With billions of dollars of commercial real estate expected to be sold in 2015, more and more real estate owners and investors have utilized the 1031 tax free exchange to reinvest sale proceeds for like-kind property, therefore deferring the capital gains tax due. An Internal Revenue Code Section 1031 (“Section 1031”) exchange allows for the deferral of gain on the exchange solely of like-kind property which is held either for productive use in a trade or business or for investment. If the transaction meets the criteria under Section 1031, gain deferral is mandatory.
Today many real estate owners who have recognized significant profits selling assets in one of the strongest investment sales markets in history, prefer to seek a like-kind investment as opposed to paying the federal and local income taxes, which would be due today. This is aiding to increase the volume of investment sales which currently may represent as much as twenty five percent of the sales volume for this year. “When you look at the sales market today-in terms of private capital, a substantial portion of the winning bids are coming from buyers in 1031 exchanges. Running a close second is foreign family offices looking to deploy money from overseas into the New York market”, said Peter Von Der Ahe, First VP Investments, Marcus & Millichap. “Over the past 24 months, we have made a significant effort to place those 1031 proceeds for private buyers because we feel it’s an underserved portion of the market.”
Under the tax code Section 1031, the taxpayer is afforded non recognition of realized gain or loss only when three conditions are met: (1) the properties transferred in the exchange must be properties held for productive use in a trade or business or for investment; (2) there must be an exchange; and (3) the properties that are exchanged must be like-kind. The term “like-kind” refers to the nature or character of the property, not its grade or quality. Additionally, real estate can be exchanged only for real estate and personal property can be exchanged only for other personal property. Most real estate and like-kind to other real estate. However, a Section 1031 exchange cannot involve (1) stock in trade or other property held primarily for sale; (2) stocks, bonds or notes; (3) partnership interests; or (4) certificates of trust.
Under a qualified section 1031 exchange, realized gain/loss is calculated, but not necessarily recognized. The realized gain/or loss is calculated by comparing the fair market value of the property received to the cost basis of the property relinquished. That basis is increased by a cash or other non-like kind property transferred in the exchange, and any gain that is required to be recognized.
Even though the benefits of deferral is often considered a wise and prudential business decision, certain investors prefer not to consider a 1031 deferral. One of New York City’s prominent owners of more than 3,000 residential rental units, who prefers to remain anonymous said,” the real negatives may outweigh the perceived positives of tax deferral. You are selling an asset which you understand and has value and purchasing another asset at what might be considered the height of the market. You are only deferring the taxes, not avoiding payment of the taxes. When you recognize the profit on the sale today, you are aware of the current taxes, while deferring to a later date, you are gambling on the taxes when you pay the taxes in the future.” Those future taxes may be substantially reduced if the replacement property passes through as estate and receives a basis step-up to fair market value at date of death.
Additionally, not all transactions occur simultaneously. To qualify as a 1031 exchange, the replacement property must be identified by the taxpayer before the 45th day after the date on which the taxpayer’s relinquished property is transferred. Additionally, the taxpayer must receive the replacement property no later than the earlier of 180 days after the taxpayer’s original property is transferred, or the due date, with extensions, of the taxpayer’s tax return for the year in which the taxpayer’s property is sold. Another approach for an exchange is a reverse exchange which is more complex than a deferred exchange. It involves the acquisition of replacement property through an exchange accommodation titleholder, with whom it is parked for no more than 180 days. During this parking period the taxpayer disposes of its relinquished property to close the exchange.
In the right circumstances, tax-free exchanges can be a valuable deferral technique. It should be no surprise, therefore, that there is talk in Congress about rescinding Section 1031. Sellers contemplating engaging in a tax free exchange should weigh the benefits of acting sooner rather than later.