BawldGuy Here: This isn’t just another post about Section 1031 tax deferred exchanges. I’ve talked numerous times on these pages on that topic. The key takeaway here is how to make use of asset protection techniques while not impeding a future option for exchanging, tax deferred. It’s always been more a ‘practical’ problem posed by the lenders, not primarily a tax problem. The lender requirement calling for the borrower(s) to buy/borrow in their own names caused the tax dilemma. The lenders were the ones who’ve inadvertently pulled investors’ pants down. I’ve seen it literally dozens of times in my practice. In this post Clint very simply and elegantly explains how to have your cake and eat it too. Enjoy . . .
Section 1031 of the Internal Revenue Code is one of the few tax deferral strategies available for real estate investors. It is basically an “avoid tax on the sale” provision for real estate. It should go without saying that in order for this provision to apply, the sales proceeds are reinvested in similar or like kind property. However, reinvestment in like kind property is just part of the qualification for an exchange. For investors who utilize entities for their property, the knowledge of this has come at inopportune times. The use of land trusts, limited liability companies, corporations, or other entities may nullify an exchange if you do not have a complete grasp of the requirements under 1031.
Basic Rules For a 1031 Exchange
- The Property You Are Selling Must Be Held For Investment or Used In Your Trade Or Business. Investment property is straightforward. It includes any real estate, improved or unimproved, held for investment or income producing purposes e.g., residential or commercial property, raw land, fractional interests, leasehold interests, easements, water or mineral rights, oil and gas interests, even development rights. Property used in your trade or business includes real estate and equipment used by your business. In an exchange this is sometimes referred to as “incidentals” depending on the type of property e.g., dump truck or excavator received to assist with developing the property acquired in the exchange.
- The Replacement Property Must Be Like Kind. Like kind does not mean an exact replica of what is exchange, i.e., a 3-bedroom rental for another 3-bedroom rental. This prong is an intent based requirement and not a physical requirement i.e., if the property you are selling was held for investment then the property you are buying must also be treated the same.For instance:
- An apartment building can be replaced with raw land or vice versa.
- One rental property can be exchanged for two or more properties or the reverse.
- A commercial building can be exchanged for land and equipment.
- Replacement Property Title Must Be Taken In The Same Name as The Relinquished Property Was Titled. If the property you are selling is owned in your name then the replacement property must be taken in your name. Similarly, if the property is held in a land trust, corporation, LLC or other entity, the replacement property must be taken in the name of the entity.
Planning Considerations for Entity Owned Property
The last rule can prove problematic for investors contemplating a 1031 exchange who currently own property in a land trust or LLC. If financing will be involved in your acquisition of replacement property you do not want to show up to closing and be told to pull it out. Your lender is not sensitive to your tax deferral strategy and will not close on the loan unless title is taken in your personal name. You lender’s insistence on title will implode your exchange if you originally sold property held in an entity. This is a violation of the 3rd rule “replacement property must be taken in the same name as the relinquished party was titled.” Unlike other aspects of the tax code the IRS does not grant safe harbors for 1031 exchanges.
Pre-Planning is Your Solution
If you plan on entering into an exchange with property held in an entity and you anticipate acquiring residential real estate with the exchange proceeds, then my recommendation is to deed the property into your personal name prior to listing it for sale. In so doing, you will ensure that the exchanged property will be sold in your name and acquired in the same. I recommend you adopt this strategy even if you do not plan on using financing for the replacement property to keep your options open.
After your exchange is finalized, you can transfer the property back into your entity. Many CPAs will recommend you wait until the following tax year to make this transfer. I disagree with this recommendation if you are transferring the property into a disregarded LLC.
Property Held in an Entity with Other Partners
The above approach is also useful in those situations when you have invested with other individuals and now it is time to sell the investment. Frequently, one or more of the partners in a partnership desire to take cash when the property is sold rather than roll the proceeds into a replacement property. This presents problems that require careful planning and is not without tax risk.
To preserve your exchange options in a partnership setting, the prudent course of action is for the individual partners to deed the property out of the partnership and into the individual partners names in advance of the sale. Deeding the property from the partnership to its partners as tenants in common does this. In doing so, each individual partner is then free to sell or exchange his ownership interest in the real estate. People familiar with 1031 exchanges will refer to this strategy as a “drop and swap”.
1031 exchanges are a great tool for tax deferral but with everything in real estate investing, it pays to invest in some pre-planning to ensure you are maximizing your benefits. As I have stated before in previous posts it can be the little things i.e., an afterthought, that can disrupt the entire plan.