1031 Tax Trick Saves Sellers on Swaps

In the past decade, Rocky Vantine has seen a dramatic jump in the number of 1031s coming through his Rogers office — from about three a year to 60.

Most people consider Vantine the local expert on buying and selling properties that fall under Section 1031 of the Internal Revenue Service tax code. These “like-kind exchanges” allow sellers to avoid paying capital-gains taxes (usually about 20 percent) by buying a similar piece of real property.

“It’s really ratcheted up over the last five years or so,” said Vantine, who estimates he’s done around 500 Section 1031 exchanges in the past 25 years with deals stretching from Florida to California.

Vantine said the real estate boom in Northwest Arkansas, coupled with a wider knowledge of Section 1031, has contributed to the surge in exchanges.

Such exchanges have been part of U.S. law since the 1920s, but it wasn’t written into the IRS tax code until Section 1031 was added in the early 1980s. That’s when the IRS began enforcing certain restrictions on exchanges.

Besides the seller, also known as the exchanger, at least three people are needed to execute a 1031 exchange properly. They are the seller’s certified public accountant or tax lawyer, the buyer’s CPA or tax lawyer and a third-party, called a qualified intermediary, to facilitate the exchange.

Vantine is often asked to speak at workshops that teach employees of banks and real estate companies about all the nuances associated with 1031s.

“That part of my job is an educational process,” Vantine said. “So now, that Realtor who is out there selling a farm for somebody for $2 million can say to them with some knowledge, ‘Have you ever considered a 1031?’

“There’s a good chance that the farmer has never heard of it, but now the Realtor or the people at the title companies or the bank or accountant are all aware of 1031s.”

First 1031

Vantine remembers the first time he got involved in a 1031 exchange. A couple, originally from eastern Oklahoma, wanted to leave the West Coast and retire in Arkansas.

“They had sold a small apartment building in California,” Vantine said. “Their Realtor had told them about 1031 exchanges, so when they got here, they asked for help with a 1031 and so I got in contact with the attorney, Realtor and title company in California and worked out all the details. They ended up buying several duplexes here.”

Folks are fortunate to have another expert on exchanges in the area. Working for the Internal Revenue Service’s chief counsel in the late 1980s, Chris Rogers helped interpret the rules of tax code Section 1031.

Rogers, now a tax attorney for the Mitchell-Williams Law Firm in Rogers, said there were some gray areas in the code and the issue became a “front burner” for the chief counsel during Rogers’ time in Washington, D.C. The work they did helped iron out rules — such as defining exactly what like kind is and the steps for deferred exchanges — for Section 1031s as they are applied today.

Since returning to his home state in 1990, the Fort Smith native also has noticed a rise in the number of 1031s.

“Popularity is growing because people are finding out how great it can be … in the right circumstances,” Rogers said. “I wouldn’t want to force a situation where I have a client who really wants to get out of real estate ownership and do something different.

“But if the client wants to purchase new property, it really makes all the sense in the world to do a like-kind exchange.”

No Pain With Gain

Section 1031 states that, “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.”

Several pages follow the general definition and are full of many twists and turns that are defined as “special rules.” A major problem these days is that some are getting documents off the Internet and trying — often unsuccessfully — to complete a 1031 exchange on their own. That’s why it’s wise, before selling a property in which an exchange is planned, to contact a CPA or tax attorney.

“I think it’s too risky for what you have at stake to try to do it on your own,” said Blake Hanby, president of Accommodators Inc. of Lowell, a company that serves as a qualified intermediary for exchanges. “Your best bet is to contact your tax attorney and let them advise you on making sure the property does qualify as like-kind properties, how much you need to invest and determine if you even need to do it.”

Most every 1031 requires the use of a qualified intermediary to facilitate the exchange. As part of the exchange agreement, sale proceeds from the relinquished property stay with the qualified intermediary until they are applied to the closing of the purchase property. That way, earnings never pass through the hands of the exchanger and the IRS will not consider the taxpayer to be in receipt of the funds.

In order to get full deferral of tax on the gain, the purchase property has to be equivalent or greater than the relinquished property.

There also is the “three-property” rule where the taxpayer may identify up to three replacement properties without regard to their value and the “200 percent” rule, which means the replacement property cannot exceed twice the value of the relinquished property.

Within 45 calendar days of the sale of the relinquished property, the exchanger must identify, in writing, the replacement property to a qualified intermediary. The exchanger then has 180 days from the date of the original sale to close on the replacement property.

Between sales, the funds held by the qualified intermediary go into an interest bearing account, meaning exchangers actually make money while saving money.

The only instance where a qualified intermediary is not required is when people make an even swap for property without any money changing hands.

“If there is even a two-minute gap between the time you sell to the time you buy, then technically, you are in violation if you don’t have a qualified intermediary and have an exchange agreement in place,” said Hanby, who also is the president of WACO Title Co. “The exchange agreement is really a safe harbor, not to say that the IRS wouldn’t say it’s OK, but if you follow all the rules, they can never go back on you for it for tax purposes.”

