1031 Exchange Explained

A 1031 exchange is simply a method by which a real property owner disposes of one property and acquires another without having to pay any capital gains tax on the transaction. In an ordinary sale transaction, the property owner is taxed on any gain realized by the sale of the property. In an exchange, the tax on the exchange is deferred.

1031 exchanges are authorized by Section 1031 of the Internal Revenue Code. Careful adherence to the requirements of Section 1031 is important in maintaining the tax-free status of the transaction. The sale of the relinquished property and the subsequent reinvestment in a replacement property can qualify as a trade or exchange by means of an exchange agreement and the services of a qualified intermediary. An intermediary can guide you through the IRS's regulations, making a 1031 exchange easy, inexpensive, and safe. You should also consider having your accountant and/or attorney review any real estate transaction.

IRS 1031 and Tenants in Common

Investors have long used 1031 Exchange deals to defer taxes when swapping old properties for new ones in their portfolios. Now, thanks to a 2002 Internal Revenue Service ruling, the pool of commercial properties has expanded greatly for small investors.

The ruling pertains to “Tenant in Common,” which allows individuals to own a fractional interest in a 1031 property, such as a shopping center or office building. The IRS ruling was an important step in providing assurance that TIC properties qualify as viable 1031 Exchange options.

The combination of the IRS ruling and the TIC structure opens the door to ownership in larger, higher-valued and better-located properties than an individual could afford independently. And it puts investors into long-term, triple-net leases or professional managed properties, letting them avoid the hassles of property management.

Here's how a TIC deal works: Suppose an investor has $250,000 to reinvest in a “like-kind” exchange. By pooling his $250,000 with the capital of other TIC investors, that same investor has access to a much larger and diverse inventory of investment properties such as office buildings, shopping centers or industrial facilities.

Impact of the IRS Guidelines

Although the TIC structure has been in use for more than a decade, it's clear that the new IRS guidelines issued in March 2002 helped ignite growth. Specifically, IRS Revenue Procedure 2002-22 clarified the circumstances under which the IRS will recognize the TIC structure as a viable 1031 Exchange option.

A Supply Shortage

TIC ownership solves a growing problem among 1031 Exchangers — a shortage of like-kind properties — a requirement for favorable tax treatment.  Demand is being driven by investors fleeing equities as well as by small commercial property owners heading into retirement who are looking to simplify their finances through passive ownership.

Another part of the supply problem is that the bulk of 1031 investors are chasing similar properties. The majority of 1031 Exchanges are valued below $500,000 — 45% according to Deloitte & Touche — which further limits the pool of viable exchange options. Consequently, 1031 Exchange investors clamoring to find viable buying opportunities in a crowded market are discovering the beauty of co-ownership via TIC deals.

Enjoying the Upside

Although most sponsors — those firms in charge of assembling TIC deals — set the minimum investment at $250,000, a few niche players cater to investors with as little as $50,000 to invest. Not only do TIC deals let smaller investors into the market and provide them with greater access to better buildings, they also give real estate owners a way to swap out of management-intensive properties.

Pitfalls

The TIC phenomenon is not risk-free. The biggest downside occurs when a deal falls through and prevents an investor from successfully completing a 1031 Exchange in the allotted time period. If an investor fails to close on the exchange, the investor is forced to pay a hefty capital gains tax on the original property sale. The IRS gives exchange investors 45 days to identify a like-kind property from the closing date on the sale of the original property, and 180 days to close on the purchase of the new property.

Investors also need to consider exit strategies. Most TIC deals have a long-term structure. However, the holding period can vary from three to five years to upwards of 20 years for the dissolution of the interest and sale of the property.

The first recourse for investors trying to liquidate their holdings is to sell their ownership piece to the sponsor or fellow investors, often at a discount….after that, the options typically look like a typical real estate sale with a broker or otherwise finding interested buyers

Replacement Property Criteria

THE 45 DAY RULE requires the Exchanger to identify a potential replacement property or properties within 45 days after the closing of the sale of the relinquished properties. You may identify properties under the a) 3 Property Rule (most common method) where you identify up to three properties regardless of fair market value, or b) the 200% Rule where you may identify more than three properties provided the fair market value of the identified properties does not exceed 200% of the fair market value of the property relinquished.

THE 180 DAY RULE requires the Exchanger to purchase the replacement property or properties within the earlier of a) 180 days after the transfer of the relinquished property or b) the due date of the Exchanger’s tax return (including extensions) for the year in which the relinquished property is transferred.

The 45 and 180 Day Rules can sometimes be difficult to satisfy because of the time required to locate replacement property, negotiate a purchase, perform due diligence, arrange for financing, etc. Moreover, it is not easy to find replacement properties with the right cost or ratio of equity and debt requirements which you desire.