The days of oil and gas and real estate limited partnerships tax shelters with 3 to 1, 4 to 1 and 5 to 1 write-offs are but a distant and faded memory in the minds of most experienced investors and real estate professionals. Nonetheless, even in today’s significantly more conservative climate, there is a vehicle available to help taxpaying businesses and individuals defer taxation in connection with the disposition and acquisition of property. It’s Section 1031 of the Internal Revenue Code and it is commonly referred to as a tax-free exchange, a like-kind exchange, or simply as a 1031 Exchange.
“In a typical situation, an owner selling its property would be taxed on any gain realized from the sale of the property,” says Claude P. Czaja, an attorney in the Real Estate Practice Group at Gambrell & Stolz LLP. “Section 1031 provides a mechanism that allows the property owner to defer taxation on the gain and keep all the proceeds invested.”
Smart Business spoke with Czaja about the benefits of a 1031 Exchange.
How does a 1031 Exchange work?
Typically, as a company outgrows its building, it develops a need for more space, and thus a new location. In a retail setting, the desire is to add new stores while reducing underperforming or older units. In each of these situations, the property to be sold, known as the relinquished property, is exchanged with the property to be purchased, known as the replacement property.
At the sale of the relinquished property, the proceeds are not tendered to the seller, also known as the exchangor. Rather, they are placed into an escrow account with a qualified intermediary, who holds the funds for eventual disbursement to pay for the purchase of the replacement property. Exchangor has 45 days to identify a limited number of replacement properties and 180 days to close on the purchase of the replacement property. If these and other technical requirements of the tax code are met, the exchangor will be able to roll the proceeds from the sale into the new facility and be spared from paying any tax on the gain that otherwise would have been realized in a routine sale of the property. This type of exchange is commonly described as a deferred exchange.
Besides real estate, can any other type of property benefit from a 1031 Exchange?
Yes, provided the subject property is like-kind or like-class to the property being relinquished or replaced, as the case may be, personal property used in a business can qualify for the tax shelter effect of Section 1031. Besides real estate, it is not uncommon to see equipment and furnishings, collectibles or larger-ticket items such as aircraft, being exchanged under Section 1031.
Actually, there are certain types of property that are specifically excluded from Section 1031 treatment. This group includes property held primarily for sale, inventory, stocks, bonds and other securities, and notes and other evidences of indebtedness. In general, if the property is not on the excluded list, it can qualify for tax-deferred treatment provided it is like-kind or like class property.
Are there any types of transactions that qualify for treatment under Section 1031 other than the deferred exchange?
Yes. In addition to the deferred exchange, there are a few other types of exchanges worth mentioning:
- Simultaneous exchange. As its name implies, the consummation of the closing of the sale of the relinquished property and the closing of the replacement property occur at the same time.
- Reverse exchange. This is a more complicated, costly and less frequently-used exchange method. In it, the replacement property is actually acquired prior to disposition of the relinquished property. These transactions are sometimes referred to as parking arrangements because the replacement property is purchased and ‘parked’ with an exchange accommodation titleholder who holds title to the replacement property until the exchangor is able to sell the relinquished property.
- Multi-asset exchange. This is an exchange that involves both real estate and personal property. Typical examples include exchanges of hotels or restaurants. In such transactions, the exchangor will exchange the real property as one part of the exchange and the furnishings and equipment as the second part of the exchange, with careful attention paid to ensuring that the furnishings and equipment are separated into groups of like-kind or like-class property.
- Construction exchange. In the construction exchange, the exchangor is allowed to build on or make improvements to the replacement property which is parked with an unrelated entity much like in the reverse exchange method. The exchangor can utilize escrowed exchange proceeds from the sale of the relinquished property to fund construction on the parked property. However, construction cannot occur on replacement property the taxpayer already owns.
CLAUDE P. CZAJA is an associate in the Real Estate Practice Group at Gambrell & Stolz LLP, concentrating on commercial real estate and business transactions. Reach him at (404) 223-2218 or firstname.lastname@example.org.