A 1031 EXCHANGE CAN HELP REDUCE TAX LIABILITY-BUT BE CAREFUL
(12-16-09)A 1031 EXCHANGE CAN HELP REDUCE TAX LIABILITY FOR INVESTMENT PROPERTY SALES – BUT BE CAREFUL
by Edmund S. Kindelan, CPA, Kostin, Ruffkess & Company, LLC
Over the last couple of decades, the Internal Revenue Service (IRS) has made it increasingly difficult to escape capital gains tax liabilities on the profit from the sale of an investment property. One of the few remaining options to avoid paying a large tax bill is by utilizing Section 1031 of the IRS Code, which is often referred to as a “like-kind exchange.”
What is a 1031 Exchange? We’ll discuss how a 1031 Exchange is done shortly, but we first need to define what “like-kind” means. Like-kind, in general, includes most real property to be held for investment or use in a trade or business – for example, you could “exchange” a shopping center for an apartment complex. Let’s say that you own a multifamily investment property. You can do a 1031 Exchange if you sell that property with the intention of purchasing another investment property. However, this new property (or properties) must have a purchase price that is equal to or greater than the net selling price of the property you are selling, and both the old and new properties must be in the .
To make the 1031 Exchange work you need to conduct the sale and purchase of the properties utilizing a Qualified Intermediary (QI). QIs are companies that receive cash from a property sale and hold onto those funds until they are used for the purchase of a like-kind property. There are restrictions on who you may engage to act as your QI. The QI cannot be someone who has acted as your attorney or accountant in the past. Often, qualified intermediaries are companies that have been established as affiliates of title companies.
Let’s look at an example of how a 1031 Exchange can work: Bob Jones and other family members have owned a retail shopping center in Using a 1031 Exchange, the partnership sells the shopping center for $2.8 million (after paying costs related to the sale) and the funds are transferred to a Qualified Intermediary at closing. Bob now has 45 days to identify potential replacement properties (limited to 3 properties or 200 percent of the net selling price) that the partnership can purchase. He negotiates to purchase an apartment complex in
Since the partnership never officially held any of the funds from the sale of the old property, Bob and his partners will not be responsible for paying taxes on the $2 million gain (Possible graphic: $2.8m selling price - $800K cost basis = $2m tax liability) that was realized on the sale of his Springfield property – as long as the partnership followed all of the specific rules that have been set forth by the IRS in Section 1031.
Choose Your QI Carefully. Historically, it has been critical for those considering 1031 transactions to perform due diligence on their QI to ensure that they are financially strong and have a strong reputation in the industry. There have been cases in past years of unreputable QIs that have absconded with client funds. However, due to the recent tumult on Wall Street and in the banking sector, some Qualified Intermediaries who had been considered financially strong companies with solid reputations have faced considerable financial problems.
Just last year, LandAmerica Exchange Services, a QI associated with what was thought to be rock-solid LandAmerica Financial Group, filed for Chapter 11 bankruptcy due to poor investment choices. When this happened, many clients who were using LandAmerica Exchange Services as their QI suddenly found that their funds were not accessible and in fact will lose a substantial portion of their assets. A tragic occurrence, to say the least, especially considering many of these funds were probably investment funds for retirement.
I caution anyone considering a 1031 Exchange to make sure they “look behind the curtain” to see how solvent and secure their QI company is. Is the QI a separate subsidiary? Is there a guarantee by the parent company? Are your funds in a segregated account or combined with others? If you don’t ask probing questions, you are taking significant risks with your hard-earned assets. It is also critical to use advisors (CPAs, attorneys) that have experience in dealing with these issues
Additional Use? There are ways that you might be able to utilize a 1031 Exchange to exit out of your current investment and purchase other properties with lower capital requirements and still avoid any current capital gains taxes. So instead of having to pay $450,000 in taxes on that $1.5 million differential (Possible graphic: Real Estate Mortgage $2m - Cost Basis $500K = $1.5m tax liability), you might be able to invest in a highly leveraged property and avoid or delay your tax burden for a significantly lower amount
Do Your Homework. For example, you can’t use a 1031 Exchange to turn a business property into a personal property. If you want to sell an investment property and then use those funds to buy a condominium that you halfheartedly try to rent only to find a few months later you are living in this new property full time – the IRS will not look kindly upon you! But if you are in the situation where you truly will benefit by unloading one investment property where you have realized significant capital gains and are looking to invest in another property of similar value, then a 1031 may just be the right decision for you – again, as long as you follow the stringent rules imposed by the IRS.
As always, your best advice is to talk to your tax planner and accountant to figure out what solution is right for your situation.
Edmund S. Kindelan, CPA, is a Member of the Firm and leader of the Real Estate Services Group at Kostin, Ruffkess & Company, LLC, a certified public accounting and business advisory firm committed to helping clients succeed. Beyond traditional accounting, auditing and tax consulting, the firm also specializes in employee benefit plan audits, litigation support, business valuation, succession planning, business consulting, forensic accounting, wealth management, estate planning, fraud prevention, and information technology assurance. With 140 employees and offices in
A 1031 Exchange is one of the last ways that the IRS allows a taxpayer to avoid paying tax when selling property at a gain. However, the catch is it can only happen when you sell one property held for investment or use in a trade or business with the intent of using those funds to purchase another “like-kind” property. The asset to be sold must be a direct interest in qualified real estate and not stock in a closely held corporation; an interest in an LLC that owns real estate, securities or stock; or intangible property such as patents.
At first blush it’s easy to see the appeal of a 1031 Exchange. But as with all investments, there are risks. The biggest concern we stress to our clients is the need to have confidence in the stability and reliability of their Qualified Intermediary. Many people just take the QI at their word when doing a 1031 Exchange and fail to thoroughly vet the company and its policies. But considering the QI will typically hold a large sum of money – and for many these are retirement or other nondiscretionary funds – it is in your best interest to do a thorough review of the QI.
Another way that 1031 Exchange rules might be leveraged to help an investor in today’s tough economic times is in the case of a foreclosure on an investment property. For example, let’s say you own an investment property with a $2 million mortgage. Due to the depressed nature of the real estate market, the property is now worth less than the mortgage, you are having trouble paying the mortgage and your cost basis on the property is $500,000. You will still be faced with capital gains even if you had to give the property back to the lender and receive no cash. In this instance, you could easily be responsible for $450,000 of income taxes.
Any time you are considering making a move involving investments, taxes and the IRS, you need to do your homework and ensure that you are making the right decision before jumping in with both feet.
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