Tax Free Exchange of Like Kind Property
Under Code Section 1031
Generally speaking, when one sells a capital asset, such
as Real Estate or Capital Equipment, it is required that a
capital gain tax be paid on the difference between the adjusted
basis of the property and the gross selling price. The gain
may be caused by the property having appreciated in value
over a period of time or by the owner having taken depreciation
deductions on their income tax return or, more likely, by
a combination of both of these.
Under Section 1031 of the Internal Revenue Code, property
which is held either for productive use in a trade or business,
or for investment, may be exchanged for “like-kind” property
in a simultaneous exchange or in a “deferred” or a “reverse”
exchange, provided that certain requirements are maintained.
The law firm of Huck Bouma
has extensive experience in handling all aspects of a like-kind
exchange of property, in order to defer the capital gain that
would otherwise be payable upon the sale.
There are a number of different types of exchanges that we
identify, and it is critically important that all of the provisions
of Section 1031 of the Internal Revenue Code, and its supporting
regulations, be maintained in order to achieve the tax deferral
for each type of exchange.
Delayed Exchange
The delayed exchange is the most common exchange format,
providing investors the flexibility of up to a maximum of
180 days (the “Exchange Period”) following the closing of
the sale of property, to close on the purchase of a replacement
property. Delayed exchanges are also known as “Starker” exchanges
and they must be performed strictly in accordance with the
regulations promulgated by the Internal Revenue Service, including
the following requirements:
The Exchangor has 45 days following the date of the closing
of the sale of the relinquished property to identify the replacement
property; up to three potential replacement properties may
be identified.
The Exchangor has 180 days following the date of the closing
of the sale of the relinquished property to close on the purchase
of the replacement property, which was properly identified.
The transaction must be done through a “qualified intermediary”,
generally a title company or a bank.
No part of the selling proceeds may be payable to the Exchangor,
although a portion of it may be released as earnest money
on the replacement property contract.
In order to avoid taxable gain, the replacement property
must be of the same or a greater value than the relinquished
property, and all of the cash proceeds from the sale
transaction must be invested in the replacement property.
Simultaneous Exchange
Simultaneous exchanges, also known as “swaps” can involve
two parties, each with property that is being exchanged to
the other party, or can involve three parties, wherein two
parties have property and one party has cash. In the three
party exchange, only the party receiving property in exchange
for property receives any tax benefit. Although these transaction
do not require a qualified intermediary under the Internal
Revenue Code, it is recommended to do so in order to take
advantage of the safe harbor provisions thereby eliminating
risk of an inadvertent tax.
Improvement Exchange
An improvement exchange allows the Exchangor to use the proceeds
from the sale of the relinquished property to make improvements
to the replacement property, including constructing a new
building. The improvements must be made by the qualified
intermediary or by the seller during the Exchange Period
and the qualified intermediary must transfer the improved
property to the Exchangor within the Exchange Period. There
is potential for failure to qualify because of what would
be considered normal construction delays such as inclement
weather, inability to secure proper governmental permits,
shortages of materials or labor, etc. When these delays cause
the completion of the improvements to be delayed beyond the
180 day Exchange Period, then the exchange will fail and the
Exchangor will be fully taxed on the gain from the sale of
the relinquished property.
Personal Property Exchange
Although we generally see exchanges of real estate, exchanges
of personal property, such as business equipment or aircraft,
can qualify for tax deferral. Generally, both the relinquished
and the replacement properties must be classified in the same
general asset class or within identical standard industrial
classification (SIC) sectors. For example, a business aircraft
may be exchanged for another business aircraft, or restaurant
equipment may be exchanged for other restaurant equipment.
Reverse Exchange
A “reverse exchange” or “reverse Starker” is a transaction
where for one reason or another the replacement property must
be received first before the Exchangor has the opportunity
to sell the relinquished property. In such a situation the
Exchangor has to “park” the replacement property until a buyer
can be found for the relinquished property so it will not
concurrently own both properties.
Prior to September of 2000, the IRS regulations pertaining
to like-kind exchanges did not apply to reverse exchanges.
Therefore, taxpayers had to struggle with uncertainty with
reverse exchange transactions. Typically, an accommodation
party would be used to acquire one or both of the properties
and be required to have a sufficient level of the legal characteristics
of ownership to be treated as the property’s owner. There
were no specific regulations or guidelines to follow which
added a significant level of complexity and uncertainty to
these types of transactions.
Beginning September 15, 2000, the IRS has taken most of the
guesswork out of the reverse exchange transactions by issuing
safe harbor rules for reverse exchanges to qualify for tax
deferral. The primary requirement is that exchange must be
conducted through what is known as an “exchange accommodation
titleholder” which must enter into a written agreement with
the Exchangor that it will hold legal title to the property
for the benefit of the Exchangor with the intent of facilitating
the exchange and will be treated as the owner of the property
for federal income tax purposes. The new IRS rules also provide
that a reverse exchange will have 45 and 180 day requirements
similar to a traditional exchange.
The new rules regarding reverse exchanges add a whole new
avenue of flexibility to structure tax efficient transactions
for real estate investors or developers.
Problems with “boot”
To insure a properly structured exchange, and thus the deferral
of all capital gain taxes, the property received must qualify
as like-kind property and any cash or other property must
be recognized as taxable. Such “money or other property”,
known as “boot”, includes liabilities assumed or attaching
to property received in a exchange. Boot will be deemed to
include cash, notes, stock in trade, contract rights, partnership
interests, or property which is not of “like-kind” with the
property surrendered in the exchange. To insure 100% tax
deferral, the Exchangor must (i) reinvest all exchange proceeds
from the sale of the relinquished property; and (ii)
acquire property with the same or greater debt. The general
rule is often stated as “even or up in equity and even
or up in value results in a fully tax deferred exchange”.
Do It Right
The ability to use an additional 20% of the gain as equity
in a new property instead of paying it to the Internal Revenue
Service is a powerful tool that can dramatically increase
wealth on an exponential basis. However, there are many complex
issues and pitfalls that must be transversed in order to qualify
for this extraordinary tax benefit.
To insure that your exchange will be properly structured
to defer, and potentially eliminate, the payment of any Capital
Gain Tax you should contact your Huck, Bouma, Martin, Jones
& Bradshaw real estate attorney before signing
any contracts or agreements regarding the property that will
be the subject of the exchange.
