Section 1031 of the Internal Revenue Code is one of the most powerful tax deferral strategies available for real estate investors. It is basically a “never pay capital gains tax” provision on the sale of property, provided the sales proceeds are reinvested in similar or like kind property. However, for the active real estate investor who has structured his investments in business entities, Section 1031 can prove to be a minefield for the unwary.
Basic Rules For a 1031 Exchange
- The Property You Are Selling Must Be Held For Investment or Used In Your Trade Or Business. Investment property is straightforward. It includes any real estate, improved or unimproved, held for investment or income producing purposes e.g., residential or commercial property, raw land, fractional interests, leasehold interests, easements, water or mineral rights, oil and gas interests, even development rights. Property used in your trade or business includes real estate and equipment used by your business.
- The Replacement Property Must Be Like Kind. This requirement prevents many investors from implementing an exchange for fear that the property is not like kind. This is an intent based requirement and not a physical requirement i.e., if the property you are selling was held for investment then the property you are buying must also be treated the same. For instance:
- An apartment building can be replaced with raw land or vice versa.
- One rental property can be exchanged for two or more properties or the reverse.
- Note that a personal residence or secondary residence, land held for subdivision and sale, or fix and flips do not qualify for an exchange.
- Replacement Property Title Must Be Taken In The Same Name as The Relinquished Property Was Titled. If the property you are selling is owned in your name then the replacement property must be taken in your name. (After you have taken title in your name you can later transfer the property into a land trust and/or LLC provided there is no change in beneficial ownership. Most CPA’s will recommend you wait until a new tax year to make this change. However, if the entity you are using is disregarded for tax purposes, then I do not believe you must wait because the entity is ignored for income tax purposes.) Similarly, if the property is held in a land trust, corporation, LLC or other entity, the replacement property must be taken in the name of the entity.
Planning Considerations for Entity Owned Property
The last rule can prove problematic for investors contemplating a 1031 exchange who currently own property in a land trust or LLC and plan on using financing to acquire the replacement property. As you are aware, when financing the acquisition of residential real estate a lender will require that title be taken in the borrower’s personal name. I am sure you can understand how this can implode your exchange if you originally sold property held in an entity only to arrive at closing and your lender refuses to close in the entity. The lender requires title to be taken in your individual name thus violating the 3rd rule and voiding your exchange.
Pre-Planning is Your Solution
If you plan on entering into an exchange with property held in an entity and you plan on acquiring residential real estate with the exchange proceeds, then my recommendation is to deed the property into your personal name prior to listing it for sale. I recommend you adopt this strategy even if you do not plan on using financing for the replacement property to keep your options open.
After your exchange is finalized, you can transfer the property back into your entity. (See my comment above regarding CPAs and their view.)
Property Held in an Entity with Other Partners
The above approach is also useful in those situations when you have invested with other individuals and now it is time to sell the investment. Frequently, one or more of the partners in a partnership desire to take cash when the property is sold rather than roll the proceeds into a replacement property. This presents problems that require careful planning and is not without tax risk.
To preserve your exchange options in a partnership setting, the prudent course of action is for the individual partners to deed the property out of the partnership and into the individual partners in advance of the sale. This is done in the context of a distribution of property from the partnership to its partners, who then hold the property as tenants in common. In doing so, each individual partner is positioned to sell or exchange his tenancy in common ownership in the real estate. People familiar with 1031 exchanges will refer to this strategy as a “drop and swap”.
1031 exchanges are a great tool for tax deferral but with everything in real estate investing, it pays to invest in some pre-planning to ensure you are maximizing your benefits. As I have stated before in previous posts, it can be the little things i.e., an afterthought, that can disrupt the entire plan.