David, a real estate investor, calls his lawyer. David relates that he found a property that he thinks is at a low but predicts the price will soon soar. To finance the purchase of the new property, he wants to sell a different investment property, which he just purchased a year ago. Since the purchase, the value of that property has increased significantly. David is concerned that if he sells the old property now, then he will have to somehow absorb a large tax hit because that property doubled in value over the past year.
David’s lawyer tells him that he might not have to absorb any tax hit at all. Instead, the proceeds from the sale of one investment property that is used to purchase another investment property might not be taxed at all because they may qualify as a 1031 like-kind exchange. As a 1031 exchange, explains the lawyer, the tax would be “deferred,” or pushed until a different time, perhaps when David sells the new property.
Armed with this information, David calls his real estate broker to request that he put the old property up for sale. David then calls the broker on the new property to discuss a sales price.
1031 Basics
The substance of a 1031 exchange is that it provides taxpayers neither gain nor loss, in tax terms. when property is exchanged for “like-kind” property. A 1031 exchange usually does not apply to a person’s residence, but to investment properties.
In our example above, suppose David purchased the old property for $500,000 and due to soaring Colorado real estate prices, he can easily sell it today for $1,000,000. This means that David would make a profit $500,000, which is generally taxable. However, because David sold the old investment property and purchased a new investment property, it qualifies as a like-kind exchange. As a like kind exchange, David would not owe the IRS anything at this time for the sale of the property, despite profiting $500,000.
Now, David purchases the new property for $1,000,000. Suppose that in 2020 he decides to sell the property because he does not want to be in the real estate business any longer. Suppose also that the price of the new property is now $1,100,000. David profited on $100,000 on this sale and he will be responsible for taxes on that $100,000. In addition, he will now be responsible for taxes against the $500,000 on the sale of the old property because the tax against that property was deferred, not forgiven. Since the sale of the new property in 2020 is not for a like-kind property, the 1031 advantage goes away, leaving David responsible for all tax obligations owed as a result from the sale of the old property.
In sum, a 1031 exchange is advantageous because it defers taxes on the sale and purchase of similar properties; it is only a deferment, however, so if you take advantage of it now, it does not mean that you will never pay any taxes against it.
As mentioned above, a 1031 exchange is a tax deferment tool wherein a party selling a property will not be assessed tax on the sale of the property provided that such party exchanges that property for a similar property. If such party sells the property at a later date not within the 1031 exchange context, the party will then pay taxes against the sale of that property.
This article provides more detail about the qualifications for a 1031 exchange. The following elements are required for a sale to qualify as a 1031 exchange:
- Interdependence;
- Same taxpayer;
- Receipt; and
- Identification.
Interdependence
This element requires that the sale of the first property and the acquisition of the second property be interdependent, which means that one does not happen without the other. This is based on the Fifth Circuit ruling in the Bell Lines case from 1973 (a case in which a company sold trucks and then purchased new trucks). The court in that case did not provide specifics of how to determine what qualifies as interdependence, and therefore, the exact definition of “interdependence” is not entirely clear. To definitively attain interdependence, it is good practice to obtain the assistance of an experienced real estate attorney.
Same Taxpayer
The taxpayer selling the property must be the same taxpayer who purchases the new property. As a result, a taxpayer who sells property and later forms a partnership to purchase the new property does not fall under the 1031 exchange guidelines.
There is an exception when an individual sells a property and then purchases a new property as a single-member LLC. In that case, both the sale of the old property and subsequent purchase of the new property will constitute a 1031 exchange.
Receipt
To properly effect a 1031 exchange, the taxpayer cannot take receipt of the proceeds that will be used to make the exchange. That is to say, if the taxpayer is attempting to make the exchange, the taxpayer or anyone who would be considered the taxpayer’s agent must not hold the money from the sale of the old property. Instead, a qualified third party must hold the money in escrow and then use that money to pay for the purchase of the new property.
The taxpayer’s agent includes family members and the taxpayer’s lawyer. Therefore, when attempting a 1031 exchange, the money from the sale must go directly to someone who is qualified. It is a good idea to appoint someone to hold the money long before the sale. The experienced attorneys at the Nesbitt Las Offices can assist in identifying qualified third parties.
Identification
The taxpayer must identify the new property within 45 days of closing on the old property. Therefore, even though a qualified third party is holding the proceeds of the sale, the taxpayer does not have an unlimited amount of time to act. It is therefore a good practice to have an idea about the new property prior to the closing of the old property.
A later article will discuss exchange values of the properties.
For questions about 1031 exchanges or other real estate legal needs in Colorado, contact the Law Offices of Eric L. Nesbitt, P.C. at 303-741-2354 or Info@NesbittLawOffices.com.