Top Myths Concerning 1031 Exchanges

1. Trade: "In order to effectuate a tax free exchange, I have to find someone to swap properties".

In order to accomplish a tax free "exchange", clearly there must be an exchange of properties. That doesn't mean, though, that you sit down with another property owner and just trade deeds. It would be virtually impossible to find another person with investment property of identical value who wants to make a swap. In 1984, Congress enacted legislation to allow deferred exchanges, meaning that an investor could sell property to an unrelated buyer, after having entered into an exchange agreement with a qualified intermediary, and then identify any like kind property within certain timeframes (see Myth #3).

2. Use of the Property: "If I sell raw land, I have to buy raw land".

As used in IRC § 1031(a), the words "like-kind real property" refer to the nature or character of the property and not to its grade or quality. The fact that any real estate is improved or unimproved is immaterial for the fact relates only to the grade or quality of the property and not to its kind or class. In other words, all US real estate (no matter what the form) is like kind real property and improved real estate may be exchanged for unimproved real estate; city real estate may be exchanged for a farm, Massachusetts real estate may be exchanged for Florida real estate, etc.

3. Simultaneous: "I have to sell and buy on the same day".

The tax code allows for "deferred like-kind exchanges". In a deferred like-kind exchange, the investor sells his or her real estate ("Relinquished Property") to any unrelated buyer, and then has forty-five days to find ("identify") property they wish to buy ("Replacement Property"). Although the Replacement Property must be identified within 45 days, the investor has the lesser of one hundred eighty (180) days or the due date of its tax return for the year of the sale (which such return can be extended) from the sale of the Relinquished Property to close on the Replacement Property.

4. Complexity: "1031 exchanges are difficult".

Entering into a 1031 exchange with an experienced qualified intermediary, such as All States 1031 Exchange Facilitator ("All States"), couldn't be easier. The investor simply contacts All States and executes an exchange agreement. After that, the investor proceeds as if there is no exchange conducting its own investigations and negotiating with other parties, eventually assigning the executed purchase and sale agreement to All States who then steps in the shoes of the investor at the closing. The experienced staff at All States will contact the closing attorney to ensure that the closing complies with the requirements of the Code and Regulations.

5. Investor's Agent: "I'll just have my attorney hold the sales proceeds in escrow while I look for Replacement Property".

Regulations specifically exclude the investor's agent, broker, attorney, accountant, most family members and others with a relationship with the investor. The investor should use a well established intermediary that has instituted financial safeguards to protect the sales proceeds during the exchange. All States and JP Morgan Chase Bank have worked together implementing a carefully designed trust arrangement requiring dual signatures to transfer funds (both the investor and All States must sign before funds are transferred).

6. Sophistication: "1031 exchanges are only for the big investors".

Actually, anyone who owns investment property should consider a §1031 exchange before selling. Whether they are selling a small rental unit or an office building, they can simply pay the gain and throw away their hard earned money, or effect a §1031 exchange preserving their capital. Any investor should consult a tax adviser who is familiar with §1031 exchanges to determine the most beneficial strategy.

7. Last Minute: "My closing is tomorrow, it's too late to do an exchange".

Until title has passed to the buyer and money has been received, it is not too late to set up an exchange. All States frequently receives calls from investors at the closing, asking us to prepare the necessary paperwork to get the exchange in motion.

8. Cooperation: "I need the cooperation of my buyer and seller to do the exchange".

The regulations only require that the buyer and seller be given notice of the exchange. All States prepares a "Notice of Assignment" which provides the required notice (easy! - see Myth #4). Although cooperation is not required, All States recommends that the purchase and sale agreements for both the sale and purchase of real estate contain language requiring other parties to cooperate (provided they incur no additional cost) because it prevents a suddenly reluctant party from pointing to the 1031 exchange as a reason to not go forward.

9. Out of Order: "I cannot exchange because I am about to purchase the Replacement Property and I don't yet have my Relinquished Property sold.

A reverse exchange is the "flip side" of a deferred exchange, where an investor directly or indirectly acquires a like kind replacement property before disposing of a relinquished property. In a fast paced real estate market, owners of real property often face the prospect of losing the opportunity to acquire a desirable replacement property, when the seller of such property is unwilling or unable to wait while the investor completes the disposition of a relinquished property.

