1031 Exchanges: A Quick Primer

Brown: “Many times when people hear like-kind exchange they think have to stay within the same property type.”

IRVINE, CA—1031 exchanges continue to attract interest as a method for deferring taxes on a property transaction. But the strategy can be daunting for the first timer. How does a broker approach these transactions in retail and elsewhere? To learn more about this, GlobeSt.com sat down with expert Belden Brown, SVP and national sales manager at Passco Companies. GlobeSt.com: Passco is known for its expertise in providing 1031 tax differed exchange solutions. Can you explain what brokers need to know about this process and how a 1031 exchange can benefit a seller? Belden Brown: A 1031 tax deferred exchange allows a seller to defer taxes on the sale of a property, assuming the seller follows the rules established by the IRS. When done correctly this can provide benefits to a seller. The basic rules that need to be followed include:

• Acquire only “like-kind” replacement property.
• All proceeds from the relinquished property must be used for purchasing the replacement property.
• Make sure the debt on the replacement is equal to or greater than the debt on the relinquished property. (Exception: A reduction in debt can be offset with adding additional cash; however, a reduction in equity cannot be offset by increasing debt.)
• IRS regulation requires a QI (Qualified Intermediary) to be used to properly complete an exchange.
• Do not dissolve a partnership or change the manner of holding title during the exchange. The title must remain the same during the exchange process.
• The seller has 45 calendar days from the close of their real estate to identify the replacement property (ies), known as the “Identification Period” and then another 135 days to close on the replacement property (ies) identified.

The potential benefits are the deferral of taxes and then having those dollars (which would have been paid in taxes) working for the investors to grow the value of its investment until the property is actually sold, which at that time the taxes would be due, unless the seller decides to complete another 1031 exchange. Depending upon the replacement property there can be some increase in tax sheltering of cash flow from the new property. Some sellers continue to exchange numerous times until their death. At that time the property than goes to their heirs at a stepped up basis. GlobeSt.com: Can a seller only exchange assets that are within the same product type and can the exchange be split among several different investments? Brown: Overall, a 1031 exchange provides flexibility for an investor to purchase replacement properties within different property types if they so choose, as long as those properties are held for investment. Many times when people hear like-kind exchange they think have to stay within the same property type. With any 1031 exchange, an investor can exchange assets across all property types. For example, if an investor sells a retail center and wants to reinvest that capital into a multifamily asset, that is completely acceptable. An investor may also split the exchange amount among several different investments. During the Identification Period, most sellers use the “three property” rule, by which a seller identifies three separate properties as like-kind investment options. The investor has the capability of closing on all three properties or just one if he or she chooses. The investor may also utilize the “200 percent rule,” which allows an investor to identify any number of replacement properties as long as the values do not exceed 200 percent of the value of the relinquished property. The “95 percent rule” allows an investor to identify any number of replacement properties, but the investor must close on all of the identified properties for this to qualify. The 95-percent rule is the least commonly used of the three. There is no limit as to how many times a 1031 exchange can be completed, allowing an investor to exchange from property to property until they are ready to cash out, but then also realize the deferred taxes will be due. Brokers working with sellers who want to continue to defer their tax liability should consider a 1031 exchange as a viable option. GlobeSt.com: How is the debt and equity structured in a 1031 exchange? Brown: All proceeds from the relinquished property must be used for purchasing the replacement property. Make sure the debt on the replacement is equal to or greater than the debt on the relinquished property. (Exception: A reduction in debt can be offset with adding additional cash; however, a reduction in equity cannot be offset by increasing debt.) GlobeSt.com: How would you suggest a broker structure the sale of a property? Brown: When a seller wants to complete a 1031 exchange after their sale, it’s important for the broker to have language in the escrow notifying the buyer that the sale is contingent upon the seller completing a 1031 exchange.  The escrow can have extensions, allowing more time for the seller to find a suitable replacement property. This will help to ensure that the seller is able to identify a replacement property to purchase. The second thing a broker will always want to do is to make sure the seller already has properties lined up to purchase prior to the close of the initial sale. A broker will never want to close escrow on a property and then look for a property to purchase. Once the initial property closes escrow, the clock starts and those 45 days can run out quicker than you think, especially in the current competitive market landscape.