The 1031 tax exchange is a much-used method for turning a little into a lot.  Understanding how it works is critical to making the best use of this important investment tool. 

 The 1031 tax exchange is one of the key factors keeping a fire lit under the land boom.  It takes its name from the section of the IRS code in which you will find it.  Concisely, the 1031 tax exchange allows you to sell one piece of real estate and replace it with another one while deferring capital gains tax and recaptured depreciation to a later date when you choose to cash out of your real estate holdings. 

 If you have never done the math on how much faster a tax-deferred investment grows versus a taxable investment, this next section will get your attention. 

INVESTMENT CASE STUDIES

 Let’s say that Bob and Jim both have $500,000 to invest in land.  Bob decides that he will try to grow his holdings by using the 1031 tax exchange provision to sell fairly-priced properties and buy under-priced properties.  Jim is going to do the same thing, but without the use of the 1031 exchange strategy.  You see, Jim has the attitude that capital gains taxes are likely to rise at some point in the next few years should a Democrat be elected president.  He decides to take his gains now on each sale of land before the tax rate goes up. 

 On the surface, Jim’s strategy seems reasonable, but we shall see in a moment that it will actually cost him. 

 I will run the numbers two ways.  First, I will assume that the capital gains tax stays the same over the entire period.  This assumption favors Bob’s approach.  Then I will rerun the numbers assuming that the capital gains tax stays the same for the next five years and then goes to 30% as Jim assumes.  That would seem to favor Jim’s strategy of cashing out on each sale while the rate is low.

 Next, let’s assume they each make four transactions (trading up to parcels of greater value each time) during the first five years, selling for a 25% gain in each transaction.  After four transactions, they both hold the final property for a year and then cash out in the sixth year.  Let’s further assume that they make cash purchases.  The size of their bottom line would be scary you if they finance these purchases with 25% down.  Their rate of return would skyrocket, but I’ll save that for another day.  Here are the numbers.

 Scenario 1 – capital gains tax stays at 20% (I used 20% as the total of federal and average for state cap gains tax): Bob’s property value at the end of the five years is $1,220,000.  He cashes out for $1,076,000.  Jim’s property value at the end of the same five years is $1,080,000.  He cashes out for $1,037,000.  In the end, Bob has $39,000 more than Jim has because he compounded a larger amount of money during each transaction and then paid his taxes at the end.

 Scenario 2 – capital gains tax rises to 30% after fifth year: Bob’s property value is still $1,220,000 but he cashes out for $1,040,000.  Bob still has a final property value of $1,080,000 and cashes out for 1,015,000.  Jim still beats him to tune of $25,000. 

 These numbers aren’t exactly correct because there is cost associated with each 1031 exchange.  You have to pay the intermediary.  However, in my experience, this fee is typically well under $1,000 per transaction.  Low enough we can forget it for now.

 The conclusion is inescapable.  Even in the very best case scenario for Jim, paying his capital gains taxes with each sale cost him money in the end. 

 If the capital gains tax rises in the future, it becomes even more imperative that you use the 1031 exchange after it goes up to maximize your investment return.  For example, if the capital gains tax goes to 30% after the first year, Bob really waxes Jim because Jim’s net return on each transaction after the first one is much lower than Bob’s.  In that case, Bob is still cashes out in six years at $1,040,000 but Jim cashes out at just $973,300.  That’s a full $66,700 less.

MISCONCEPTIONS

 There is a primary misconception related to the 1031 exchange that I have encountered a few times.  A number of land investors I know are under the impression that the velocity of their transactions will some day get them in trouble.  They fear that because they are buying and selling often, in the event of an audit their 1031 activities will be disqualified.  I spoke with three different accountants about this and each had a slightly different take.  My personal tax accountant said these fears are unfounded.  Here is a portion of the actual language in section 1031 of the actual IRS code:

 “…no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged solely for property of a like kind to be held either for productive use in a trade or business or for investment.”

 The problem lies in the interpretation of the word “investment”.  Some think that investment carries with it an implied holding period.  That is not the case.  As long as you satisfy the requirements of section 1031, you are not at risk of having your tax exchanges reversed at some later date because the auditors thinks you are trading too rapidly. 

 An even bigger issue revolves around the actual taxes triggered when you finally cash out.  This confusion stems from the fact that the 1031 is a tax deferral tool.  The word defer implies that you will pay them later.  When you cash out you will trigger taxes all the way back to the first sale.  Some believe that transactions involving properties held for less than a year will be taxed at the short-term rate even though you used the 1031 to move the proceeds into another parcel.

 According to my tax accountant, as long as you hold the final property for at least a year before selling it, you only pay long-term capital gains back to your original basis – the original cost you paid for the first property. 

 Other accountants interpret this differently.  They suggest that you will actually be triggering short-term capital gains on the properties you held for less than a year.  My accountant assured me numerous times that this is not true.  Be sure to come to a complete understanding of this issue with your own tax accountant before you roll a property that you have held for less than a year. 

HOW THE 1031 TAX EXCHANGE WORKS

 You must make a like-kind exchange.  Like-kind has a broad interpretation.  For example, I know a realtor who specializes in helping customers from California park the proceeds from the sales of their franchise properties in farmland until they can find a different use for the money.

