With the rapid rise in real estate values, owners and developers are increasingly looking to defer tax on their capital gains. One valuable planning tool that can be used to accomplish this goal is a like-kind exchange, also known as a 1031 exchange.
The framework for a deferred exchange was added to our tax laws over 100 years ago. Originally passed by Congress to stimulate economic growth, the law may allow capital-gains taxes resulting from the sale of business real estate to be deferred when proceeds are invested directly into "like-kind" properties of equal or greater value. As such, real estate investors may be able to perpetually roll over capital gains into successive replacement real property purchases.
With real property values on the rise, increasing the value of tax-deferral strategies, especially in the multifamily housing sector, the use of 1031 exchanges has been growing. Before leveraging this important tool, it is crucial to understand certain rules, especially as we witness a string of challenges, from finding properties in a fast-moving market to deploying capital to secure them.
The Crucial First 45 days
To qualify for this tax benefit, the entire 1031 exchange must be completed within a 180-day window, which includes a 45-day period to identify a replacement property. The seller has only 45 calendar days from the closing date of the real estate sale to make a list of replacement properties and provide it to an intermediary. The Internal Revenue Service (IRS) has provided flexibility regarding the number of properties that can be identified through three different rules you can choose to follow during the identification period.
- 3 Property Rule – Can identify up to three replacement properties without regard to the fair market value of the properties;
- 200% Rule – Any number of properties can be identified provided the aggregate fair market value does not exceed 200% of the value of the relinquished property; or,
- 95% Rule – Any property identified but only if the property received as a replacement is at least 95% of the fair value of all identified replacement properties.
In the current market, those first 45 days have never been more crucial. Gone are the days when a real estate owner can safely identify only one potential replacement property and have confidence that the deal will be completed. With limited available inventory and increased market aggressiveness, by the time a seller has identified a replacement property, chances are it has already been sold. If that happens to take place on day 45, it will not be possible to complete the 1031 transaction, ultimately missing out on this great tax benefit.
Proactive Strategies for a Successful 1031 Transaction
- In the current real estate environment, identify the maximum number of replacement properties considering the 3 rules previously mentioned.
- Depending on where you are in the 45-day period, unavailable properties may be removed and replaced with available ones. However, once day 45 has passed, it is too late. Begin the replacement property search as soon as the property is listed for sale.
- Understand the market trends in the areas of interest and be ready to make offers on replacement properties as soon as they become available.
- In addition, get the replacement properties under contract as quickly as possible, allowing additional flexibility if issues arise during the 45-day identification period. To improve the likelihood of closing on the property you have identified within the 180-day required period, it is encouraged to secure additional cash and any lending, if necessary, early in the process, making sure all parties to the acquisition of the replacement property are aware of the time-sensitive nature of closing.
1031 exchanges have increasingly become a valuable planning tool to defer tax on capital gains. Proactive strategies for the first 45 days are crucial in a successful 1031 transaction.
It Takes a Team
The requirements of section 1031 which must be followed to successfully defer gain can be complex. Real estate owners and developers considering a property sale should proactively discuss these requirements with their tax advisor. Once the decision to execute a 1031 exchange is made, it takes a team of advisors to see it through. The majority of 1031 exchanges will require an independent qualified intermediary to facilitate the process. This qualified intermediary oversees the property sale and new purchase, holds exchange funds, and documents the process.
At DHG, we will work with your intermediary and other service providers, such as real estate agents and lenders to help identify potential issues and actionable solutions early in the process enhancing your ability to complete a successful 1031 exchange. To learn how we can help you leverage section 1031 in your tax-planning strategies, please contact us.