Q. What is a like-kind exchange?
A. A like-kind exchange is a technique for deferring gain on the sale of property by reinvesting the proceeds of sale in “like-kind” property. The theory is that if you do not cash out of an investment (having rolled over proceeds into new like-kind property), the economic gain has not been realized in a way that produces the cash to pay the tax, and so no tax should be due.
Q. Do I permanently escape tax?
A. No. The like-kind exchange rule is a tax deferral technique not a tax elimination technique. The new property purchased with the proceeds from the sale of old property has the same tax basis as the old property. When the new property is later sold, the original deferred gain, plus any additional gain realized since the purchase of the new property, is subject to tax. Of course, you can sell the new property as part of another like-kind exchange and continue to roll over. Only upon your death will you escape tax due to the step-up in basis to the fair market value of the property at the time of death.
Q. What is like-kind property?
A. In the context of real estate, the definition of like-kind is very broad. Virtually any real estate is like-kind to any other real estate (such as vacant land for a strip shopping center, an office building for an apartment building, etc.). Personal residences cannot be exchanged. Foreign property cannot be exchanged for U.S. property. Long-term leases of real estate (30-plus years) can qualify as real estate for purposes of an exchange, and this is useful in the context of ground leases.
Q. What about exchanges for real estate developers?
A. To have an exchange, both the old and new property must be held for investment or for use in a business. Inventory is not exchangeable. A real estate developer generally cannot exchange something he builds with the intent to sell when it is done. Accordingly, if you buy with an intent to sell the property right away, then you’re out of luck. Section 1031 operates on an intent test.
Q. How is an exchange different than a sale and purchase?
A. Technically, the two legs of an exchange (the sale and the purchase) must be part of an “interdependent” transaction. In reality, there are just a few mechanical steps that are necessary to coordinate the sale with the purchase so that they are treated as an exchange. With the use of a “qualified intermediary” (discussed below), neither the buyer of the old property nor the seller of the new property hardly needs to be involved in the exchange. (However, keep in mind that there is a technical requirement that other parties be notified that an exchange is occurring.)
Q. What is a qualified intermediary?
A. A qualified intermediary is an independent agent that facilitates an exchange. Using a qualified intermediary is one way to satisfy one of the Internal Revenue Code’s “safe harbors” for completing an exchange. Essentially, the qualified intermediary takes an assignment of rights in the sale contract for the old property and the purchase contract for the new property. These are documents that the qualified intermediary provides, along with a written exchange agreement. Through these three documents, the intermediary is brought into the exchange and, subject to compliance with the timing rules discussed below, the transaction can qualify as an exchange rather than a taxable sale. Only under certain conditions may the taxpayer’s attorney or accountant act as a qualified intermediary.
Q. What happens to the money?
A. The most important role of the qualified intermediary is that it holds the proceeds of sale pending reinvestment in new property. If the seller receives (or has direct or indirect use of or control over) the proceeds of sale, then the transaction will be taxed. By arranging for the qualified intermediary to hold the money, the taxpayer never receives the cash and therefore the transaction can qualify as an exchange.
Q. What are the timing rules?
A. Within 45 days of the closing of the sale, the taxpayer must “identify” the new (repolacement) property. The identification must be specific (such as the street address of the real property). As a back-up plan, to cover the possibility that the preferred transaction may fall through, the taxpayer may designate more than one property (generally up to three, or more than three if the total value of the new properties designated is less than 200% of the value of the property sold). You identify the replacement property by sending the qualified intermediary written notice of the targeted property or properties.
Q. When must I close on the replacement property?
A. You must close on the replacement property(ies) within 180 days of the date of closing on the relinquished property. This is not 45 days plus 180 days. The 45 and 180-day periods run concurrently. The 180-day period is cut short if the tax return filing deadline comes up before the end of that period. However, you can get the full 180 days by extending the time for filing the tax return.
Q. What if I miss a deadline?
A. You’re out of luck. There are no extenuating circumstance that will extend the deadline.
Q. How do I buy more time on the sale of my old property?
A. Contract sales do not work, since a contract sale is treated as a sale for tax purposes. What may work is a lease with an option where the buyer can take occupancy now but the closing is deferred. Or, you can do a reverse exchange.
Q. What is a reverse exchange?
A. As of September 15, 2000, reverse exchanges (when the new property is purchased before the old property is sold) are permitted. However, you must use a special “parking arrangement” with a qualified intermediary to purchase and hold the new property until the old property is sold. The old property sale can be structured as a normal “forward” exchange where the proceeds are rolled over into the new property being “warehoused” or “parked” with the parking intermediary. The parking intermediary can hold the new property for up to 180 days.
Q. What about newly constructed property?
A. You can do a “build-to-suit” or “improvement” exchange, but you cannot own the land on which the improvements are being built. The land must be owned by the seller, the developer or a parking intermediary. If the taxpayer already owns the land, it can be sold to a parking intermediary or the developer. The seller or intermediary will enter into a contract to construct the improvements, and at the end of the 180-day period can convey the property (completed or partially completed) to the taxpayer to close out the exchange. This is usually a race against the clock to try to spend as many construction dollars as is necessary to complete the exchange. Keep in mind that you cannot prepay construction costs.
Q. When you say proceeds need to be rolled over to avoid gain, is that all there is to it?
A. No. The essence of a trade is that a person has not cashed out any part of the investment. In general, you must trade equal or up on the price. You must also use all of the cash proceeds from the sale. Taking this altogether, the transaction generally will be taxable to the extent that the purchase price of the new property is less than the selling price of the old property. Furthermore, the transaction is taxable to the extent that there is cash left over with the qualified intermediary after the purchase of the new property (except that if the left-over cash is attributable to real estate tax prorations, security deposits or other prorations on the purchase of the new property, that money can often be taken off the table without creating tax). If you trade up or even in price and use up all the cash, then the debt (comparing the mortgage on the old property to the mortgage on the new property) should be roughly the same or greater. If the debt goes up, there is potential tax unless more cash is put into the deal. You cannot borrow more on the new property as a way of trading up and taking money out of the transaction.
Q. How do I get my equity out?
A. As mentioned above, you must generally trade up or even on price and use up all the cash. So while you can put more debt on the new property (if it costs more than the old property), you cannot refinance in the middle of the trade and take cash off the table. However, an exchangor may desire to increase the debt on the old property prior to the sale or complete the exchange and then refinance the new property to take the cash out. In both cases, the additional financing must be independent from the exchange.
Q. What about partnership or LLC exchanges?
A. You cannot exchange partnership interests, even if the partnership owns real estate. The same prohibition applies to interests in limited liability companies and corporations. But in the case of limited liability companies and partnerships, there are ways to structure ownership with multiple parties as co-tenancies, preserving the notion of individual ownership and avoiding partnership classification. There are special tax elections that certain partnerships and limited liability companies can make in order not to be treated as such for income tax purposes (even if they are valid entities for state law purposes). There are also ways of cashing out non-trading partners from a partnership to allow the trading partners to remain in the partnership and accomplish their sale. All of these transactions require careful structuring in advance of a transaction.
These questions and answers should not be construed as legal advice. The rules and their interpretations change constantly, and the application of these rules to particular facts requires careful scrutiny. As a result, if you are interested in starting an exchange, please call us for more information.