Tax-Deferred Exchanges

Selling real estate normally triggers capital gains tax, plus tax on depreciation recapture at ordinary income rates. Section 1031 of the Internal Revenue Code defers recognition of that gain when the proceeds are used to buy other like-kind property held for business use or investment.

An exchange doesn’t make a sale tax-free — the deferred gain is recognized when the replacement property is eventually sold. The main benefit is greater investment capacity through tax deferral.

1. Both properties must be held for productive use in a trade or business or for investment.
2. Replacement property must be identified within 45 days and purchased within 180 days of the relinquished property’s closing.
3. You cannot touch the sale proceeds. An independent qualified intermediary must hold them — not an escrow, family member, friend, employee or agent.
4. Generally, the owner of the relinquished property must also own the replacement property.
5. All proceeds must be reinvested, and the replacement property must be worth at least as much as the relinquished property.

Individuals, corporations, partnerships, limited partnerships, LLCs and other business entities may all use Section 1031.

Like-kind refers to how the real estate is used, not its type. Raw land is like-kind to improved real estate; farmland may be exchanged for an apartment building; a shopping center may be exchanged for an office building.

The key factor is the owner’s intent at the time of the exchange and the nature of the owner’s trade or business — not how others use the property. The IRS generally expects property to have been owned for about two years, although no regulation sets that period.

Ideally before you sign a contract to sell the relinquished property. It must begin before the relinquished property closes — after closing, Section 1031 benefits are unavailable.

The titleholder of the replacement property must match the titleholder of the relinquished property, with exceptions: tenants in common may each decide whether to exchange; a sole owner may acquire an undivided tenant-in-common interest; and a sole owner may take title through a single-member LLC.

Replacement properties must be identified within 45 calendar days under one of three rules:

• Three Property Rule: identify up to three properties of any value, and buy one, two or all three.
• 200% Rule: identify any number of properties as long as their combined fair market value doesn’t exceed 200% of the relinquished property’s value.
• 95% Rule: identify any number of properties of any value, provided you actually acquire at least 95% of their combined fair market value.

Yes. The contract should state your intent to complete an exchange and require the other party’s cooperation, at no additional liability or material cost to them, and permit assignment of the contract to Investment Protection Exchange Services, LLC, a Michigan LLC, as qualified intermediary. Call us for sample clauses for both the sale and the purchase.