By Brian E. Ravencraft, CPA, CGMA, Partner at Holbrook & Manter, CPAs
In the farming industry, a 1031 real estate exchange is a common strategy to allow a farmer “defer” paying the capital gains and/or ordinary income taxes on an investment property when it is sold, as long as the “like-kind property” is purchased with the profit gained by the sale of the first property.
Over the years, I have seen where folks have common misconceptions about this very complicated and technical section of tax law. Here is a list of various misconceptions I’ve found that folks have about 1031 Exchanges:
- “Like-kind” means I must exchange the same type of property, such as an apartment building, for another apartment building.
The term “like-kind” refers to the nature or character of the property not its grade or quality. For this reason nearly all real property is like-kind to each other. Here are a few examples of qualifying properties that could be exchanged: raw land or farmland for improved real estate, or
residential, commercial, industrial or rental properties for any real estate.
- A 1031 Exchange means that the sale and the purchase have to happen at the same time. In other words, the seller has to find someone willing to swap properties.
The odds of that you will find someone who wants to swap properties are slim. For that reason the vast majority of exchanges are “delayed exchanges” which allows you to sell your property and then purchase any new investment property you desire providing the 1031 rules are followed. Probably the most important rule is that taxpayers must hire a 1031 intermediary prior to transferring their old property. In addition, the taxpayer must remember these two important deadlines. The 45-Day Deadline: You must identify your potential like-kind replacement properties to your qualified intermediary no later than midnight of the 45th calendar day following the close of the relinquished property sale transaction. The180 Day Deadline: You must complete your 1031 Exchange transaction, which includes the conveyance of title to all of your like-kind replacement properties that you intend to acquire, no later than the earlier of:
- Midnight of the 180th calendar day following the close of the relinquished property sale transaction, or
- The due date of your Federal income tax return for the tax year in which the relinquished property was sold, including any extensions of time to file.
- I can only defer my capital gains tax via a 1031 Exchange.
Besides capital gains taxes, you can also defer the depreciation recapture tax, the Medicare tax and State taxes (if applicable). Therefore, if you do not exchange and elect to pay taxes, you may have an effective or blended capital gains rate as high as 35% to 40%
- All of the funds from the sale of the relinquished property must be reinvested.
A taxpayer can buy down in value. Or a taxpayer can choose to withhold funds or receive other non-like-kind property in an exchange. But the amount that they buy down, or money they withhold, or any other non-like-kind property received, is considered “boot” which means the exchanger likely will have to pay some taxes.
- You must replace the debt that you had on the relinquished property with at least the same amount of debt on the replacement property.
The exchanger can always bring their own cash (from outside of the 1031 Exchange) to the closing table for the replacement property to offset any reduction in debt. You need to replace the value of the debt paid off on the relinquished property.
- If I sell property I can only exchange into one property.
You can sell one property and exchange into multiple replacement properties. In addition, you can sell multiple properties and exchange into one larger and more easily managed property.
As you can see, compliance with 1031 exchanges is a lot of form over substance — if you want to attain a tax benefit, every “I” has to be dotted and every “T” crossed. Thus, over the years, many misconceptions of the rules have been twisted. There are many ways an exchanger can get tripped up even if he is acting in good faith to keep to the regulations, particularly when it comes to constructive receipt of the funds. If you are looking into a Section 1031 transaction, your advisor should take great care to plan appropriately and avoid possible pitfalls.
Brian E. Ravencraft, CPA, CGMA is a Principal with Holbrook & Manter, CPAs. Brian has been with Holbrook & Manter since 1995, primarily focusing on the areas of Tax Consulting and Management Advisory Services within several firm service areas, focusing on agri-business and closely held businesses and their owners. Holbrook & Manter is a professional services firm founded in 1919 and we are unique in that we offer the resources of a large firm without compromising the focused and responsive personal attention that each client deserves. You can reach Brian through www.HolbrookManter.com.