Many real estate investors know that capital gains taxes can be deferred with an exchange of property meeting the requirements of Section 1031 of the Internal Revenue Code. An exchange differs from a sale in that an exchange requires a transfer of property for property. A sale of property is a transfer of property for money. The primary advantages with an exchange are to defer the capital gains tax and to fully use your equity for the acquisition of other property. Even with the reduction of the capital gains tax rates, the benefits of Section 1031 can be very substantial.
The rules of Section 1031 can trap the unwary, resulting in a loss of some or all of the tax deferral benefits. The use of a tax advisor familiar with those rules is recommended. An experienced advisor is especially important if your exchange involves multiple properties. Other issues can come into play, such as:
- What does it mean if some property is "incidental" to the exchange?
- Is the transaction a single exchange or multiple exchanges?
- Must the same Taxpayer that started the exchange also finish it?
ALTERNATIVE AND MULTIPLE PROPERTIES
To ensure a valid exchange, potential replacement property must be identified within 45 days from the transfer of the relinquished property and acquired within 180 days from the same transfer date, unless the transfer occurs after later in the year when the 180-day period can be shortened by the due date of your tax return. If you transfer multiple relinquished properties through one exchange, the identification and exchange periods begin on the date of transfer for the first relinquished property.
Example No. 1: Let's assume you transfer four apartment buildings with the first closing on November 1st, the second closing ten days later and the third and fourth closings fifteen days later. The 45-day identification period will end on December 16th, not on December 25th or January 9th. The exchange period will end on April 15th unless you obtain an extension to file your tax return and thus extend the exchange period to the full 180 days.
No matter how many relinquished properties are transferred as part of the same exchange, the limits on the number of potential replacement properties that can be identified remains the same. You can identify up to three properties without regard to their fair market values or any number of properties, provided that the fair market values of all identified properties don't exceed 200% of the relinquished property values. In other words, if you identify more than three properties, make sure that the values of those properties do not exceed two times the value of the relinquished properties. There is no difference between identifying too many properties, and not identifying any properties. Your exchange will fail due to an improper identification.
There are two noteworthy exceptions to the identification rules: (1) any replacement property that you acquire within the identification period is presumed to have been properly identified; and (2) or if you acquire replacement properties with a total value of at least 95% of the values of all the identified replacement properties.
Example No. 1: If you transfer a property for $100,000 and identify four properties worth $55,000 each, you will be treated as if you did not identify any properties unless you close on all four properties. Acquiring three of the four will not be sufficient because they amount to only 75% of the aggregate fair market values of the replacement properties, not the required 95%.
The exchange rules apply whether you exchange real property for real property or personal property for personal property, but what about transactions that involve both property types. For example, in apartment building or hotel transactions, personal property such as furniture or laundry machines will be included with the sale of the real property. The personal property items are not considered 'like-kind' to the real property. For purposes of the identification rules, "incidental" personal property does not have to be identified separately if the aggregate value of those items does not exceed 15% of the value of the larger item of property (i.e. the real estate). An incidental item is something transferred with a larger item in standard commercial transactions.
For purposes of the 3-property rule, the building, furniture, laundry machines, and other personal property are treated as one property. The properties are all considered to be unambiguously described if the legal description, street address, or distinguishable name of the building is specified, even if no reference is made to the furniture, laundry machines, and other personal property. In those instances when the incidental property is greater than 15% of the value of the larger item, a separate identification will be needed.
It is important to note that even though a separate identification is not required for those incidental items, those items cannot be ignored in the exchange. Such items will be considered taxable "boot" if not replaced with other like kind items.
SINGLE OR MULTIPLE EXCHANGES
A single exchange can involve multiple relinquished and replacement properties. The time periods begin on the date of transfer for the first relinquished property. The limits on the number of properties that can be identified do not increase simply because the exchange has multiple properties. In addition, it may be challenging to use one exchange for multiple relinquished properties closing on different dates.
Depending on your circumstances, creating more than one exchange may be to your advantage. You may have more flexible time periods and the potential to identify additional replacement properties. Be aware that the IRS may try to recharacterize your separate transactions as being only a single exchange. For example, if all of the buildings are transferred to a single buyer under one contract, using the same escrow, the IRS could argue that the transaction is one exchange. Another relevant factor is whether the relinquished properties are contiguous and/or operated as a single property.
If separate exchanges are to be used, it is important to retain competent tax advice and make each relinquished property closing separate and distinct from the other closings.
SAME TAXPAYER REQUIREMENT
While it would seem obvious, the same Taxpayer that transfers the relinquished property needs to acquire the replacement property. There are circumstances when the owner of the relinquished property will be different in name from the owner of the replacement property. Such situations are common with larger properties. A lender will often require that the owner of the replacement property be a bankruptcy remote entity. In most states, a single member limited liability company ("LLC") is permitted. Federal tax laws permit an LLC to elect to be taxed as a sole proprietorship, and thus the entity is disregarded for tax purposes. In a number of private letter rulings the IRS has approved the use of a single member LLC for the acquisition of replacement property, without violating the same Taxpayer requirement. When considering an exchange it is strongly suggested that you seek the advice of your legal counsel or other tax advisor on your specific circumstances.