 My own experience with the 1031 exchange has been tame by comparison.  I replace rural land with rural land.  It is very simple.  However, any kind of real property is exchangeable with any other kind of real property.  However, you can’t exchange the sale of ownership in a subchapter S land corporation with personal property or other shares in a subchapter S.  I tried to pull that off once and was shot down.  Stock in a limited partnership is not personal property.

 The 1031 exchange works as long as you never have actual or constructive receipt of the funds from the sale of the relinquished property before those funds are used to purchase the replacement property.  In other words, an intermediary has to handle both closings for you and you can’t have any kind of access to the money – even to borrow against it – until the entire process is completed.

WORKING WITH THE INTERMEDIARY

 You empower the intermediary to receive the proceeds from your sale and further instruct the intermediary as to which property you want to purchase as the replacement.  The intermediary then makes the purchase (or purchases) on your behalf and finally signs the purchased property (or properties) over to you after the closing. 

 In exchange for this service, you pay the intermediary a fee.  I’m sure it depends on your market and the nature of your transaction, but in my experience the intermediary receives well under $1,000 for a simple exchange. 

 Typically, a lawyer handles most of my transactions.  He finds another attorney in the area that he is comfortable with to act as the intermediary.  There are also hundreds of specialized companies set up to serve as intermediaries throughout the country.  The intermediary doesn’t have to be a local entity to handle this service for you.  If you type “1031 tax exchange” into your internet search engine, you will quickly see that you have many options. 

 You must notify your buyer and seller that you are going to perform a 1031 exchange because they have to sign off on the exchange.  They are effectively acknowledging that you have empowered an intermediary to act on your behalf in these transactions.  You typically make this notification in the purchase agreement so the buyer and seller are bound by law to cooperate. 

 If you plan to execute a 1031 exchange, or think you might, be sure to add the appropriate language to any purchase agreement you enter into regarding the relinquished property and the replacement property.

TIMELINE

 You have 45 days starting the day after you close on the sale of your relinquished property to identify its replacement.  If you don’t notify the intermediary of the replacement within this time, the 1031 exchange will fail and you will immediately trigger the transfer of your assets into your name and you will be responsible for any taxes that result from the sale.  Further, you have 180 days starting the day after your closing on the relinquished property to close on its replacement. 

 You can identify more than one replacement property.  Certain rules apply if you identify more than three, so be sure to consult with your intermediary if you are considering identifying four or more properties.

 The exchange has to take place within a single tax year.  You may be able to play some games with filing dates to make that work, so consult with your tax accountant if you are at risk.

TYPES OF EXCHANGES

 There are several types of 1031 tax exchanges.  I have detailed them below.

 Delayed exchange: The most commonly used type of 1031 exchange is the delayed exchange.  This is the type that I have discussed so far, where you sell the relinquished property first and then purchase the replacement property. 

 Simultaneous exchange: For an exchange to be a simultaneous exchange, both closings must occur at the same moment – the closing for your sale and the closing for your purchase.  Again, this satisfies the requirement that you have no actual or constructive receipt of the funds of the sale of the relinquished property before purchasing the replacement.  At one time, this was how all exchanges were done, but today, simultaneous exchanges are rarely used.

 Improvement or construction exchange: Construction exchanges permit you to make improvements on the replacement property before assuming ownership.  To do this, the intermediary makes the improvements before signing the property over to you.  For example, suppose you sell development property worth $700,000.  Your goal is to use the proceeds to buy a piece of bare land and put a spec home on it.  You can defer all the capital gains taxes on your sale as long as the replacement property, plus the improvements (the home), are worth at least $700,000.

 Reverse exchange: Reverse exchanges are the most complex.  In this scenario, you buy the replacement property before relinquishing the original property.  Again, you can’t hold title to both at the same time.  An Exchange Accommodation Titleholder makes the purchase and holds the title of the replacement property on your behalf and this starts the clock ticking.  You have 45 days from that closing to identify the relinquished property and 180 days to close the sale of the relinquished property. 

 Obviously, identifying the relinquished property is easy, but closing it in 180 days may not be so easy unless you already have a buyer on the hook. 

 Partial exchange: You don’t have to use every dollar of the proceeds from the sale of your relinquished property to purchase a replacement property.  If you use only a portion, the taxable gains are prorated accordingly.  If you perform a partial exchange, the amount of money remaining after the replacement property is purchased is called cash boot.

 When performing an exchange where the relinquished property is under mortgage, you still have to replace the entire sale price of the relinquished property (not just your equity) or the IRS will treat it as a partial exchange.  You can replace the debt with cash or new debt to defer all capital gains taxes.  However, if you don’t, you will have what is called mortgage boot, which will incur a tax liability.

 The 1031 tax exchange is a powerful investment tool that should be a big part of any real estate investment strategy.

 One situation in which you can’t replace real property for real property occurs if you try to replace investment or business property with a home that will become your primary residence.  Some have tried to use this loophole to eliminate capital gains taxes completely by then satisfying the primary residence requirements and selling the property tax-free.  The IRS allows you to defer capital gains taxes but they get kind of funny when you try to avoid them altogether.  In other words, the replacement property can’t become your personal residence or the exchange will fail.