The Section 1031 tax deferred exchange is alive and well. It’s a tax planning technique for moving from one business or investment real estate property to another while deferring tax payment and allowing more capital to remain invested.
Most tax deferred exchanges are transacted as forward exchanges and orchestrated through a qualified intermediary (QI). A property is relinquished, the replacement property is identified within 45 days, and then the replacement property is acquired within 180 days of the relinquished property closing.
Section 1031 is a detailed and process-driven code section. Professional assistance is advised.
Unpack the rules, understand the opportunities
There are rules governing exchange agreement structure, who can function as a QI, how to identify and transfer relinquished and replacement properties, and more. In addition to these rules, consider some lesser-known opportunities in the tax deferred exchange provisions.
Scenarios around exchanging properties
When exchanging multiple relinquished properties for a single replacement property (or vice versa), pay special attention to identification and property transfer timing.
Exchanging a relinquished property for a property that does not yet exist is commonly known as a build-to-suit exchange. In this case, the QI steps in the shoes of the taxpayer and acquires land and constructs improvements on behalf of the taxpayer.
Acquiring replacement property prior to transferring the relinquished property is known as a reverse exchange and entails use of special property parking arrangements and the services of an exchange accommodation title holder.
Partnership interests
Fee simple property can be exchanged into a co-ownership arrangement such as a tenant-in-common holding or a more formalized fractional ownership structure such as a Delaware Statutory Trust. However, a taxpayer is not allowed to exchange real estate for a partnership interest. A tenant-in-common arrangement can be treated as a partnership for tax purposes in some circumstances, so proper structuring is critical to qualifying for the tax deferral.
Partners often want to go their separate ways when a property is sold. This can be accomplished through various arrangements, but these are quite technical and require proper seasoning.
Looking to the future
Many taxpayers look for opportunities to exchange a business or investment real estate project for a property that may become a future personal residence after a period of continued business or investment use. This occurs so frequently the IRS dedicated a revenue procedure (Rev. Proc. 2008-16), creating a recipe to follow — and an advisor can help you structure such an exchange following IRS guidelines.
Cost segregation of replacement property
Cost segregation is a common depreciation-related technique used to allocate real estate costs to shorter-lived assets, accelerating depreciation and qualifying assets for “bonus” depreciation. The tax lives of the replacement property are generally fixed by the asset lives of the relinquished property, so there is less benefit of doing a cost segregation on property acquired in an exchange than property purchased outside of an exchange. There may be an opportunity, however, to do a cost segregation on the excess cost (trade-up element) in an exchange.
Example
- Value of relinquished property: $2 million
- Value of replacement property: $2.5 million
- Excess cost potentially eligible for cost segregation: $500,000
Involuntary conversion statute
Property acquired by a governmental entity through eminent domain proceedings is governed not by Section 1031, but rather by Section 1033, which is the involuntary conversation statute. Rules around property replacement under eminent domain are much more flexible than Section 1031 tax-deferred exchange rules.
CLA has a real estate industry team ready to assist.
For more information on tax opportunities, contact Ken Zacharias at ken.zacharias@CLAconnect.com or 920-455-4207.
The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting, investment, or tax advice or opinion provided by CliftonLarsonAllen LLP (CliftonLarsonAllen) to the reader. For more information, visit CLAconnect.com.
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