The general idea behind the 1031 exchange is based upon the presumption that, when a property owner reinvests the sale proceeds and retired debt into a like-kind property, his or her economic situation goes unchanged.
According to the Greenstreet Commercial Property Price Index, as of July 2017, commercial real estate prices have risen a staggering 107% from their trough in May 2009. In fact, commercial real estate prices are currently 26% higher than they were at the peak of the real estate bubble (August 2007).
The dramatic rise in value has led many commercial property owners to look for ways to defer what could ultimately be a considerable tax burden once they sell their property. For those property owners, a 1031 exchange may provide an opportunity to defer taxes while remaining invested in income-producing real estate.
Although the first “like-kind exchanges” were authorized by the Revenue Act of 1921, Section 1031 exchanges, as we know them today, began with an amendment to the federal Tax Code in 1924.2 This amendment set the groundwork for the definition and structure of tax-deferred, like-kind exchange transactions. Internal Revenue Code 1.1031 states, “No gain or loss shall be recognized on the exchange of property held for the productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment.”3
The general idea behind the 1031 exchange is based upon the presumption that, when a property owner reinvests the sale proceeds and retired debt into a like-kind property, his or her economic situation goes unchanged. However, if the replacement property is sold, and the owner does not initiate another 1031 exchange, all original deferred gains plus any additional realized gains on the replacement property would become taxable.
Section 1031 exchanges are a popular tax-deferral strategy for certain property owners who want to accomplish a wide range of business and/or investment objectives, which may include:
A properly structured 1031 exchange, or other tax-deferral strategy,provides property owners the opportunity to defer 100% of federal and/or state capital gains taxes, as well asdepreciation recapture taxes. This can effectively provide the property owner with an interest-free, no term “loan”on taxes due until the property is ultimately sold for cash. The additional cash saved from deferring taxes mayincrease the property owner’s return on equity over the term of the investment period.
Many property owners exchange from a property where they have a high equity position, or no debt, intoa larger and more valuable property. Presumably, a larger property is a higher-quality asset and may provide betterreturn prospects, potentially higher cash flows and more depreciation benefits.
Property owners have a number of opportunities todiversify through exchanges. They can diversify into another geographicregion or acquire another asset class. They may also invest in a portfolioof assets via a Delaware Statutory Trust or through a 721 exchange (i.e.contribute property to an existing REIT in exchange for REIT operatingpartnership units), both of which can provide cash flow diversificationfrom multiple assets.
Some property owners acquire several propertiesover the years and find the management burden of dealing with thetenants, capital items and accounting to be too time-consuming. In aneffort to reduce the time burden of actively managing real estate, theyhave the ability, through a 1031 exchange, to sell multiple assets andexchange them into a single, larger asset or invest in a passive interestin a Delaware Statutory Trust. This may provide the benefit of deferringtaxes, maintaining cash flow and reducing the time burden of managingthe real estate portfolio.
Taxpayers can continue to defer taxes until their death,at which point the estate receives the asset at a stepped-up basis, whichcan then be liquidated with minimal taxes to the estate.
There are six rules a property owner must adhere to in order to qualify for a Section 1031 Exchange:4
Like-kind property does not mean the replacement property must be the exact same kind of real estate in order toqualify. However, the relinquished property and replacement property must be vacant land or buildings used fortrade, business or investment. Rental properties may also qualify, provided the owner can prove the property hasbeen expressly rented out for the purpose of investing and not resale. Therefore, property owners looking to “flip”houses will not qualify for a 1031 exchange. Also ineligible are an individual’s personal residence and any propertieslocated outside of the United States.
Property owners wishing to sell their property and utilize a 1031 exchangemay not have actual or constructive control of any proceeds receivedupon the sale of the relinquished property. By law, the selling propertyowner must use a third-party, referred to as a Qualified Intermediary (QI),to take receipt of the money and handle the exchange. The QI is requiredto hold the proceeds from the sale of the relinquished property in aseparate account until the purchase of the new property is complete.
While the property owner will not have access to these funds, he or sheis entitled to the interest generated by these funds and must treat theinterest as ordinary income during the escrow period. The property owneris also responsible for preparing the documents at the time of sale for therelinquished property and the purchase of the replacement property. It isalso important to note that the QI must not have had a family or businessrelationship with the property owner within two years of the exchange.
The property owner who is selling has 45 days from the date of closing on the old property to identify a list of newproperties he or she may wish to buy with the proceeds. Up to three properties can be identified, regardless of theirprice. If the property owner wishes to identify additional properties, he or she must abide by the 200% rule. This rulestates that if more than three properties are identified, the total value of all the properties may not exceed 200%of the value of the property being sold. Therefore, keeping the identified properties to three or less tends to be themore logical option for many.
