As discussed in my last post, our tax code gives homeowners who sell their primary residence a nice tax break. But where does that leave commercial and rental property owners?
After all, where was Uncle Sam while you were fixing a tenant’s toilet at 10:00 pm? Where was Governor Cuomo when your office tenant snuck out in the middle of the night, leaving an unpaid rent bill and a suite full of chaos and damage? And where was Mayor Bloomberg when you spent 4 hours in tenant’s court explaining to the judge that the “no pets” provision in your lease includes poisonous snakes and alligators? So when you sell, why should government get a piece of your building when they didn’t share your risk, your hard work and your aggravation?
Good news: Congress has provided some help for commercial property owners. Using a popular provision in the tax code, many real estate investors have been able to keep the cold hand of government out of their pockets, at least temporarily. Internal Revenue Code Section 1031 allows investors to “defer” their capital gain tax by rolling their sales proceeds into other real estate. There are some important nuances:
1. Must Be Investment Property. By its terms, Section 1031 only applies to the exchange of property held for “productive use in a trade or business or for investment.” If the properties are rental houses, great! If the property is a warehouse used to store business inventory, perfect! If the property is your primary residence, it doesn’t work–no section 1031 soup for you. See our previous post on Section 121 and count your blessings. And remember, both the property you are selling and the property you are acquiring must be investment property.
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2. The Properties Must Be “Like Kind”. When we’re dealing with real estate, this second requirement is fairly easy to meet. Real estate is generally considered “like kind” to other real estate. It doesn’t matter that you are selling a factory and you want to purchase a condo for rental. As long as both properties meet the test in point number one above, you’re good to go. But if you want to sell an office building and buy the AC Shelby Cobra pictured to the right, you’ll forever have my envy, but you won’t have a valid exchange. In order to take advantage of Section1031, you must exchange your real estate for other real estate. Exchanges of automobiles and other personal property are much more restrictive and are outside the scope of this article.
3. You Can’t Touch The Money. For a valid 1031 exchange, the taxpayer must receive property in exchange for other property. Any cash the taxpayer actually or constructively receives from the sale will be subject to taxation, even if taxpayer subsequently purchases another property. To avoid receiving the funds, you generally need to employ the services of a “Qualified Intermediary” (“QI”) for your exchange. The QI essentially serves as a middle man through which the sales proceeds flow from the closing of the property being sold to the closing of the property being acquired. The QI keeps the money out of the taxpayer’s control. The most important point of this article: if you plan to do a 1031 Exchange DO NOT close on either property until you have employed a Qualified Intermediary AND signed their agreements!
4. There are Deadlines. The Treasury Department and the IRS are impatient–you don’t get a particularly long time to complete your exchange. Within 45 days of the closing of the sale, you must identify in writing the property or properties you plan to acquire. You can identify up to 3 potential properties regardless of their value. If you identify more than 3, additional rules limit the total value of all the properties you may identify.
If that isn’t convoluted enough, you must close on any of the properties you identified within 180 days from the closing of the property you initially sold. Both the 45 and 180 day deadlines are hard and fast. With the exception of certain federally declared disasters that affect the region where either the taxpayer or one of the properties are located, extensions of these time-periods are not granted.
5. Talk to Your Accountant. It is essential that you consult with your accountant before you sell your property to see if a 1031 exchange makes sense for your situation. A good CPA will help you figure out exactly how much you need to spend to fully defer the capital gain taxes and how much tax you will pay if you do not spend enough. To fully defer your gain, you must acquire property that is at least as expensive as the property you sold (less certain closing costs), and spend all of the proceeds from the sale. Just spending your profit is not sufficient. While a good Qualified Intermediary can give you some guidance, ultimately you and your accountant must be on the same page with regard to these calculations.
So now you know enough to be dangerous. The purpose of this article is only to give the basics. Issues like dealing with related parties, ownership by partnerships, limited liability companies and corporations, seller financing, different types of property interests, holding periods and other issues can create problems and cause unintended tax consequences.
No website or blog post is a substitute for professional guidance. Do your homework, consult with your advisors, and you just may be able to keep your profits working for you in a new more lucrative property.
In our next post, will wrap up our discussion on capital gain tax by discussing how the primary residence exclusion in IRC Section 121 can work with the tax deferral provisions of IRC Section 1031, potentially giving additional relief to a homeowner who is fortunate enough to have gain in excess of the primary residence exclusion.
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Related articles
- Hellwig: The Holding Intent Requirement in § 1031 Exchanges (taxprof.typepad.com)
Brady Business & Real Estate Advisor 
Posted on 08/21/2011
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