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1031 Exchange Overview

Presented by The OC Owner User Group

· Knowledgebase

The 1031 Exchange

The delayed exchange is a very special investment technique, which can be used in real estate transactions involving properties held for investment purposes. You are allowed to sell your property today and to reinvest the profits as long as six months later without having to pay the taxes due on the sale. Taxes are deferred to a future date that you choose. The 1984 Tax Reform Act provided Congressional approval of the concept of delayed exchanging by requiring that the investor identify his like-kind trade property within 45 days and complete the exchange by 180 days after the sale of his property. The 1986 Tax Reform Act increased capital gains taxes and is responsible for a rapidly growing interest in the use of delayed as well as simultaneous exchanging.

The delayed exchange procedure was brought to the attention of the real estate community when an investor by the name of T.J. Starker and his family attempted to trade timberland to the Crown Zellerbach Corporation in exchange for a promise to deliver suitable trade properties to the Starkers in the future. The I.R.S. challenged this transaction and after a series of tax court trials, the 9th Circuit Court of Appeals ruled in favor of Mr. Starker. The I.R.S was not happy. As recently as March of 1988 they stated that the appellate decision applied only to Mr. Starker and that the widespread use of delayed exchanges may create problems for many investors. However, Regulations issued in 1991 validated the use of the delayed exchange on a national basis. The delayed exchange is entirely legal, defensible, and has been used thousands of times over the years.

What is a like-kind property?

The Internal Revenue Code Section 1031 (a) (1) says, "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." What does the code really mean? Property that is held for investment can be exchanged for any other property that is being held for investment and the investor will be allowed to defer paying capital gains taxes.

What are some properties held for productive use in a trade or business or for investment? The list would include raw land, motels, office buildings, apartments, warehouses, and single family rentals to name a few. The way the code reads, any combination of these properties can be exchanged. That means an apartment can be exchanged for an office building, a warehouse exchanged for a motel, and finally raw land exchanged for a single family rental. In an exchange of real property for real property, the fact that any real property is improved or unimproved is immaterial, because that fact relates only to the grade or quality of the property and not to its kind or class.

Many options are available. Here are a few ideas:

-Exchange from a property which cannot be refinanced to improved property. This will give the exchangor the ability to refinance and perhaps acquire more property.

-Trade from non-productive land for improved property that can generate cash flow.

-Trade from a high appreciation property, such as a house or apartment, for a high cash flow property, such a retail store. This can be used to create cash flow for retirement.

-Exchange from a property with a high debt service for a property with lower payments and lower interest rates.

-Exchange to change the lifestyle of a client. For example, exchange for a property requiring reduced management effort for the retiree who desires to travel.

-Trade from multiple properties into one larger property, or trade one property for multiple properties depending on the desires of the client.

Exchange Strategy

Investors buy real estate to earn a profit. Decisions are carefully made to determine the effects of location, potential rents and expenses, financing and a multitude of other important factors in an attempt to realize as much of a profit as possible. Once the profit is made, the typical investor sells his property, pays his taxes and reinvests in other real estate. The vast majority of real estate investors seldom make use of the wealth-building advantages of the tax-deferred exchange.

Every investor knows that leverage creates wealth. A 20% down payment can result in a 50% investment return because of leverage. Tax deferment is also leverage. Just as you use financing to leverage a purchase, you can use tax savings to acquire even greater wealth. The 40% or more of capital gains taxes, which normally would be paid to the Federal and State government, can now be used to acquire larger properties. An investor is able to accelerate his investment program by eight years or more by carefully developing an investment strategy utilizing exchanges.

Exchanges are useful in a wide variety of circumstances. They provide excellent opportunities for resourceful investors to create transactions which would not be possible through a sale/purchase format. The overriding advantage of exchanging lies in the ability to move equity from property to property without having to pay the capital gains taxes. Exchangors can create an entire investment program using the wide variety of benefits available.

The steps of an exchange

1. Exchangor finds a Buyer and opens escrow.

2. Ownership to the Relinquished property is transferred to a 1031 accommodator

3. Ownership is immediately transferred to the Buyer of the Exchangor's

4. At the close of escrow the proceeds are wire transferred from escrow to a designated bank.

The funds are held in a separate account set up for each specific transaction. The first half of the transaction is completed at the close of escrow. It is at this time that the Exchangor must locate a replacement property within 45 days, and then complete the exchange within 180 days of the close of escrow of the Relinquished Property.