From the date of closing on the old property, property owners have 180 days to close on one or more of the threeproperties listed during the 45-day identification period. The clock for the 180 days begins on the date of closingand runs congruently with the 45-day identification period. Simply put, the property owner has a total of 180 days,or 135 days after the identification period, to close on the new property(s). It is very important to be vigilant duringthese 180 days, as there are no extensions or exceptions.
The title holder of the old property must be exactly the same as the titleholder of the new property. In some instances, the property owner mayrequire a spouse or business partner to be on the new title in order, forexample, to secure a loan. The property owner should seek advice from atax advisor in order to find the most effective way to change an existingtitle during the 180-day time period.
In order to qualify for the 100% tax deferral, the property owner mustinvest all cash proceeds from the sale into a new property, or properties, ofequal or greater value. The property owner may deduct closing costs andselling commissions from the property being sold. Any excess cash from thepurchase of the replacement property, referred to as the “boot,” may betaken out but will be taxable as ordinary income if the property was heldfor less than a year or as capital gains if held for more than one year.
Upon the property owner’s death, his or her heirs typically take ownership of the property at a comparable market price, therefore “stepping-up” the basis and avoiding all potential taxes assumed by the original owner.
For example, let’s say a property owner bought a property for $100,000. When the property owner decided to sell, the property was worth $300,000. Recognizing a substantial tax liability, the property owner initiated a 1031 exchange into a new property to take advantage of the tax-deferred exchange. Years later, at the time of the owner’s death, the replacement property is worth $500,000 with a basis of $100,000. At this point the heirs who inherited this property, if they choose to sell, would owe taxes on any additional capital gains from the point in which they became the property owners. The previous capital gains tax would no longer be owed and is removed from the equation.
Since the early 2000s, 1031 exchanges into professionally managed portfolios have been used by those wishing to shed landlord responsibilities while continuing to reap the benefits of a 1031 exchange.7 Before the Delaware Statutory Trust (outlined later) became the preferred funding vehicle, another type of investment called a TIC was often utilized.
Although the TIC structure of a 1031 exchange was established in the early 1990s, it became popular when the Treasury Department issued Revenue Procedure 2002-22, which effectively approved the use of the TIC structure for 1031 exchanges.8 Under the TIC structure, each TIC owner holds a direct ownership position in the property, which qualifies as a like-kind exchange. Each TIC owner holds a title in the form of a deed to the property and retains voting rights on major decisions concerning the property.
The TIC structure typically works well for property owners looking to roll smaller exchange positions into larger assets alongside other property owners looking to do the same thing. Also, the TIC structure may allow property owners to exchange into a property alongside operators who have specific property expertise or unique business plans that meet the TIC owners’ investment objectives.
However, during the 2008 downturn, many of these structures began to fall apart and quickly proved to be an administrative nightmare. There are certain limitations to note within the TIC structure:
The TIC structure allows only 35 property owners, and each owner is a borrower on the mortgage, which requiresunderwriting and monitoring for each TIC owner.
It is often recommended that each TIC owner set up a single member LLC to protect his or her personal assetsshould the TIC file for bankruptcy.
The IRS limit of 35 TIC owners can put constraints on the size of property that may be purchased, forcing highminimum investments.
TICs require a unanimous vote to raise more capital or sell the property, which can be difficult if each owner hasdifferent motivations and objectives.
During the 2000s, TICs initially enjoyed immense popularity because cash flow and property values were strong. However, during the 2008 downturn, many TIC structures fell apart because they could not receive the unanimous approval necessary to navigate the slowdown in the real estate market.
1031 exchanges can be a valuable tax and business strategy for property owners who wish to sell and buy property(s). However, in some cases, property owners wish to rid themselves of the “three Ts” (toilets, trash and tenants) and move to a more passive investment for either management relief or for additional diversification. Often times, these property owners have an eye on retirement and no longer wish to manage a property. Or, the property owner inherited the property and wants to shed the responsibility of ownership. In these cases, a property owner may wish to consider a DST.
In 2004, the IRS released Revenue Ruling 2004-86, which provided instruction on how to structure a DST so that it would qualify as a replacement property of a 1031 exchange.10 This was music to the ears of property owners who had become frustrated with the limitations and administration of TICs, especially in the period following the Great Recession.
