Over the last few decades, the Internal Revenue Service (IRS) has made it increasingly difficult to escape capital-gains tax liabilities on the profit from the sale of an investment property. One of the few remaining options to avoid paying a large tax bill is by utilizing Section 1031 of the IRS Code, which is often referred to as a ‘like-kind exchange.’
What Is a 1031 Exchange?
It is one of the last ways that the IRS allows a taxpayer to avoid paying tax when selling property at a gain. However, the catch is that it can only happen when you sell one property held for investment or use in a trade or business with the intent of using those funds to purchase another ‘like-kind’ property. The asset to be sold must be a direct interest in qualified real estate and not stock in a closely held corporation, intangible property such as patents, or an interest in an LLC that owns real estate, securities, or stock.
Like-kind, in general, includes most real property to be held for investment or use in a trade or business — for example, you could ‘exchange’ a shopping center for an apartment complex. Let’s say that you own a multi-family investment property. You can do a 1031 exchange if you sell that property with the intention of purchasing another investment property. However, this new property (or properties) must have a purchase price that is equal to or greater than the net selling price of the property you are selling, and both the old and new properties must be in the U.S.
To make the 1031 exchange work, you need to conduct the sale and purchase of the properties utilizing a qualified intermediary (QI). These are companies that receive cash from a property sale and hold onto those funds until they are used for the purchase of a like-kind property. There are restrictions on whom you may engage to act as your QI. The QI cannot be someone who has acted as your attorney or accountant in the past. Often, qualified intermediaries are companies that have been established as affiliates of title companies.
Here’s an example of how a 1031 exchange can work: Bob Jones and other family members have owned a retail shopping center in Springfield for nearly 30 years in a partnership. It’s now worth about $3 million, and the partnership’s cost basis on the property is $800,000. Bob, who has managed the property for the partnership, is getting ready to retire to Florida and would like the partnership to continue to own an investment property but wants to own one closer to his new home.
Using a 1031 Exchange, the partnership sells the shopping center for $2.8 million (after paying costs related to the sale), and the funds are transferred to a qualified intermediary at closing. Bob now has 45 days to identify potential replacement properties (limited to 3 properties or 200% of the net selling price) that the partnership can purchase. He negotiates to purchase an apartment complex in Florida for $2.8 million and now has up to 180 days from the date of the sale of the shopping center to close on the new property. Once the purchase is complete, the funds go straight from the Qualified Intermediary to the seller of the Florida property.
Since the partnership never officially held any of the funds from the sale of the old property, Bob and his partners will not be responsible for paying taxes on the $2 million gain that was realized on the sale of his Springfield property — as long as the partnership followed all of the specific rules that have been set forth by the IRS in Section 1031.
Choose Your QI Carefully
At first blush, it’s easy to see the appeal of a 1031 exchange. But as with all investments, there are risks. The biggest concern is the need to have confidence in the stability and reliability of their qualified intermediary. Many people just take the QI at their word when doing a 1031 exchange and fail to thoroughly vet the company and its policies. But considering that the QI will typically hold a large sum of money — and for many, these are retirement or other nondiscretionary funds — it is in your best interest to do a thorough review of the QI.
Historically, it has been critical for those considering 1031 transactions to perform due diligence on their QI to ensure that they are financially strong and have a strong reputation in the industry. There have been cases in past years of disreputable QIs that have absconded with client funds. However, due to the recent tumult on Wall Street and in the banking sector, some qualified intermediaries who had been considered financially strong companies with solid reputations have faced considerable financial problems.
Anyone considering a 1031 exchange should look behind the curtain to see how solvent and secure their QI company is. Is the QI a separate subsidiary? Is there a guarantee by the parent company? Are your funds in a segregated account or combined with others? If you don’t ask probing questions, you are taking significant risks with your hard-earned assets. It is also critical to use advisors (CPAs and attorneys) that have experience in dealing with these issues.
Another way that 1031 Exchange rules might be leveraged to help an investor in today’s tough economic times is in the case of a foreclosure on an investment property. For example, let’s say you own an investment property with a $2 million mortgage. Due to the depressed nature of the real-estate market, the property is now worth less than the mortgage, you are having trouble paying the mortgage and your cost basis on the property is $500,000. You will still be faced with capital gains even if you have to give the property back to the lender and receive no cash. In this instance, you could easily be responsible for $450,000 of income taxes.
There are ways that you might be able to utilize a 1031 exchange to exit your current investment and purchase other properties with lower capital requirements and still avoid any current capital-gains taxes. So instead of having to pay $450,000 in taxes on that $1.5 million differential, you might be able to invest in a highly leveraged property and avoid or delay your tax burden for a significantly lower amount.
Do Your Homework
Any time you are considering making a move involving investments, taxes, and the IRS, you need to do your homework and ensure that you are making the right decision before jumping in with both feet.
For example, you can’t use a 1031 exchange to turn a business property into a personal property. If you want to sell an investment property and then use those funds to buy a condominium that you halfheartedly try to rent, only to find a few months later you are living in this new property full-time — the IRS will not look kindly upon you!
However, if you are in a situation where you truly will benefit by unloading one investment property where you have realized significant capital gains and are looking to invest in another property of similar value, then a 1031 may just be the right decision for you — again, as long as you follow the stringent rules imposed by the IRS.
As always, your best advice is to talk to your tax planner and accountant to figure out what solution is right for your situation.
Edmund S. Kindelan, CPA, is a member of the firm and leader of the Real Estate Services Group at Kostin, Ruffkess & Co., LLC, a certified public accounting and business-advisory firm with offices in Springfield, as well as Farmington and New London, Conn. Beyond traditional accounting, auditing, and tax consulting, the firm also specializes in employee benefit plan audits, litigation support, business valuation, succession planning, business consulting, forensic accounting, wealth management, estate planning, fraud prevention, and information-technology assurance; www.kostin.com