Other Exchanges

There are other types of exchanges.

A build-to-suit (improvement or construction) exchange allows the taxpayer to build on or make improvements to the replacement property using the exchange proceeds. There also is personal-property exchange as well as a multi-asset exchange, which involves both real and personal property such as when a hotel that includes the surrounding land and interior furnishings is involved.

A reverse exchange is the second most popular behind the usual like-kind exchange. That’s when the replacement property is acquired prior to transferring the relinquished property.

“That typically comes up where I’ve found the perfect property and my seller on the replacement property is insisting that I close now, but the buyer of the relinquished property is not ready to close yet,” Rogers said. “When I’m doing the reverse exchange, it does become substantially more complicated.”

In Northwest Arkansas, many exchanges deal with farms. Perhaps, the farmer wants to get away from counting chickens and into counting rent checks by purchasing duplexes or office space.

However, there are a few wrinkles added to an exchange in dealing with farmland such as the depreciation of the poultry houses or what’s called a single-purpose agricultural facility. If there’s a personal residence on the farm, the home and surrounding acreage has to be separated from the rest of the land that is considered the investment property.

Are Taxes Ever Due?

The tax is deferred, or rolled over, from exchange to exchange and as long as the taxpayer continues making exchanges, they never have to pay taxes on the property. In other words, the basis of the original relinquished property follows the purchased property. If the property is ever sold for cash, then at that point, it would be taxed.

It can be a huge benefit for the children of the original exchanger since when he or she dies, so do the tax obligations.

“If that person dies and leaves it to their child, that child then gets a stepped-up basis on that property,” Vantine said. “If it’s a piece of property that was bought, say 40 years ago for $10,000 and sold for $400,000 as part of an exchange, [the kids who inherited the property] could sell that property for $400,000 and pay no tax on it.

“That’s what happens with people who are inclined to own property anyway. They eventually die and when they do, it’s a stepped-up basis and at that point, all the income tax is bypassed.”

Using a 1031 exchange is really a no-brainer when considering the benefit of deferring taxes for the duration of the time the property is owned. Another reason the number is growing in this area is because of the domino effect that comes with every exchange breeding an additional exchange and so on.

“The like-kind exchanges have created a lot of people out there who have sold property,” Rogers said. “Now, all those people are out there looking to buy replacement property. Then when they buy that replacement property, then we’ve created another seller and those sellers are now looking for replacement property.

“In that respect, it’s just going to keep building in popularity.”

Defining ‘Like-Kind’ Properties

Understanding what qualifies as a like-kind property is the first step in executing a Section 1031 exchange under the Internal Revenue Service tax code.

John Ervin, a certified public accountant in Fayetteville, used a personal business deal to illustrate how the tax deferment law can be applied. It started several years ago when he wanted to buy property on Beaver Lake.

“The seller was moving and wanted to buy a piece of property down on Lake Martin in Alabama,” Ervin said. “So what I did, without even seeing it, was bought that piece of property in Alabama and traded it with the guy up here for his lake property, so we did a like-kind exchange on that transaction.

“And I owned a piece of property in Alabama for five seconds one time,” Ervin said with a chuckle.

A like-kind exchange often concerns swapping investment property for investment property. There are specific things that do not qualify as like-kind such as inventory, stocks, bonds or other investment securities. Interests in a partnership and certificates of trusts or beneficial interest are excluded as well.

In addition, property located outside the United States does not qualify as like-kind with property located inside the United States.

Other examples would be exchanging a racquetball club for a golf course or duplexes for an apartment building. Farmland falls under the category of investment property since it also is income producing.

“It’s primarily centered around real estate, but it can be for other things,” Ervin said. “Personal property is not excluded. For instance, swapping a cow for a cow might be like-kind exchange. But swapping a cow for a bull would not be even though they both are cattle.

“You have to understand what like-kind for like-q2kind is all about.”

Before attempting a Section 1031 exchange, sellers should ask their tax attorney or CPA if their property qualifies as like kind.

Key Words For 1031s

Exchanger — The property owner(s) seeking to defer capital gains by utilizing a Section 1031 exchange. The IRS uses the term “taxpayer.”

Like Kind — To qualify as like-kind property in a 1031 exchange, the property must be real estate and not personal property. All real estate can be exchanged for real estate and qualifies as like kind. Raw land for improved land is like kind and vice versa.

Qualified Intermediary (QI) — The IRS requires that an investor does not take possession of the proceeds of the sale of the relinquished property during an exchange. The QI acts as the fiduciary over the proceeds of the sale to keep the investor in compliance with IRS rules and laws.

Relinquished Property — The property sold by the exchanger. This is sometimes referred to as the “exchange” property, or the “downleg” property.

Replacement Property — The property acquired by the exchanger. This is sometimes referred to as the “acquisition” property, or the “upleg” property.

Source: Internal Revenue Service