1031 Exchanges: 3 Common Pitfalls to Avoid
Written by: Gary M. Markoff
Unless Congress comes to terms with itself before year’s end, all indications point to rising income tax rates next year.
One way for an owner of income producing real estate to reduce her or his personal tax burden is to take advantage of the tax-free exchange provisions of Section 1031 of the Internal Revenue Code. Yes, compliance rules are complex, and the failure to meticulously adhere to them will not only result in the recognition of capital gains, but interest and penalties as well. But the rewards for playing by the tax rules may not only defer taxable gain on a sale of real estate, deferral can become permanent if replacement property acquired from one or more successful 1031 exchanges is owned by the taxpayer's estate at death. Heirs will reap the benefit of a step-up in tax basis to the real estate’s then current value, thus avoiding capital gain tax altogether. This assumes, of course, that Congress doesn’t alter this longstanding tax avoidance strategy. Attempts have been made to do so in the past.
Here are some commonly experienced pitfalls that cost taxpayers dearly, particularly when they try to go it alone without professional tax counsel.
1. Identification and time line requirements are strictly enforced. The taxpayer should be looking for replacement property long before any agreement to sell the relinquished property is made. At a minimum, replacement property must be identified in writing within 45 days and purchased within 180 days from the sale of the relinquished property. Identification is usually done in the form of a letter to a qualified intermediary. The taxpayer may identify as many as three alternate properties of any value. If more than three are identified, the value of the identified properties cannot exceed 200 percent of the value of the relinquished property unless at least 95 percent in value of the identified properties are acquired. This 200 percent trap can be avoided by limiting designation to a maximum of three replacement properties.
2. The major underlying premise of every 1031 exchange is that the taxpayer can not have constructive receipt of any portion the sale proceeds at closing. Actual possession of the cash is not required to demonstrate constructive receipt. Receipt of the sales proceeds by seller's attorney or accountant is considered constructive receipt by the taxpayer. National title insurance companies have subsidiaries that act as qualified intermediaries. They make convenient and competent QI's because they are intimately familiar with the workings of a real estate transaction and also available to insure title to the replacement property. Avoid constructive receipt and use a qualified intermediary!
3. Can a taxpayer undertake a 1031 exchange with a related party? Surprisingly yes, but the relinquished and replacement properties must be held by the related parties for at least two years. Beware of this two-year trap!
If these and other rules are ignored, so-called "boot" will be taxed and not all of the gain will be deferred. Avoid Boot!
The last pitfall is to avoid going it alone. Sophisticated tax and real estate counsel can properly structure and implement a tax deferred exchange so that there are no surprises either when the tax return is prepared and filed, or if the return is chosen for audit by the IRS. Safe exchanging!