When you are selling vacant land or non-owner occupied property held for commercial or investment purposes, you need to consider structuring the sale as an Internal Revenue Code ("Code") Section 1031 Tax-Deferred Exchange, which can result in significant financial benefits for you. Funds you otherwise would have paid to the Internal Revenue Service ("IRS") can instead be used to purchase replacement property.
What is a Section 1031 Tax-Deferred Exchange?
A Section 1031 Tax-Deferred Exchange is an investment and tax deferral strategy permitted by Section 1031 of the Code which reads in part as follows:
1031. Exchange of property held for productive use or investment
(a) Nonrecognition of gain or loss from exchanges solely in kind.
(1) In general, no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.
This provision enables you to sell commercial or investment property, called the "relinquished property," and defer the recognition of taxable gain (or tax deductible loss) as long as you subsequently acquire another property, called the "replacement property," which will be used for commercial or investment purposes within certain time frames set forth in the Code. Tax recognition is deferred until sometime in the future, usually when the replacement property is sold.
How Does It Work?
Of course, a simple exchange of property in which you convey your property to Party B in exchange for Party B's property (without any "boot" paid by either party— if there is "boot," you will have to pay taxes on it), qualifies for a Section 1031 exchange. However, such "true exchanges" are very rare.
Most exchanges occur as "deferred exchanges," in which you sell the relinquished property to one party and then, within a statutorily mandated time period, you purchase a replacement property from a third party. To accomplish tax deferment in such cases, you must honor certain "formalities" required by Section 1031. Many will say that in a common Section 1031 exchange, form truly prevails over substance.
Such a Section 1031 exchange has to be set up before the sale of the relinquished property because you can never come into possession or control of the proceeds of the sale. In the time period between the sale of the relinquished property and the closing of the purchase of replacement property from a third party, your proceeds must be held by a "qualified intermediary," who cannot be you or any agent of yours such as your attorney, until the closing for the replacement property.
The qualified intermediary holding the money will be the "straw man" purchaser of the replacement property, but will assign the purchase contract for the replacement property to you and pay the seller of the replacement property for it using the sales proceeds from the relinquished property. The money from the sale of the relinquished property never comes into your possession or control.
The paperwork for a deferred exchange is complicated and must be precise. The qualified intermediately usually prepares the required documentation to effectuate the exchange because it (a) is usually a party very familiar with the intricacies of Section 1031, and (b) wants to insure that it does not become liable as a property owner of the replacement property. Your closing attorney can recommend competent, efficient qualified intermediaries. Many title insurance companies have divisions that handle Section 1031 exchanges.
Timing is Everything!
As mentioned earlier, timing is everything in terms of completing a successful Section 1031 deferred exchange. Remember that the exchange must be contemplated and planned for prior to the closing of the sale of the relinquished property. After the closing of that sale, you will then have 45 days to identify the replacement property or properties and then you must actually purchase the replacement property or properties within 180 days after the initial closing. You do not have to acquire all of the properties identified during the 45 day period, but, in general, you cannot acquire properties not identified within the 45 day period.
Another rule of effectuating a Section 1031 exchange is that the relinquished and replacement properties must be of a "like-kind." This requirement is fairly easy to meet in a commercial real estate transaction because the IRS treats most commercial and investment real property as like-kind with other commercial or investment real property; i.e., you can sell a shopping center and purchase farmland or residential rental property. Note also that under Section1031, real estate located in one state is considered like-kind to real estate located in another state.
The "Qualified Use" Requirement
The "qualified use" requirement mandates that you must have held the relinquished property, and will hold the replacement property, for use either "in a trade or business" or "for investment purposes." This rule precludes you from deferring taxable gain when selling a personal, principal residence. It also precludes a dealer/builder from taking advantage of a deferred exchange when selling its inventory or dealer items.
There is not a lot of guidance from the IRS or the courts regarding the "held for investment" prong of the "qualified use" requirement. However, it is important to look at the length of time you owned the relinquished property before the sale and Section 1031 exchange, and the length of time you hold the replacement property after the Section 1031 exchange. In general, ownership of six months or less is probably not going to meet the requirement, ownership of one to one to two years is more reasonable, and ownership of two or more years is probably going to meet the requirement.
Another factor in determining whether the qualified use requirement is met is your market activity in connection with the relinquished and replacement properties. The key question is whether or not you actually used the property for a business or investment property or whether you are really purchasing and selling with the intent to sell these properties quickly— i.e., as "inventory." The important facts will likely be how quickly you entered into a listing agreement with a real estate professional after purchase of either the relinquished or replacement property and/or how quickly you entered into a contract for purchase/sale.
There are several other rules you must follow in order to fully defer the gain. First, you should acquire replacement property that is of equal or greater value than the relinquished property.
The seller/taxpayer of the relinquished property must also be the buyer/taxpayer of the replacement property. That is, you cannot sell the relinquished property as an individual and then purchase the replacement property in the name of a limited liability company. Similarly, the seller of the relinquished property cannot be one limited liability company and the buyer of the replacement property an affiliated company. However, multiple owners of the relinquished property can take advantage of a Section 1031 exchange in connection with their respective interests as long as the "like-kind" rule is met with regard to the replacement property.
Reverse and Construction Exchanges
Beyond the deferred exchanges described in this article, there are other types of more complicated exchanges, such as reverse exchanges and construction exchanges. An in-depth discussion of these types of exchanges is beyond the scope of this article, but below is a brief overview.
In a reverse exchange, you acquire the replacement property through a qualified intermediary and an Exchange Accommodation Titleholder ("EAT") before you sell the relinquished property. Clearly, you must have the financial means necessary to purchase the replacement property prior to the sale of the relinquished property.
In a construction exchange, you sell the relinquished property, then, again using a qualified intermediary and an EAT, you acquire replacement property on which you will construct improvements. You are able to use exchange funds to not only purchase the relinquished property, but also to then construct improvements on the property. The exchange still must be completed within the 180 day period described above.
In both reverse and construction exchanges, the qualified intermediary, using an EAT, takes title to the replacement property and ultimately conveys it to you. This practice differs from a typical deferred exchange wherein the qualified intermediary does not need to actually take title to either the relinquished or replacement property.
Remember, there are many very important requirements in taking full advantage of the Section 1031 tax deferred exchange provisions, and the economic benefits can be significant. Our real estate and tax teams routinely handle these transactions and would be happy to assist you with structuring a Section 1031 deferred exchange.
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This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.