SAN FRANCISCO—A 1031 exchange or like-kind exchange allows a person to trade a property instead of selling it and thereby avoiding the capital gains tax that would otherwise be required to be paid. Real estate investors use these exchange strategies to maintain strong portfolios, apply more capital towards current real estate opportunities and maximize tax savings.
Property investors and commercial real estate owners have probably heard the good news that 1031 exchanges survived the recent changes to the tax code. The new tax law generally effective January 1, 2018 enacted a change to the previous law on 1031 exchanges. Now, only real estate, not personal property is eligible for the benefits of the 1031 exchange rules. In this exclusive, Steve Moskowitz, the founding partner of tax law firm Moskowitz LLP, offers insight into 1031 exchanges, the process and requirements.
GlobeSt.com: What are the requirements of a 1031 exchange to defer 100% of the tax?
Moskowitz: The same taxpayer both relinquishes and acquires real property(ies). The property that is going to be acquired in this 1031 exchange is identified within 45 days after the disposition of relinquished real estate, with acquisition of the replacement property within 180 days of the relinquishment that is equal to or of greater value than the relinquished real estate in order to defer 100% of the tax.
GlobeSt.com: What is the process for identifying which properties qualify for a 1031 exchange?
Moskowitz: The taxpayer must have a signed written document that is delivered to the person who is going to transfer the replacement property, often the qualified intermediary within the 45-day period. A qualified intermediary is the qualifying person or entity other than the taxpayer who acquires and transfers the subject real properties.
GlobeSt.com: How should one work with timelines and identification rules?
Moskowitz: Carefully! I have seen many people unnecessarily pay the full taxes on the relinquished real estate because the done deal didn’t happen with the requisite time period. A person should consider naming a “Delaware Statutory Trust” as one of the named properties with the 45-day period. A Delaware Statutory Trust is a trust that is set up to professionally manage real estate, which can be purchased from the financial institution of your choice.
GlobeSt.com: What are some of the advanced concepts for complete tax avoidance using sophisticated strategies?
Moskowitz: A person can have a lifetime of continuing 1031 exchanges until the end of his or her life and then can continue to use the exchanges after death with the proper estate planning and usage of trusts. How often can an investor utilize the 1031 exchange? Although there is no limit to the number of exchanges, this area of law requires that the subject real estate be held for productive use or investment. How long must the real estate be held to qualify for the benefit of section 1031? The Congress forgot to tell us, although most tax attorneys believe that a two-year period is safe.
Often, real estate is held by partnerships of a number of people and/or entities. A very common situation in this group is that some people want to sell and cash out while others want to do a 1031 exchange. How can everyone obtain these conflicting goals? There is a mechanism called a drop and swap, which essentially drops, i.e. transfers, the interest of the investor who wants to sell so that he or she can sell it while allowing the remaining investors to swap and do the 1031 exchange.
GlobeSt.com: How would an investor diversify a real estate portfolio using the 1031 exchange to acquire different types of real estate whether in the same or different geographic areas?
Moskowitz: The qualification of like-kind real estate is very diverse. As long as the real estate is located in the United States and “held for productive use or investment,” it should qualify. For example, you could trade a hotel in San Francisco for a farm in Georgia.
GlobeSt.com: When is a reverse or construction exchange a good option?
Moskowitz: A reverse exchange is when you acquire the replacement property before you identify the replacement property. Because of the usual role reversal here, the investor only has 135 days instead of 180 days to complete this exchange.
A construction exchange is when the real estate investor makes improvements to the identified replacement real estate by using all the cash held by the qualified intermediary to make improvements within the 180 days, which makes this property value equal or greater than the relinquished real estate.
The reverse and/or construction exchange may be a good option depending on the ever-fluctuating market variables and deals that may be struck at a certain time that would not otherwise be available. However, extra care should be taken here so as to avoid both the tax and financial pitfalls that are a trap for the wary, but an extra opportunity for the investor wise in the ways of the 1031 benefits.