An Introduction to Section 1031 Tax-Deferred Exchange - Part One of a Two Part Series
Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized if property held for productive use in a trade or business or for investment is exchanged solely for property of like-kind to be held for productive use in a trade or business or for investment. Section 1031 provides an exception to the general rule of current gain recognition on the sale or exchange of property. The exchange concept has been a part of the Internal Revenue Code since 1921 and reflects Congressional policy not to tax theoretical gains where the taxpayer has continued his or her investment in like-kind property.
Identifications and Other 1031 Exchange Issues
Section 1031 is highly technical and includes numerous complex requirements, including the following:
- identification of replacement property – all replacement property must be identified in writing within 45 days of closing the relinquished property;
- multiple property identification – three (and sometimes more) properties may be identified;
- closing deadline – all replacement property must be acquired by the earlier of 180 days or the due date of the taxpayer’s tax return (with extensions);
- replacement property debt/debt offset rule – reduction of debt in an exchange is taxable but debt secured by the relinquished property may be offset with debt secured by the replacement property (also, gain from debt reduction may be offset by cash from another source); and
- taxable boot – any cash or other non like-kind property received in the exchange is taxable.
These rules can be difficult to apply in the real world and may create numerous traps for the unwary.
Rise of 1031 Exchange Programs Starting in the late 1990’s
Exchangers typically acquire a “whole” property (that is 100% of a property) on their own as their Section 1031 replacement property. Many investors own a rental house or small commercial investment property that has been owned for a very long time with a low tax basis; others own properties that have been inherited and have a low tax basis. Low tax basis means high taxable gains on a sale for most taxpayers.
Small real estate investors typically are not active in the real estate business; they frequently struggle with the requirements of Section 1031 and may fail to satisfy the technical requirements. The biggest challenges for most investors include sourcing replacement property, conducting due diligence, identifying the replacement property within 45 days, and placing required debt on the replacement property.
To complete an exchange, investors must locate desirable replacement property. Small investors who are not in the real estate business typically do not have access to a broad menu of replacement property. They can engage a realtor or real estate broker, but this is foreign territory for many.
All replacement property must be identified in writing, typically sent to the qualified intermediary or accommodator holding the exchange proceeds. The identification must be sent within 45 days of closing the relinquished property. Failure to properly identify will result in the entire transaction being fully taxable.
The 45-day identification clock starts ticking when the relinquished property is sold for tax purposes (not necessarily the date on the settlement statement), and there are no extensions (barring a Presidentially-declared disaster, terrorism or military action). What if the timing is bad because the pricing of desirable properties is high, the inventory of available properties is low or the exchanger is on vacation? The 45-day requirement is inflexible; failure to properly identify will result in the entire transaction being fully taxable.
What if the investor has located several prospective replacement properties and has not decided which property or properties to acquire? Taxpayers can always identify three properties of any value and sometimes more using the so-called 200% rule or the 95% exception, to identify more than three properties. However, multi-property identification is problematic; a number of taxpayers will inadvertently over identify, which results in the entire transaction being fully taxable.
Conducting extensive due diligence is beyond the ability of many smaller investors; delegating the due diligence process to attorneys and CPAs can be very expensive. This creates a dilemma for smaller investors who understand that prudence dictates extensive due diligence on prospective real estate investments but do not have the skills or want to incur the costs to obtain professional help.
Taxpayers must reinvest the net proceeds from sale of their relinquished property. Any portion of the sales proceeds not reinvested by the taxpayer will be treated as taxable boot. Also, taxpayers must offset debt on the relinquished property with an equal or greater amount of debt on their replacement property. Many smaller taxpayers struggle reinvesting the exact amount of proceeds from their exchange and do not have access to commercial real estate lenders.
Also, many taxpayers own actively-managed real estate, such as a rental house or small commercial building but seek more passive replacement property. They may have access to other rental houses or small commercial properties but no longer want to deal with the “tenants, toilets and trash” and desire a more passive investment.
There is good news for real estate investors—many of the exchange challenges have been overcome by real estate firms known as “sponsors” who have created 1031 exchange programs to provide turn-key replacement property.
“Whole” Replacement Property; Net Leased Retail Properties
Historically, most exchangers have acquired a “whole” replacement property (that is, 100% of a property). Many real estate investors struggle with the requirements of Section 1031 and some will fail without professional help. Due to the complexity of satisfying the 1031 requirements, a number of real estate firms have developed a speciality in brokering net leased retail properties, such as Walgreens and CVS pharmacies. Such properties have become commoditized in part because they are relatively easy for exchangers to source, conduct due diligence, identify within 45 days, finance and acquire. Over the past decade, net leased retail properties have become the replacement property of choice for many exchangers acquiring a whole property.
Syndicators to the Rescue in the late 1990’s with TIC Programs
Beginning in the late 1990’s, a handful of real estate syndicators familiar with real estate partnerships began to syndicate fractional interests in real estate specifically structured for exchangers. These offerings became known as Tenant in Common, or TIC, offerings because the exchangers acquired an undivided Tenant in Common interest in the replacement property. Triple Net Properties, LLC, Passco Companies and Inland Private Capital Corporation were early adopters of the TIC structure.
TIC programs typically were sold as securities through independent broker-dealers across the nation. The goal was to provide a quality replacement property in a more convenient form for smaller investors who did not want to source, conduct due diligence, finance, and manage their own replacement property. Over time, TIC sponsors created a turn-key product where the due diligence was complete, the loan was in place, and the TIC interest could be acquired quickly, simply and with certainty to satisfy the strict requirements of Section 1031. Sponsors of TIC programs also provided full scope property and asset management services, creating a passive investment sought by many aging baby boomers.
The first round of TIC offerings from late in 1998 to early 2002 were structured based on the analysis of tax counsel who rendered legal opinions that the TIC interest “should” qualify for 1031 treatment; this was prior to specific IRS guidance issued on March 19, 2002. While most sponsors used the TIC structure, some sponsors, including Triple Net Properties and Inland, also used a Delaware Statutory Trust, or DST, structure for exchange programs.
Rev. Proc. 2002-22 Validates TIC Programs
On March 19, 2002, the IRS issued unprecedented guidance commonly referred to as the “Rev. Proc.” that essentially validated the tenant-in-common legal structure. With the tax status finally nailed down, the sale of TIC interests sky rocketed. According to widely reported industry statistics, TIC equity grew from less than $200 million in 2001 to over $3.8 billion in 2006. Industry statistics show that 2006 was the high-water mark (before the 2007-2011 recession), when sponsors sold over $7 billion of TIC real estate to exchangers. TIC programs became a national phenomenon, sold by hundreds of broker-dealers from coast to coast. Back in 2006, while waiting in a grocery store line in Southern California, the author once heard two friends discuss their next TIC exchange. At the time, it felt as if TICs had become an overnight sensation.