1031 Exchanges Explained
Under §1031 of the Internal Revenue Code, no gain is recognized if an owner exchanges real estate held for business or investment for other real estate to be held for business or investment. Owners use an independent intermediary like PRE to facilitate an “exchange.” If the owner trades into property having equal or greater value and equity, no gain is recognized on the exchange. If the owner trades down in value or equity, gain is recognized only to the extent that the owner “trades down” (and receives cash or other property, or has net relief of debt).
In contrast, owners who “sell” their property must recognize all of their gain. Owners sell their property if they actually or constructively receive the sales proceeds. Once their sale closes, they cannot exchange. They must recognize all of their gain even if they immediately reinvest the sales proceeds in real estate. NOTE: Owners who do not exchange with a qualified intermediary and unilaterally direct the escrow holder to use the proceeds to purchase new property do NOT effect a valid exchange, even if the owner never actually touches the funds.
Gains remain subject to significant tax rates. The federal rate on long-term capital gains (property held longer than 12 months) was reduced to 15% for sales or exchanges after May 5, 2003, but the portion of the gain that represents prior depreciation deduction continues to be taxed at 25%. If the property is held for less than 12 months, the federal tax rate may be as high as 35%. California imposes state income tax of up to 9.3% and withholding of 3 1/3% of the gross sales price for taxable sales by individuals. For example, a $500,000 gain on the sale of California depreciable property may be subject to approximately $150,000 in federal and state income taxes. The amount of taxable gain may be greater than expected if debt was added to the property or if the owner has a low tax basis from depreciation deductions or a prior exchange. In some cases, tax on the gain may exceed the net sales proceeds.
The main benefit of a like-kind exchange is TAX DEFERRAL. If no gain is recognized, the owner defers paying income tax on the gain. Gain recognition is postponed indefinitely until the owner disposes of property in a taxable transaction. No interest is charged on the tax deferral. Over time, a tax deferred may become a tax saved. During the owner’s life, the investment of money that would have been spent currently on taxes generates a return. The cumulative return on this money may, at some point, exceed the amount of the tax! When the owner dies, recognition of gain is permanently avoided. The heirs take the property with a basis equal to its fair market value.
Exchange vs Sale
Form and substance distinguish a tax-free exchange from a taxable sale. The form of the transaction must be an exchange, including proper exchange agreements and contractual relationships between the parties. In substance, the owner must not have actual or constructive receipt of the sales proceeds. For example, owners cannot simply sell their property and direct the escrow holder to deposit the proceeds to purchase new property. These transactions are invariably treated as taxable sales under case law. The owner is not “exchanging” with any party and has constructive receipt of the sales proceeds through the escrow holder.
Use of Intermediary
To avoid a taxable sale and reinvestment, owners exchange with an independent intermediary like PRE. The owner and PRE enter into an exchange agreement under which the owner transfers the old property in exchange for new property to be acquired by PRE. PRE completes the sale of the owner’s property and uses the sales proceeds to purchase new property that is transferred to the owner. A qualified intermediary (i) enters into an exchange contract with the owner, and (ii) avoids actual or constructive receipt of the sales proceeds by the owner. The owner safely qualifies for an exchange under Treasury Regulations. See Treas. Reg. §1.1031(k)-1(g)(4).
In a simultaneous exchange, the transfer of the old property and the receipt of new property occur at the same time. The owner and PRE enter into an exchange agreement. PRE acquires the owner’s property, sells it to the buyer, acquires the new property, and transfers it to the owner. These transactions are interdependent and close concurrently. If the owner exchanges with a qualified intermediary, the transfer and receipt of property is treated as an exchange. See Treas. Reg. §1.1031(b)-2(a).
In a deferred exchange, the owner’s property is transferred before new property is received. The owner and PRE enter into a Deferred Exchange Agreement. PRE acquires the old property, immediately sells it to the buyer, and receives the sales proceeds. The owner identifies new property in 45 days after closing. PRE uses the sales proceeds to purchase one or more identified properties, transfers the property to the owner, and completes the exchange in 180 days. The IRS endorses this procedure for effecting a “deferred exchange.” See Example 4 of Treas. Reg. §1.1031(k)-1(g)(8). The advantage of a deferred exchange over a simultaneous exchange is additional time. In a deferred exchange, the owner has more time to identify (45 days) and to receive (180 days) new property after relinquishing the old property.
PRE acts as a “qualified intermediary” under IRS regulations. If the owner exchanges with a “qualified intermediary,” the IRS will not challenge the exchange on grounds of agency or actual or constructive receipt of cash. Since the IRS provides a “safe harbor” for such transactions, owners should not risk their exchange with anyone but a “qualified intermediary.”
PRE provides agreements and other documentation to effect a valid exchange. PRE maintains a complete “exchange file” for the owner. The importance of proper documentation cannot be overemphasized. In auditing a transaction reported as an exchange, the IRS focuses on the documents to determine whether a valid exchange was made. The IRS also examines whether the owner had actual or constructive receipt of the sale proceeds.
PPRE specializes in real estate exchanges. PRE is owned and operated by licensed California attorneys with many years of exchange experience. We are regarded as national experts on tax-free exchanges and are faculty members for the nation’s premier exchange conferences. Although we do not provide legal or tax advice while serving as intermediary, we have a complete library of all Section 1031 cases and rulings. Copies of the legal authority relating to any exchange issue can be provided to you and your tax advisor so that you can make informed decisions.
Sales proceeds are held in secure accounts until needed to complete the exchange. Funds are held in accounts with Merrill Lynch, Bank of America and Citibank. Funds are wired to and from escrow accounts to ensure safety.
Various services are offered by PRE in connection with simultaneous and deferred exchanges. The cost for most exchanges is only $750. If more than two replacement properties are involved in the exchange, the added cost is only $250 per additional property. For example, if one property is exchanged for two new properties, the fee is $1,000 ($750 plus $250 for an additional property).See “Costs” for additional information.
PRE may handle special items in connection with some exchanges. For example, PRE may receive a carryback note from a buyer, or PRE may be involved in an exchange of property that is partially rented and partially used as the owner’s residence. PRE and its affiliated companies engage in other special or complex transactions, including reverse exchanges. Any additional services are priced reasonably at fixed amounts or hourly fees.