Taxpayers often make the mistake of focusing on the potential payout from an investment without considering how much of that will disappear to taxes. A classic example is real estate. Owning a business or investment property can result in significant profits, but when it comes time to sell that property, taxpayers may be unprepared for the massive capital gains tax attached. This is where you come in as a tax professional—with the strategies that taxpayers need to minimize that tax bill.
Sometimes the key is simply time. Investors may benefit from delaying the moment that they have to pay that tax. In this case, if they are willing to stay in the real estate market, the best strategy may be the 1031 exchange. The 1031 exchange allows property owners to trade property held for business or investment purposes for a “like-kind” property without paying a capital gains tax for that trade. This exchange does not eliminate the tax, of course—it simply defers it. When the property owner does sell that property outright, then they will pay that capital gains tax.
To complete a 1031 exchange, the taxpayer will need to work with a Qualified Intermediary whose job is to ensure the trade meets all of the legal requirements for 1031 benefits.
Depending on the needs of your client, you might suggest different types of 1031 exchange. There are four main options:
- Simultaneous Exchange
- Delayed Exchange
- Reverse Exchange
- Improvement Exchange
Simultaneous Exchange
A simultaneous exchange is the simplest form: two property owners swap the deeds and ownership of their properties. This can even work if multiple properties are exchanged for a single, more valuable property. The important thing is that each owner relinquishes their original property and receives a replacement property at the same time. Even a small delay can disqualify the exchange in the eyes of the IRS. While it is theoretically possible to complete this transaction without a Qualified Intermediary, working with one can ensure all the boxes have been checked to qualify for 1031 tax benefits.
Taxpayers should be warned that the logistics here can be complicated. Property owners may have difficulty finding a trading partner whose property has a similar debt and equity structure. Getting the legal aspects of the transaction in order may also prove tricky to accomplish quickly.
Delayed Exchange
The most common type is the delayed or deferred exchange. This occurs when the property owner has a buyer for their original property but has not yet identified a replacement property. If the property owner chooses to sell their property first, the Qualified Intermediary plays an especially essential role by holding onto the cash from that sale until the replacement property is acquired. Then the Qualified Intermediary exchanges that cash for the new property and finally transfers the new property to the investor themselves.
To qualify for a 1031 exchange, the owner must find a replacement property within 45 days of that first sale. Secondly, the Qualified Intermediary can only hold onto the sale proceeds for 180 days, which means that is the maximum amount of time the investor has to find and close on the replacement property.
Reverse Exchange
A reverse exchange is the opposite of a deferred exchange: the property owner has found the property they want to obtain but has not found a buyer for the property they currently own. In this case, the property owner buys that new property first through an Exchange Accommodation Titleholder—an entity such as a limited liability company that may be set up for this specific purpose. This entity initially takes the title to the new property, since the property owner cannot own both properties at the same time and still qualify for 1031 exchange benefits.
With a reverse exchange, the property owner has 45 days to declare the sold property as relinquished. They then have 135 days to find and complete the purchase of a replacement property. An issue property owners may run into is that many banks will not fund this type of purchase, and the deed transfer process may be complicated depending on the state where the property is located. However, if a quick purchase is necessary to secure an ideal replacement property, this may be the best option.
Improvement Exchange
Lastly, an improvement or construction exchange provides a way for a property owner to upgrade the replacement property by using the exchange equity, or the deferred tax amount. This option can be beneficial to a property owner who wants to acquire a replacement property that does not fully fit their needs, say to rent out the property. This must occur before the 1031 exchange is complete, since the construction is considered part of the exchange.
In this case, the property owner must identify a replacement property, relinquish ownership of their current property, and allow the Qualified Intermediary to hold the proceeds from the sale. The Qualified Intermediary then pays for any property renovations, which must be specifically outlined as part of the sales contract for that property. All renovations must occur within 180 days of the sale. When the Qualified Intermediary deems this process complete, the investor can take ownership of that property.
Summary
For taxpayers looking to benefit from a 1031 exchange, tax advisors can provide immense value by walking them through the differences between a simultaneous, delayed, reverse, or improvement exchange. The taxpayer will also want to enlist the help of a Qualified Intermediary to take control of the funds or property during the exchange so that property owners can avoid holding any cash from a sale or owning both properties at once.
The key to successfully applying this strategy is staying on top of the rules and deadlines for the chosen exchange type. This is where you as the tax expert can provide guidance by incorporating this process into your clients’ overall tax plan. For additional training on 1031 exchanges and similar tax deferral opportunities, sign up to become a Certified Tax Planner today.
