1031 Exchanges — so called because they are covered in Section 1031 of the Internal Revenue Code written by the U.S. Congress — are not widely publicized in the business world. Yet they can be highly beneficial to taxpayers who want to defer capital gains taxes from commercial real estate swaps.
A 1031 Exchange is a good public policy incentive provided to investors by the U.S. Congress. It allows investors to trade real estate or capital equipment for similar assets, and defer the capital gains taxes on the increase in value of the property being exchanged. And it is not an abusive tax shelter, as some people might believe. But those who qualify for and take advantage of 1031 Exchanges do realize significant capital gains tax savings.
Smart Business spoke with Richard Witek, vice president of MB Financial Bank’s Asset Management and Trust Group, to gain an insight into 1031 Exchanges and the benefits involved.
Who is eligible for 1031 Exchanges?
Taxpayers who hold property for productive use in a trade or business or for investment can take advantage of 1031 Exchanges. 1031s are not available to taxpayers who want to trade property simply for personal use or who hold it primarily for sale.
How does a 1031 Exchange work?
First, the taxpayer sells his old or relinquished property, then identifies new or replacement property. This has to be done within 45 days of the sale of the old property. Generally, the taxpayer closes on the purchase of the new property within 180 days of the sale of the old property.
One of the beauties of 1031 Exchanges is that a taxpayer can then sell the new property as part of another Like-Kind exchange and continue to roll over the proceeds. There is no limit to the number of times this can be done.
What types of property are included in Like-Kind exchanges?
Properties include domestic apartment buildings, farms, shopping centers, railroad and computer equipment, boats, trucks … the list goes on. It is important to note that foreign property cannot be exchanged for U.S. property.
Not all property has to be tangible. For example, the IRS allows taxpayers to sell real estate property and transfer all the money into entities like petroleum producing wells without paying any tax on the profits.
Can taxpayers trade one type of property for another?
Yes, but there are some caveats. For instance, a taxpayer can trade an apartment building for a shopping mall, or a farm for a warehouse. But once an exchange involves smaller assets like boats and trucks, Like-Kind is interpreted more narrowly. If a taxpayer is going to swap a truck, for instance, it must be traded for another truck.
Nuances like these suggest that taxpayers interested in 1031 Exchanges should work closely with professional advisors such as tax attorneys, commercial bankers, and accountants to make sure everything is done according to IRS guidelines. Therefore, choosing a qualified intermediary, defined as an independent agent that facilitates an exchange, is advisable.
How does an eligible business person identify a qualified intermediary to implement a 1031 Exchange?
One way is to identify experts and institutions that have positive track records in administering 1031s. Look for information about how much experience they have, how many transactions they have completed, and whether they can be trusted to hold investors’ money. The last concern has a major impact on who is ultimately selected as a qualified intermediary.
Why is it important to choose a qualified intermediary who can be trusted with clients’ money?
Qualified intermediaries perform important functions. They simplify the process, keep taxpayers aware of deadlines, make sure that everything is in compliance with IRS guidelines, and maintain control of the funds that result from sales.
It is important to recognize that a client involved in a 1031 Exchange cannot take ownership of the funds from a transaction. Once a transaction is complete, it is too late to set up an exchange. The qualified intermediary must control the funds in order to implement an exchange.
The theory behind this is important to understand. The intermediary holds the proceeds from the sale of the relinquished property until the taxpayer directs it to release them to acquire the replacement property. Effectively, the taxpayer has never had control of the relinquished property sale proceeds, which are then rolled into the purchase of the Like-Kind replacement property. That is the essence of the 1031 Exchange concept envisioned by Congress. And, even though it sounds complicated, a Like-Kind exchange can be implemented efficiently when qualified professionals are involved in it.
RICHARD WITEK is vice president of MB Financial Bank’s Asset Management and Trust Group. Reach him at (847) 653-1788.
