1031 Tax Deferred Exchanges
This article first appeared in the "Ask an Expert" column of the Santa Barbara Rental Property Association's newsletter, May 2016.
Question: How can I defer paying capitals gains tax if I sell my commercial property?
Answer: The sale of a commercial property can create significant tax ramifications that must be considered carefully with wise counsel from your CPA or tax attorney and your real estate professional, especially if the asset has been owned for a number of years. With the federal capital gains tax rate between 15% and 20% and the California State tax rates between at 9.3% and 13.3%, the tax liability on a sale of property could be substantial.
The Internal Revenue Service (IRS) has a provision in the tax code that was enacted by Congress in the Tax Act of 1921 that allows a property owner to exchange a property for a "like kind" replacement property without paying capital gains taxes that would otherwise be due. Internal Revenue Code Section 1031 provides the guidelines for tax deferred exchanges. Up until 1977, in order to qualify for a tax deferred exchange, the IRS required a property owner to close escrow simultaneously on the properties being exchanged. Then in 1977 a court case was decided which made it easier for property owners to complete their tax deferred exchanges. The court case was T.J. Starker v. United States. Starker sold timberland to Crown Zellerbach Corporation and in exchange over the next several years Starker received other real property, not cash. The IRS disallowed the exchange but Starker challenged and won his case against the IRS, which created non-simultaneous exchanges in common use ever since. These delayed exchanges became known as "Starker Exchanges" and are simply referred to today as "1031 Exchanges."
In a 1031 Exchange, a property owner sells property known as the Relinquished Property and within a specified timeframe, identifies and purchases "like-kind" Replacement Property or properties. Provided the property owner follows all of the rules established by the IRS, that property owner is allowed to defer paying taxes on the capital gains earned on the sale of the Relinquished Property.
Between 1984 and 1991, the IRS further clarified and defined the rules or guidelines on qualifying for a 1031 Exchange. There are multiple rules to a 1031 Exchange that property owners and their advisors must consider but for this article, I will focus on only a few.
One rule is that a property owner will pay tax on any cash proceeds (or Boot as it's called) received through the close of the sale of Relinquished Property. To defer paying any tax, the cash proceeds must go to a Qualified Intermediary (also sometimes referred to as a "QI") who will facilitate the 1031 Exchange. The Qualified Intermediary receives the proceeds of the sale and then later disburses these funds to purchase the Replacement Property on behalf of the property owner. There are a number of reputable Qualified Intermediaries available to assist property owners and most are experts and well versed on the "ins and outs" of 1031 Exchanges.
The IRS also established clear time limits for delayed 1031 Exchanges. The first limit is that a property owner has 45 days from the date the Relinquished Property closes escrow to identify potential Replacement Property. This identification must be in writing, signed by the property owner and delivered to an independent person involved in the exchange such as the Qualified Intermediary. Notice to your attorney, real estate agent, and accountant or similar persons acting as your agent is not acceptable.
The 45-day window to identify replacement property goes by very quickly. Most property owners I work with begin their search for a Replacement Property long before they close the sale of their Relinquished Property. Some may even have begun their search or even located their Replacement Property before ever agreeing to sell their Relinquished Property.
The second time limit is that the Replacement Property must be acquired and the exchange completed no later than 180 days after the sale of the Relinquished Property, or the due date (with extensions) of the income tax return for the tax year in which the Relinquished Property was sold, whichever is earlier.
Also, the Replacement Property or properties purchased must be substantially the same as the properties identified within the 45-day limit described above.
The 45 and 180 day deadlines run concurrently, not consecutively. From the close of escrow on the Relinquished Property, a property owner has only 45 days to provide written identification of possible Replacement Property and then another 135 days to complete any and all purchases. Again, the complete exchange from the closing of escrow on the Relinquished Property to the closing of escrow on the final Replacement Property can be no longer than 180 days.
While 1031 Exchanges can be a great tool for property owners to use in order to sell one property, acquire a new property and defer any capital gains tax liability, one must remember that it will only defer a property owner's capital gains tax liability and does not eliminate it. If a property owner completes successive 1031 Exchanges over the years, the property owner's tax liability will accumulate with each profitable sale.
I always recommend that property owners considering a possible 1031 Exchange should consult with a team of advisors including a competent CPA or tax lawyer knowledgeable and experienced in 1031 Exchanges, a seasoned and reputable Qualified Intermediary, and their commercial real estate broker who also should be experienced in 1031 Exchanges. Each of these advisors may have a slightly different perspective and experience, and collectively, they can provide sound advice to the property owner on how to successfully navigate the process of a 1031 Tax Deferred Exchange.
If you'd like to discuss this topc more, feel free to call or email me. ...Steven