, so the taxpayer planned to engage in a second transaction — a deferred exchange — to defer the gain that remained after the relinquished property was exchanged for the replacement property.
A qualified intermediary (QI) was retained to execute the transfers of the properties in both exchanges. The QI followed all guidelines to ensure the taxpayer wasn’t in constructive receipt of any of the exchange funds during the two 180-day exchange periods.
The IRS memo concluded that, as long as you follow the regulations, you can use the same relinquished property in both forward and reverse exchanges — even though allowing this structure could result in up to 360 days between the day you park the replacement property at the beginning of the reverse exchange and the day you complete the deferred exchange.
Caution, though: An Office of Chief Counsel memo is specific to the particular facts that it addresses and has no binding effect on future cases. But it can serve as a guideline for how to structure such a transaction.
How about an example?
Imagine you decide to take advantage of property values and buy an investment property in Florida for $550,000 in February 2017. You park it with an accommodator so you can determine which property you’d like to sell in order to reap the benefits of a reverse exchange.
Within 45 days, you identify a property in Colorado. In August 2017 — within 180 days of parking the Florida “replacement” property — you sell the Colorado “relinquished” property for $950,000, completing the reverse exchange.
You begin executing a deferred exchange within 45 days, identifying additional like-kind replacement properties to buy with the remaining $400,000 of proceeds from the relinquished Colorado property. And you have 180 days from the close on the Colorado property to close on one or more identified replacement properties.
So you don’t have to close on those properties and complete the deferred exchange until February 2018 — nearly a year after you bought the Florida property.
Does a 1031 exchange sound too good to be true? It’s not. But whether it’s right for your real estate portfolio may not be so clear. Talk with your real estate and tax advisors to find out more.