A DST is derived from Delaware Statutory law as a separate entity created as a trust. Each property owner looking to complete a 1031 exchange can buy an ownership interest in the trust that holds title to the underlying properties. Unlike the TIC structure, the owners of a DST are passive investors with limited, if any, voting rights within the DST. However, because the trust is a single entity, lenders may look more favorably on the DST structure than the TIC structure where there are multiple borrowers and property owners.11
Rather than exchanging into a single asset, property owners who exchange into a DST may have an option to invest in a portfolio of assets that have the ability to provide a diversified income stream and access to potentially higher-quality assets. While this may seem similar to other multi-building real estate offerings, such as a public or non-traded REIT, a beneficial interest in a DST is considered a direct interest in the replacement properties, therefore qualifying the property owner for a 1031 exchange.10
Ultimately, DSTs are passive investments. The portfolios are typically established with a goal of providing ongoing, consistent distributions to the property owner. Each DST property owner buys an interest in a trust that holds title to the property.
Though less limited in structure than a TIC, it is important to be aware of the limitations of a DST:12
Once an offering is closed, there can be no additional equity contributions to the DST by either current or new investors.
The trustee of the DST cannot renegotiate the terms of the existing loans, nor can it borrow new funds from any otherlender party.
The trustee cannot reinvest the proceeds from the sale of investments. All distributions must be paid to the investors.
Any liquid cash held in the DST between distribution dates can only be invested in short-term debt obligations.
All cash, other than necessary reserves, must be distributed to the co-investors or beneficiaries on a current basis.
The trustee cannot enter into new leases or renegotiate the current leases.
There is a safety net if these limitations place a DST at risk. The state of Delaware permits a DST to convert into a “Springing LLC.” This can allow the DST to raise new funds and/or refinance its properties. However, this may have tax consequences and is often only put in place when absolutely necessary.
Property owners who are looking to defer capital gains taxes while also gaining diversification in a real estate portfolio may consider completing an “UPREIT Exchange.” Section 721 of the Internal Revenue Code allows for property to be directly contributed into a trust in exchange for an interest. This makes it possible for property owners to defer taxes by contributing their property directly to a Real Estate Investment Trust (REIT) in exchange for shares in the REIT’s operating partnership.
By doing this, the property owner has the ability to defer capital gains taxes and potentially benefit from the diversification provided by the REIT’s underlying real estate portfolio. In addition to diversifying into a portfolio of assets, the property owner is relieved of the day-to-day management of the real estate property, as the REIT provides for the management of the underlying portfolio. However, in order to complete this exchange, there has to be a REIT that is willing to purchase the asset at a price acceptable to the property owner. REITs often have specific acquisition criteria, so finding a “perfect fit” can sometimes be difficult.
It is important to note that the shares the property owner receives cannot be exchanged again within a 1031 exchange. Therefore, if the property owner were to sell his or her shares, or if the REIT were to sell assets and return capital to the property owner, then a taxable event would occur.
There are several options for those looking for tax-deferral strategies within a real estate portfolio. Like any tax-deferral strategy, property owners should understand the benefits and drawbacks of the various options and should work alongside their attorneys, accountants, tax counsel and financial advisors. At Platform Ventures, we understand the potential pitfalls and possible advantages of 1031 exchanges, and our goal is to help property owners identify, execute and manage the right strategy to meet their specific objectives.
For additional information about how Platform Ventures supports wealth advisors and property owners during a 1031 exchange, please contact us.
6. Please note, this is an example being provided for illustrative purposes only. These are not actual events. Actual events are difficult to predict, are beyond our control and may differ from those assumed.
The information contained herein is intended for informational purposes only and does not constitute legal, tax, or accounting advice or any other advice of any kind. Information contained herein relates to general market information and/or general firm business information and does not constitute an offer to sell or a solicitation of an offer to buy any security and may not be relied upon in connection with the purchase or sale of any security. If any offer of securities is made, it shall be made pursuant to a formal offering which will contain material information not contained herein and that will supersede, amend and supplement this information in its entirety.
It is important to note that although 1031 exchanges may be appropriate for some, it may not be appropriate for others. Please consult with your attorneys, tax counsel, financial advisors and other professionals regarding the applicability of 1031 exchanges to your current situation.
Please note, this piece contains broad market commentary regarding a specific point in time, is subject to change without notice, and should not be considered blanket advice or advice of any kind – each property owners’ situation is different and should be evaluated on an individual basis prior to determining whether or not a 1031 exchange is appropriate. Certain of the economic and market information contained herein has been obtained from published sources and/or prepared by third parties. While such sources are believed to be reliable, Platform Ventures and its affiliates, employees and representatives do not assume any responsibility for the accuracy of such information and have no obligation to verify its accuracy.