1031 Exchanges – A Beneficial Method When Used Appropriately
The 1031 exchange, named after Section 1031 of the tax code, is a powerful technique for real estate investors, allowing them to defer capital gains taxes on the sale of investment properties if the proceeds are reinvested according to IRS guidelines. The IRS’s goal in allowing the deferral is to encourage the continuous flow of investment capital within the real estate market by removing the tax burden if properties are exchanged rather than sold outright. Despite periodic discussions and proposals for its alteration or elimination, the 1031 exchange provision has endured, providing a valuable strategy for investors seeking to defer taxes and reinvest in real estate.
Use a Qualified Intermediary
A qualified intermediary (QI) plays a crucial role in a 1031 exchange, and care should be taken in choosing the appropriate QI.
A QI is required for a number of reasons including:
- Preventing actual or constructive receipt: If the taxpayer receives the funds from the sale of the relinquished property, even for a moment, it will disqualify the exchange. A QI acts as a middleman, preventing the taxpayer from gaining constructive receipt of the funds.
- Facilitating the exchange process: QIs streamline the exchange process by handling the documentation and ensuring that the exchange meets the strict timelines set by the IRS.
- Expertise: Although a QI does not provide tax or legal advice, they provide expertise in navigating the complexities of 1031 exchanges, reducing the risk of errors or non-compliance.
It’s important to choose the right QI to ensure a successful 1031. A skillful and knowledgeable intermediary can provide solutions to many situations. Often, an experienced QI can be the difference between the ability to do an exchange or not. They can provide insight and ideas to structure transactions and property types to facilitate an exchange that might otherwise be thought to be ineligible.
Overall, the involvement of a QI is not only mandated but can also be beneficial to the transaction.
Evaluating the Options
Although deferring taxes would seem to be an obvious choice for any astute taxpayer, that is not always the case. There are some situations where a 1031 exchange might not be the best option, including the following:
- Cash requirement: In a 1031 exchange, all proceeds from the sale must be reinvested into the new property. If the taxpayer needs access to the cash for other reasons, a 1031 exchange might restrict this or her financial flexibility.
- Timing issues: The IRS imposes strict deadlines for completing a 1031 exchange. From the sale of the initial property, there’s a 45-day window to identify potential replacement properties and 180 days to close on one or more of those identified properties. If those deadlines cannot be met, the exchange won’t qualify.
- Deferral is not abatement: Utilizing a 1031 exchange defers taxes, but it doesn't eliminate them. When the replacement property is eventually sold without another exchange, the deferred gains and any depreciation recapture become taxable. If the goal is to avoid taxes completely, it must be exchanged until the step-up in basis upon the taxpayer’s passing.
- A deferral is not always best: A taxpayer may have a lower tax rate now than they may have somewhere down the line. Sometimes paying the liability at the current tax rates is most beneficial. Other taxpayers may have passive activity loss carryforwards that can be utilized instead to offset the gain.
- Tax and legal advice: Lastly, if the client doesn’t have experienced tax and legal advisors, proceed with caution. The IRS has very specific rules, and missteps can lead to disqualification and unexpected tax liabilities.
A 1031 exchange is a valuable tool for deferring taxes and facilitating investment continuity, but it’s not a one-size-fits-all solution. It is important to choose a knowledgeable and trustworthy intermediary. Consider, as well, the unique circumstances of the client’s investments and their financial goals, and seek professional guidance before opting for a 1031 exchange to ensure a successful exchange.
Barry S. Neustadt
Barry S. Neustadt, CPA, is the tax director at Madison Exchange, LLC. He is a member of the NJCPA.