On October 2, 2000 the Internal Revenue Service ("IRS") issued Revenue Procedure 2000-37 providing long awaited guidance on structuring reverse exchanges to avoid IRS challenge. The Revenue Procedure describes a safe harbor for reverse exchanges if certain requirements are met. All States has been a leader in structuring and implementing reverse exchanges, and has formed an affiliated company, All States Reverse 1031 Exchange Facilitator, LLC, to handle the high volume of transactions.

10. Conversion: "I can never use the Replacement Property for personal use".

This is a common misconception, as many investors purchase replacement property in a vacation haven, with an eye towards using such property exclusively for their own personal use. The answer is that there is no hard and fast rule, but a subsequent conversion should not prevent the exchange from satisfying the use requirements provided that the investor did not have a concrete intention to convert the property to personal use at the time of the exchange. Although the preceding sentence is the legally correct answer, most clients want defined time frames. For the most conservative, we recommend two (2) years, as the IRS has ruled that a two-year minimum rental period was sufficient to meet the qualified use test. For an aggressive client, we explain the pitfalls of a negligible rental period under the intent standard, and typically urge such a client to rent the property for at least one season.

11. Mixed Use: "I can't do an exchange if I use my property partially as a residence and partially as a rental property".

In such an exchange, allocation of value between the two types of property becomes important. For example, if an investor owns a three family house occupying one floor as a personal residence, the allocation may be by the respective square footage, the number of units, the quality of interior improvements, or by appraisal. Any reasonable allocation is permissible. The gain attributable to the personal residence may be eligible to be excluded under IRC § 121.

12. Liability Protection: "I cannot sell individually owned property and buy through an entity".

This is true unless a disregarded entity is involved. IRC § 1031 provides that no gain or loss will be recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of a like kind which is to be held either for productive use in a trade or business or for investment (a so called "qualified use"). If the exchanging investor changes the form of ownership of the property contemporaneously with the exchange, the IRS argues that the investor held the property primarily to dispose of it (a nonqualified use) rather than for productive use in a trade or business (a qualified use).

Certain entities with a single owner, such as a single member LLC, are "disregarded" as an entity separate from its owner. The IRS has recently ruled that a transfer of replacement property directly to a single member LLC owned by the investor did not disqualify the transaction from the non-recognition rules of IRC §1031 even though title to the relinquished property was held in the name of the investor. The IRS correctly reasoned that because the single member LLC is a disregarded entity, the exchange in question would be viewed as if the investor itself had directly received the replacement property, thereby satisfying the requirements of IRC §1031.

13. Financing: "I cannot refinance my property if I am doing an exchange".

It is the position of the IRS that the effect of refinancing relinquished property shortly before an exchange allows a investor to receive cash which should be treated like boot (i.e. taxable). The logic behind the IRS' position is questionable. It is well established that a investor can encumber property without tax consequences. Furthermore, if property is encumbered and then transferred as part of a like-kind exchange, the Regulations are clear that the transferor will recognize gain unless an equal or greater amount of debt encumbers the replacement property received in the exchange. Thus, from a before-and-after perspective the investor's liabilities will not be reduced as a result of a like-kind exchange.

Their appears to be no reason why an investor cannot encumber property after the exchange, and there is no valid reason why the investor should wait before encumbering the same. The receipt of debt proceeds from a refinancing does not give rise to taxable income, and the fact that the debt proceeds are from replacement property obtained in a like-kind exchange should not alter this result. Accordingly, the investor can defer the recognition of gains tax on the exchange, and immediately thereafter tap into the equity in the replacement property placing cash in his pocket.

14. Partnerships: "My partners don't want to exchange, but I'm going to exchange my percentage interest".

Exchanges of partnership interests generally do not qualify for non-recognition treatment under IRC § 1031. Therefore, when partners want to end their relationship, they cannot each exchange out of their partnership interests into another partnership interest or real property under IRC § 1031.

Such transactions can be structured as exchanges, however, by converting the partnership interest into a real property interest. The various structures include partnership split-ups, split-offs, buy-outs and formations. All such structuring is not without tax risk, and requires the advice of an experienced tax professional.