  • Once the Replacement Property is located and is ready to close, exchange credits will be wire transferred from the bank to the escrow handling the closing of the Replacement Property.
  • Ownership to the Replacement property is transferred to a 1031 accommodator.
  • Ownership to the Replacement property is then transferred to the Exchangor to complete the Exchange.

The exchange is completed with the Exchangor giving property to the Facilitator and in turn receiving a like-kind property.

The most common uses for exchanging are:

  • Exchanging from property which cannot be refinanced, such as land, to improved property which will support a new loan gives the client the ability to obtain cash. Trading from non-productive land to improved property can also create cash flow.
  • Trade from a high appreciation property, such as a house or apartment, to a high cash flow property, such as a retail store, or from a cash producer to one which generates more capital appreciation.
  • Exchange from a property with high debt service payments for property with lower payments or lower interest.
  • Exchange for a property that is easier to sell.
  • Exchange to change the lifestyle of a client. For example, exchange for a property requiring no management for the retiree who wishes to travel or move.
  • Exchange from many smaller properties to a larger building to consolidate ownership benefits or from a larger building to smaller properties to improve liquidity or to divide ownership among several persons.
  • Trade to convert the nature of the investment. For example, trade from an investment house to a small medical building for the doctor who wishes to practice in a building he owns.
  • Leases of 30 years or more may be traded for real estate. Sale lease/backs have been ruled to be exchanges, if done properly.

The uses of trading are limited to the imagination of the investor and his advisor. Almost any problem can be solved or objective reached more quickly by using the tax-deferred exchange

Tenant-In-Common Overview

(Alternatives to Sole Ownership in Real Estate flourish in wake of new IRS guidelines)

A common choice for 1031 tax deferred exchanges is Tenant-in-Common (TIC) ownership, sometimes called fractional ownership or shared equity ownership. You can own an undivided "fractional" interest in a property and receive your pro rata share of the income, tax benefits, and appreciation. You have the same rights as a sole owner.

"If the stock market uncertainty of the past two years has given investors an incentive to invest in real estate, the IRS's issuance of clear guidelines on tenancy-in-common, or TIC agreements provides another. This comes just as TIC's, a by-product of the 1031 exchange market, are increasingly drawing investor attention - and dollars", according to D. Mitchell of the Shopping Center News.

"1031 (tax deferred) exchanges account for about $300 billion of real estate deals done each year. The TIC component of this volume has grown significantly each year and is considered by many as clearly the new wave of investment - for 1031 exchanges and real estate at large", according to Rob Hannah, CEO of Tax Strategies Group, a Chicago real estate firm.

A 1031 exchange allows one owner to sell a property to another and buy another one of equal or greater value within 180 days (the nomination of the "upleg" must be made within 45 days). This "replacement" purchase allows the seller to defer taxes from the profits of the initial property.

Some sellers are not satisfied with suitable local property listings and prefer to acquire mature, institutional grade properties that offer stable yields and low downside risk through an "economy of scale" affect. The financial size of the investment typically requires that these institutional grade properties must be purchased with other investors through a TIC 1031 sponsor, like SCI, who acquires quality properties and then sells portions to investors as tenancy-in-common interests.

TIC 1031 participants each receive an individual "fee simple" deed at closing for their undivided percentage interest in the entire property. Each owner has the same rights as an individual owner. Investments can be made to fit exact dollar amount exchange requirements. All tax benefits are preserved, heirs can receive a stepped up basis and the capital gains tax can be completely avoided. Non-recourse loan qualification is typically the responsibility of the sponsor, as the primary borrower. TIC 1031 participants typically receive monthly distribution checks without the day to day management of their investments. TIC 1031 ownership makes it economically feasible to identify and acquire an ownership interest in several properties instead of one, thereby decreasing risk through diversification. Properties can be identified and closed in a timely manner since the sponsor already owns the properties or has choice properties under

contract with supportive, third party due diligence reports available.

In March, 2002, the market got a significant boost when the IRS drafted Revenue Procedure 2002-22, a set of 15 guidelines by which the industry could set up legal TIC structures for IRS exchanges. "As long as you are in the boundaries of those 15 points, you can create any structure you want," said Hannah. "It's given the market guidance and contributed to the popularity of 1031 exchanges." The guidelines have stimulated interest from individuals seeking reliable investment options.

Among the guidelines, investments cannot be diluted by the sponsor for any cash flow, depreciation or net profit upon disposition. TIC participants are actually on title and they are allowed to sell their interests to buyers outside of their TIC agreement with the initial investors. TIC agreements include other aspects of the guidelines and allow all participants to benefit from a structured operational agreement.

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