Section 1031 exchanges – which allow investors to exchange like-kind properties to defer capital gains taxes – can offer real tax benefits. But they also come with strict rules, such as time limits for completing the exchanges.
Fortunately, a twist on Sec. 1031 exchanges may be available to you that could essentially double the length of one critical time limit. This might help you take advantage of the weak commercial real estate market and obtain valuable properties at reduced prices.
Crucial time limits
Like-kind exchanges are named after the Internal Revenue Code section that allows you to exchange business or investment property (called relinquished property) for business or investment property (called replacement property) of a like kind without initially recognizing any capital gain until you sell the replacement property.
Since buyers and sellers’ timing is not always exact, the law allows a deferred exchange when you transfer relinquished property before the replacement property is acquired.
In such cases, you must identify the replacement property within 45 days of when the relinquished property is transferred. The IRS has some rules to help with meeting the identification of the property, but the key is that the IRS is very strict on the time frame, so generally no extensions are granted.
Then you must acquire the replacement property within 180 days of the transfer or by the due date of your tax return (including extensions) for the year in which the relinquished property is transferred.
Again, the IRS is very strict on the time frame. The requirements for the exchange must be met no later than the last business day prior to the deadline date.
The same time limits apply to reverse exchanges. In a reverse exchange, the replacement property is acquired first and held by an exchange accommodation titleholder (the accommodator) before you transfer the property you’re relinquishing.
In a memo from the Office of Chief Counsel (Memo No. 200836024), the IRS considered a scenario in which a taxpayer structured two separate exchanges.
In the first, a reverse exchange, the replacement property was acquired and warehoused with the accommodator, and the taxpayer identified the relinquished property in a timely manner, within 45 days.
The relinquished property had a much higher value than the replacement property, so the taxpayer planned to engage in a second exchange – a deferred exchange – to defer the gain that remained after the relinquished property was exchanged for the replacement property.
A qualified intermediary (QI) was retained to execute the transfers of the properties in both exchanges. The QI followed all guidelines to ensure the taxpayer wasn’t in constructive receipt of any of the exchange funds during the two 180-day exchange periods.
The IRS memo concluded that, as long as the various guidelines are followed, the same relinquished property can be used in both forward and reverse exchanges, even though allowing this structure could result in up to 360 days between the day on which replacement property is warehoused at the beginning of the reverse exchange and the day the deferred exchange is completed.
It’s important to note that a memo from the Office of Chief Counsel is specific to the particular facts that it addresses and has no precedential value. That said, it does provide a guideline for how to structure such a transaction.
How it works
Imagine you decide to purchase a property in Florida for $450,000 in January 2013. You warehouse it with an accommodator so you can determine which property you’d like to sell so you can take advantage of the benefits of a reverse exchange.
Within 45 days, you identify a property in Michigan. In July 2013, within 180 days of warehousing the Florida replacement property, you sell the Michigan relinquished property for $1 million, completing the reverse exchange.
You begin executing a deferred exchange within 45 days of selling the Michigan property by identifying additional like-kind replacement properties to purchase with the remaining $550,000 of proceeds from the relinquished Michigan property.
And you have 180 days from the close on the Michigan property to close on one or more identified replacement properties.
So, you don’t have to close on those properties and complete the deferred exchange until January 2014 – nearly a year after you purchased the Florida property.
Although the above example might sound a bit overwhelming, a 360-day forward and reverse exchange combination is definitely attainable. The key is to consult your tax adviser to ensure that you satisfy all of the requirements and guidelines for Sec. 1031 exchanges.
Consulting with your adviser could get you assets you need and save you some tax dollars.