LIKE KIND EXCHANGES UNDER INTERNAL REVENUE CODE SECTION 1031
Prior to 2000, the real estate market was so hot that a property might appreciate more than 20% overnight, especially at the height of the market in 2006. Now, we are happy that some real estate experts are predicting an appreciation of 20% for this year. It appears that the real estate market has turned a critical corner. We are no longer seeing depreciation in the local real estate market. When the market takes a turn such as this, it’s time to create a strategy that fits a client’s changing needs in terms of tax planning. Since the capital gains tax was increased at the beginning of the 2013 tax year, an avenue for postponing a client’s tax liability should be considered.
Many investors confident with purchasing real estate during the downturn will soon be seeing their investment appreciate. Certain segments of the real estate market are still considerably depreciated; certain investors, therefore, may feel inclined to continue adding to their portfolio. If a client wishes to sell a property they’ve been holding to utilize the cash from that investment in order to invest in a new property, there is a way to devise a strategy for deferring the capital gains tax on that investment. This would be through a 1031 Exchange. This vehicle effectively allows an individual to defer the tax on the capital gain(s) for as long as the investment(s) are held.
Here is a simple illustration of how the 1031 Exchange works:
“A” buys a commercial building in 2008 for $200,000, and leases it for 5 years. After 5 years, the property appreciates 20% and is now worth $240,000. “A” sells the commercial building for $240,000, and purchases a larger commercial building for $500,000. Rather than immediately paying capital gains tax on the $40,000 profit, “A” buys a new and better investment with the proceeds of the sale.
There are many other “non-tax” reasons to utilize a 1031 Exchange. Some examples are:
-A fully-depreciated property may be exchanged for a higher value property that can now be depreciated.
-Refinancing issues such as moving from a vacant property (that is not able to be financed) to improved property.
-To create or increase cash flow (i.e., selling a building that may be owner-occupied in order to purchase a building that may have multiple uses, including generating revenue through rents).
-Better appreciation. Depending upon market conditions, certain areas may have better appreciation.
-Meet Investor new location criteria. An Investor may move to another location, and wants to be closer to the property in order to better manage it.
-Lifestyle changes of Investor.
-Investment changes in regard to portfolio (larger parcel to smaller parcels, etc.)
-Property Investor may use for its own business.
-Partial interest in one property to Fee Interest in another.
-Management fee changes.
-Diversification or minimize risks in terms of property type. Market conditions may be better or worse for certain property types (residential vs. commercial).
It is critical the “Exchanger” comply with very strict time limits. There are 45 days to identify a “replacement” property from the time the Exchanger sells or “relinquishes” the property that is being sold. The Exchanger then needs to have the purchase of the “replacement” property completed within 180 days of closing the “relinquished” property.
In addition to the timing issues, in order to qualify as a “replacement” property and defer payment of the capital gain tax, the property must:
-be of equal or greater value than the relinquished property;
-all of the proceeds from the relinquished property must be used to purchase the replacement property;
-and, the debt must be equal to or less on the replacement property as was on the relinquished property (cash may be used to replace existing debt from the relinquished property on the replacement property.
Furthermore, the “relinquished” property must have been used by the Exchanger either as investment property, or for business purposes. The same holds true for the replacement property. Property qualifies as “Like-Kind” if Exchanger intends to hold the property(ies) for investment, or for productive use in a trade or business. This is more important than the type of property.
Due to the inherent complexities involved, it is strongly recommended that a team of experts be involved in order to ensure that the goal of deferring capital gains taxes is not sidetracked by IRS code violations or by timing issues.
Those experts include the attorneys at Demorest Law Firm, who can advise clients regarding the legal aspects of the transaction; the real estate agent of the Exchanger’s choosing, who can help sell and market the current property and actively assist with selecting an adequate replacement property; Complete Title Services~Commercial Division, to assist with making sure the title to both properties is cleared in time for a closing, and that the vesting between the relinquished and replacement is consistent; and the Qualified Intermediary, Investment Property Exchange Services, Inc., who needs to hold the funds and disburse them at the appropriate time.
This is a guest post by Ellen S. Mahoney, Commercial Division President of Complete Title Services of SE MI, LLC, in Birmingham, Michigan who may be reached by emailing: emahoney@ctitleonline.com. Ms. Mahoney is the Proud 2013 Chair of Outreach Committee for Commercial Real Estate Women (CREW)-Detroit, the LBN Birmingham Mid Day Chapter President, and an Active Member of Women’s Council of Realtor’s Birmingham/Bloomfield (WCR).
