Introduction to Tax-Deferred Exchanges
Are you looking to sell your real estate without paying federal and state capital gain taxes? Did you know that you can sell conservation easements, development rights, water rights, and the like without paying federal and state capital gain taxes? Since 1921, Section 1031 of the Internal Revenue Code has permitted farmers (and other owners of investment and trade or business property) to defer the gain on the sale of property by acquiring the like-kind replacement property. What qualifies as investment/business property? As a general rule, almost any real estate other than an owner-occupied residence. This page will discuss the basics of a 1031 Tax-Deferred Exchange – also commonly known as a 1031 Exchange.
Basics of Tax-Deferred Exchanges
Investment or Business Property
Your current property (the “relinquished property”) must be held for investment or use in a trade or business. Farm property generally qualifies. In fact, almost any property other than your primary residence typically qualifies.
Like-Kind Replacement Property
The replacement property must be of “like-kind” to the property you’re selling. Virtually any kind of real estate will satisfy the like-kind requirement, provided it is not a principal residence, second home, or other personal use property. Similarly, most types of real estate should qualify as replacement property, for example, apartments, office buildings, TIC properties, DST properties, and shopping centers. However, things like farm equipment (tractors, etc.) are not like-kind to real estate and can only be exchanged for other like-kind equipment.
Simultaneous vs. Deferred Exchanges
Simultaneous Exchange: You may structure a simultaneous exchange where you close on the relinquished property and the replacement property at the same time.
Deferred Exchange: Alternatively, you may structure a deferred exchange (the most common type of exchange) where you close on the relinquished property today and acquire the replacement in the future. Most exchanges are structured as deferred exchanges. In a deferred exchange, the replacement property must be identified within 45 days of closing on the relinquished property and you must acquire the replacement property within 180 days of closing.
Where does a Qualified Intermediary fit in?
In most deferred exchanges, the taxpayer engages a QI or “qualified intermediary” (1031 Exchange Place!) who 1) prepares an exchange agreement and 2) holds the net proceeds from the relinquished property in an exchange escrow account pending closing of the replacement property. The Treasury Regulations provide a “safe harbor” for use of a qualified intermediary that protects the taxpayer from being in constructive receipt of the funds in the exchange escrow even though the qualified intermediary is required to disburse the funds at the taxpayer’s direction.
Rules on the use of Proceeds: Debt and Equity
In order to defer all capital gain taxes, you are required to reinvest the net proceeds from the sale in qualifying replacement property. This means all cash proceeds must be reinvested and, likewise, if your relinquished property is encumbered by a mortgage or other liability, then you must also incur a mortgage of equal or greater value on your replacement property. You may also use other funds to reduce the amount of debt on the replacement property. Further, you can “trade up” by leveraging the replacement property. Such a trade-up provides a new tax basis which may generate depreciation deductions to help offset taxable income generated by the replacement property.
You have a duplex with $200,000 in equity and $100,000 left on the mortgage that you sell for $300,000. In order to defer all the capital gain you must buy a replacement property for $300,000 or more and invest all $200,000 cash and incur new debt of at least $100,000. Simple enough, right? Any cash/debt you do not replace is referred to as “boot” and is considered taxable income.
There is really no downside to structuring the sale of your property as a 1031 tax exchange – if you fail to identify or acquire qualifying replacement property, the funds in the escrow will be returned to you.
Common Scenarios We See
Tired Rental Property Landlords (Tenants, Toilets, Trash!)
By structuring the sale of excess farmland as an exchange, you can generate cash flow to provide for current needs and, possibly, save for retirement. Your earning power will be increased by the return on the tax that otherwise would have been paid in federal and state taxes. In addition, you can exchange non-income-producing land for a replacement property that generates cash flow.
Landowners Selling and Looking for Cash Flow
Example of Use of 1031 to Generate Cash Flow: For example, assume you have no basis in a parcel of farmland that a developer would like to purchase for $1 million. On the sale of the property, you would owe a 20% capital gains tax and 5_% (Virginia) state income tax. Accordingly, you would owe approximately $250,000 in combined taxes, resulting in approximately $750,000 of the net after-tax proceeds. Alternatively, if you were to exchange the parcel as described above, you could reinvest $1 million in qualifying replacement property. Assuming that the replacement property generates an 8% net return, by structuring an exchange you would have an additional $20,000 cash flow per year for as long as you own the replacement property. Moreover, if the farmland was not generating any net income, you would have an additional $80,000 of cash flow per year for as long as you own the replacement property (and you can structure another exchange when the time comes to sell the replacement property). This is one of the only ways “land poor” farmers can provide for their current and future needs.
Example of Trade Up: In addition, you may wish to “trade up” by incurring debt. If you were to acquire $2 million of replacement property with $1 million of debt (which may be nonrecourse), your earning power would be increased through the power of leverage. Additionally, you may be able to diversify through the use of leverage — meaning you may be able to acquire more property of a different type, with different tenants, and possibly in a different location, which may help minimize the risk of having only a single replacement property (“all your eggs in one basket”).
Tenant in Common Replacement Property: You may acquire an undivided tenant in common (“TIC”) interest in a larger property. These TIC interests are structured to permit investors to acquire a small piece of a larger property with better tenants and property managers than they could have afforded on their own. For many people, a TIC replacement property is the perfect solution to their needs for cash flow, capital appreciation, and desire not to actively manage the property. Also, you may acquire a TIC interest in a number of properties to create a diversified real estate portfolio.
In conclusion, you should consider the exchange option whenever the opportunity presents itself to sell a portion of your farm, conservation easements, development rights, water rights, or the like associated with your farm.
- What is a Simultaneous Exchange?
- What is a Tax-Deferred Exchange?
- Which Real Estate Is Not Eligible For Section 1031?
- What Time Limitations Apply In A 1031 Exchange?
- Can I Use The Proceeds From The Sale Of My Relinquished Property For Any Purpose During The Exchange?
- Can I Exchange Property With A Related Party In A 1031 Exchange?