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Orchestrating 1031 and Reverse 1031 Exchanges
Almost everyone has heard of 1031 exchanges. However, just in case you don’t understand everything about them, following are some rules, pitfalls, and logistics of pulling one off.
First of all, why do an exchange? It allows you to defer a taxable capital gain on a property into the future indefinitely, and it may even allow you to avoid capital gains tax altogether.
That’s pretty powerful. If you have a $100,000 farm that is now worth $300,000, you could sell it and pay about $50,000 in taxes, or you could exchange it and put the whole $300,000 back to work. Caveat: If you want to defer all of the capital gains tax, you must reinvest ALL of the proceeds. Every dollar of gain you don’t reinvest is a dollar of gain you pay tax on now.
A 1031 exchange refers to an IRS Code Section 1031 like-kind exchange. Normally, farmers consider trading one farm for another one, but you can actually trade any kind of investment property for any other kind of investment property. It can be a farm for an office building or even a condo for a warehouse.
The basic rules are as follows:
- A qualified intermediary must hold the sale proceeds until they’re spent on the new property.
- The exchanger cannot possess the sale proceeds at any time.
- The exchanger must close on the replacement property within 180 days of the sale of the relinquished property.
- The exchanger must identify, in writing, the potential replacement properties within 45 days of the sale.
- The entity that relinquishes an exchanged property must be the same entity that acquires the new one.
The first rule trips people up frequently. I will get a call from a client who will say, “I just sold a property for $250,000, and I want to buy another property now to avoid taxes.” Then I have to say, “I’m sorry, it’s too late. Once you have taken possession of the proceeds personally, you cannot do an exchange.” They failed to hire an intermediary to hold the funds, and there is nothing that can be done after the fact to fix it.
What is a qualified intermediary? Generally, it’s a title company or an attorney who understands real estate. However, it could be anyone who knows the rules and doesn’t have a conflict of interest in holding and disbursing your funds.
The last rule from the list also causes trouble for folks.
A lot of farms are owned jointly by a group of siblings, a partnership, an LLC, or a trust. Frequently, it’s the only asset they own together. When the farm sells, most of the time the individuals in the group are looking to go in different directions with their pieces of the pie. However, if XYZ Partnership sells a 1031 exchange property, XYZ Partnership will have to stick together and reinvest all of the proceeds in a replacement property. If not, the individual partners will owe capital gains tax upon the sale.
There is a way out, and it involves changing ownership on a jointly held property before the exchange. For example, you could take a 640-acre section owned jointly by four siblings, and retitle it into four 160-acre pieces owned by four individuals. Then each one can go do as he or she wishes with his or her sale proceeds, including arrange a 1031 exchange.
Reverse 1031 Exchange
Besides the standard 1031 exchange (where you sell first and buy later), there is also the more complicated reverse 1031 exchange (where you buy first and sell later). I recently tried to do one of these and failed, because sometimes buying a farm is easier than selling one. Not every qualified intermediary will do a reverse 1031 because of the complexities. To orchestrate a reverse 1031 exchange, your intermediary must acquire the replacement property with a loan from you or a bank. He or she will probably want to hold title inside a separate LLC, which might need to be created from scratch. That holding entity will need a bank account to accept rents and to pay bills related to the parcel during the holding period. All of this takes more time and money than the regular 1031 exchange.
In the reverse 1031 exchange, you must sell the relinquished parcel within 180 days. If you don’t, the exchange is blown up, and you just spent money on legal fees for no reason. You don’t lose the new property, but you will have to find another property to acquire if you want to reattempt an exchange. Because of the downside risks, there are far fewer reverse 1031 exchanges than standard 1031 exchanges.
Earlier in this article I mentioned that you might never have to pay tax on a capital gain related to an exchanged property. Here’s how that can happen.
If you hold the replacement property until you die, your heirs will inherit the property tax-free. They get a stepped-up basis, which means their basis in the property becomes the fair-market value of the property on the date of your death. That new value will be established by an appraisal from a licensed appraiser. Your heirs will owe taxes on any future sale of the replacement farm based upon the new stepped-up value. Neither you nor your heirs will ever pay tax on your old deferred gain from the sale of the original farm.