Investing in Real Estate: 1031 Exchanges, Part I

Between 2002 and 2007, real estate investors and developers built tremendous wealth and preserved significant equity by using tax-deferred exchanges under Section 1031 of the IRS Code. Section 1031 exchanges became commonplace in most transactional real estate planning and resulted in exceptional tax-mitigation opportunities.

During the past three years of economic downturn, however, exchanges were used less frequently for preserving equity from the appreciation of real estate—mainly due to offsetting losses from other transactions or a general erosion of equity altogether. More often, exchanges were used as a strategy for deferring potential tax liability from short sales and foreclosures.

Over the previous nine months, it has become readily apparent that taxpayers are again relying on exchanges due to real estate assets being sold again at a gain. Because it has been a few years since many taxpayers last performed tax-deferred exchanges, it is prudent to refresh one’s understanding of key concepts and new exchange developments.

Over the next few weeks I will cover the five most important things for real estate investors to keep in mind as they perform 1031 exchanges. The first two are as follows:

Know the rules of exchange timing. From the day a taxpayer sells property (the “Relinquished Property”), he or she has 45 days to identify one or more potential properties for purchase (the “Replacement Property”). Taxpayers must take title to the replacement property within 180 days from the closing date of the relinquished property sale.

Due to the rigid 45-day identification timeline, it is advisable that taxpayers begin looking for potential replacement property prior to the relinquished property closing. Taxpayers should note that the deadlines above are not extended in the event they should fall on a weekend or holiday. The only circumstance where an extension may be available are instances where the taxpayer or property has been affected by a presidentially declared disaster or where a taxpayer has been called into active military duty.

Consider both tax and non-tax exchange benefits. Most taxpayers recognize the tax-deferral element of 1031 as the most significant benefit of using exchanges. Essentially, capital gains tax at both the federal and state level, as well as depreciation recapture, may be deferred through a properly executed exchange. This deferral can be an indefinite benefit, as the taxpayer does not recognize the taxable gain until the property is sold without the use of an exchange. Should the taxpayer combine an exchange strategy within an estate planning structure, it is possible to leave exchange assets to heirs and essentially continue the deferral of the taxable gain. The assets will, of course, be subject to inheritance tax rules.

A significant byproduct of the tax deferral is the ability to preserve equity within the transaction. This preserved equity, once reinvested, allows a taxpayer to build wealth. Greater cash equity allows the taxpayer to:

Purchase a more expensive replacement asset
Buy an asset using less debt (which may improve cash flow)
Qualify for greater debt financing for the acquisition of a replacement asset due to the increased amount of equity available for the purchase

In addition to tax deferral, exchanges allow a taxpayer to do any combination of the following and see a benefit:

Diversify or consolidate one’s real estate portfolio among asset types (multifamily, office, retail, etc.).
Diversify or consolidate the geographic focus of one’s real estate investments.
Sell less-productive assets and replace them with those that have greater return potential.
Unwind partnership structures to allow the partners to invest separately from one another.

These are but a few of the numerous non-tax benefits available through the 1031 exchange process. Tomorrow, I’ll take an in-depth look at exchange alternatives, including reverse exchanges and multi-asset exchanges.

Ricky B. Novak serves as president of Strategic 1031 Exchange Advisors (“SEA 1031”), an Atlanta based consulting firm and qualified intermediary that provides real estate and tax consulting services for clients structuring complex real estate transactions and asset dispositions. Contact Ricky Novak at www.sea1031.comd
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