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Why '1031 Exchanges' Interest Investors
Since 2002 IRS clarifications, 1031 exchanges can now be used by tenants-in-common (TIC)With the recent run-up in real estate prices, investors are looking for ways to defer capital gains taxes. Unlike a primary residence, where a $250,000 exclusion amount may apply if certain criteria are met, the individual investor is left with few alternatives to avoid taxation. However, Section 1031 of the IRS Code may provide just what the individual investor is looking for.
Because of 2002 IRS clarifications, the 1031 exchange has become a very popular option for many real estate investors. A 1031 exchange (named after Section 1031 of the IRS code) is not a new idea. It was created in 1921 in order to allow for a reciprocal transfer of certain types of property. In the past, abiding by the very strict requirements of the 1031 caused investors to choose other options when selling their real estate. Now, with Tenants-in-Common (TIC) ownership, the popularity of the 1031 has been increasing significantly. Since 2001, the amount of money invested in TICs has roughly doubled each year. It is believed that TICs will reach more than $5 billion in 2006.
Tenant-in Common is a form of ownership whereby two or more individuals own a partial share of a whole piece of property. Each co-owner receives his or her portion of net income, tax benefits and appreciation. TIC investments are created by various sponsors who acquire the property and package it for sale to multiple investors who will each own a fractional interest. The typical TIC offering is a large institutional property such as an office building or luxury apartment complex.
A 1031 exchange is usually a three-way delayed exchange in which an intermediary is used to facilitate the transaction. There are four basic steps:
1. The seller arranges for the sale of property and includes exchange language in the contract.
2. At closing, sales proceeds go to a Qualified Intermediary for a 1031 exchange.
3. The seller must identify potential exchange properties within 45 days of the closing.
4. The seller must complete the 1031 exchange within 180 days of closing.
A successful exchange can result in the taxpayer being able to utilize 100% of the proceeds from the sale of property to purchase a new property, thus deferring capital gains. By doing this, real estate owners can accomplish a number of objectives: diversification, improved cash flow, greater leverage, geographic relocation, or property consolidation.
The power behind the TIC
Heirs receive a stepped-up basis on the TIC investment, potentially eliminating capital gains taxes altogether.One driving force behind the increase in TICs is the ability to defer taxes on the gains from the sale of certain types of property, while taking advantage of the recent real estate boom in highly desirable areas. Another driving force is TIC investors typically become owners of high quality commercial or industrial property. Thus, the owner becomes a passive owner, which means no 2:00 am phone calls that the toilet is clogged or the heater broke. A third benefit is TIC investors can receive monthly income from their investment while still having the potential for appreciation of the property. Lastly, heirs receive a stepped-up basis on the TIC investment, potentially eliminating capital gains taxes altogether.
There are risks involved
While a TIC investment provides many benefits, you should also be aware of the risks and limitations of such an investment. TIC interests are not freely transferable, and there is no secondary market for these interests. Cash distributions and potential property appreciation are not guaranteed. Also, investors in a TIC are subject to the typical risks of real estate ownership such as economic influences, occupancy rates, and tenant risk.
Some Dos and Don’ts
Do advanced planning for the exchange and talk to your accountant, attorney, and financial advisor prior to selling a property.
Do not miss your 45-day identification deadline as this will disqualify the entire exchange, and expose you to possible tax liabilities from the sale.
Do keep in mind that you must receive only “like-kind” replacement property in the U.S. (i.e., you can exchange any real estate investment for any other type of real estate investment; for example, vacant land can be exchanged for an office property; an apartment can be exchanged for a retail property), must use all proceeds from the sold property for purchasing the replacement, and make sure the debt on the replacement property is equal to or greater than that on the relinquished property.
Do not try doing a 1031 exchange yourself using your CPA or attorney to hold title or funds. IRS regulations require a Qualified Intermediary to properly complete an exchange.
As you can see, there are some wonderful benefits to the 1031 exchange but qualifying and following every rule can be tough. You should consult with legal experts knowledgeable on these transactions before deciding if a 1031 is right for you.