1031 EXCHANGE: Don't Get Audited!

IRC Section 1031 allows sellers of qualifying real estate to exchange it for like-kind real estate and defer payment of taxes.

THE RULES ARE STRICT:

1.      Seller must never take possession of funds from the relinquished property;

2.      Replacement property must be like-kind real estate;

3.      Real estate must be used for investment or business, and not be considered stock in trade or personal property;

4.      Property replaced must be of equal or greater value to the property being relinquished;

5.      Title of the relinquished property and the replacement property must be in the same taxpayer’s name;

6.      Replacement property must be identified within 45 days of closing on the sale of the relinquished property; and

7.      Replacement property must be purchased within 180 days of closing on the sale of the relinquished property.

One of the tricky bits is the definition of “like-kind” replacement property. Essentially, qualifying like-kind property is very broad both for the sold property and the replacement property. Both must be “real estate used for investment or business purposes.” Personal use property is generally not eligible.

Example: Curry wants to sell his office in South Jordan and purchase a residential rental property in Sandy. The 1031 exchange rules consider this a like-kind transfer because both are being used for investment or business purposes. What if Curry wanted to sell his office and exchange it for a new residence? Nope. This would be a violation.

The physical use of the real estate is not what makes it like-kind. It doesn’t have to be warehouse for warehouse or commercial office for commercial office. The condition is that the real estate being sold must have been held for investment or for use in the taxpayer’s trade or business, and not held primarily for resale, and the real estate being acquired must likewise be acquired for investment purposes or for use in the taxpayer’s trade or business and not primarily for resale.

TIMING CONSTRAINTS AND WHO HOLDS THE MONEY?

At the time of closing, the taxpayer does not need to know exactly what property will replace the property being sold. The taxpayer has 45 days to identify potential replacement property, and up to 180 days after closing to acquire the replacement property. One of the traps, however, is that the selling taxpayer cannot come into physical or constructive possession of the sale proceeds during the exchange period. To avoid a violation, the seller will have to designate a qualified intermediary to hold the funds under an exchange trust agreement. This can be done quickly, often within a day or two before closing if necessary. Although the seller/taxpayer does not have the right to access the funds during the exchange period, the seller/taxpayer does have the right to direct the qualified intermediary to apply the funds toward the taxpayer’s purchase of any replacement property which is identified by the taxpayer during the 45-day identification period.

For all taxes to be deferred, the entire sale proceeds of the real estate being sold must be used to acquire the replacement property. For this purpose, “sale proceeds” includes all cash received at closing and any mortgage indebtedness that was paid off.

IS PERSONAL PROPERTY LIKE MACHINERY AN ISSUE?

It can be. Prior to January 1, 2018 tax-deferred exchanges of certain personal property were permitted. The 2017 Tax Cuts and Jobs Act, effective January 1, 2018, ended this practice and limited tax-deferred like-kind exchanges to only real property. This raised questions about certain personal property commonly incidental to a sale of commercial property such as appliances, carpeting, HVAC systems, security systems, Wi-Fi systems, trade fixtures, machinery, etc. Would this sort of property disqualify an exchange for tax deferral or constitute taxable “boot?” Turns out, not necessarily.

Example: A cabinet making business is transferred in a 1031 exchange including the shop, warehouse, yard and fixed wood-working equipment, vacuums, and other fixtures. The fixtures and equipment are valued at $100,000 and the real estate is valued at $1,500,000. That’s approximately 6.7% of the overall value. Good!

Under Final Regulations published by the Treasury Department effective December 2, 2020, personal property that is incidental to real property acquired in an exchange will be disregarded and may therefore be included as part of the tax-deferred exchange. Personal property is considered “incidental” in commercial transactions if (a) it is the type of personal property typically transferred together with real property, and (b) the aggregate fair market value of the personal property transferred with the real property does not exceed 15% of the aggregate fair market value of the replacement real property received in exchange.

In conclusion, there are nuances to 1031 exchanges. For instance, rental property may be converted to residential property under certain conditions. Equipment and fixtures may be transferred along with the real property if certain requirements are met and thresholds are not exceeded. Funds can be held for a specific period of time as long as they are not “touched” by the transferor, etc. Be careful to involve experienced professionals to avoid the many pitfalls, tricks and traps that constrain the use of this very powerful tool.

Curry Andrews, Attorney