What is a 1031 Exchange and how does it work?
Successive US governments have encouraged both property ownership and property development across the country, for both economic and social purposes. Therefore, protagonists of real estate development have frequently been able to claim tax breaks and benefits for extended periods of time.
The 1031 Exchange deferred tax incentive
The 1031 Exchange deferred tax incentive is a tax incentive scheme uniquely available to real estate. Upon the sale of a property, it allows the owner to defer the realization of capital gains tax ("CGT”) and depreciation recapture tax (“DRT”).
Provided a strict set of rules is followed, a property owner can sell their property for a profit, invest the proceeds into other real estate, and defer paying any CGT and DRT from the previous investment(s) until such as time as the new property is sold.
What’s more, owners have the ability to apply the 1031 Exchange and defer taxes in perpetuity until such time as either they (i) sell without a 1031 Exchange, or (ii) hold the asset for the remainder of their lifetime, passing it on to their heirs free of CGT and DRT. Most syndications are owned via structures which can take advantage of the 1031 Exchange.
The properties involved in a 1031 Exchange are generally known as:
“Relinquished Property” (“RQP”) or “Down-leg”: the property being sold;
“Replacement Property” (“RLP”) or “Up-leg”: the new property being acquired.
What are some of the requirements to qualify for a 1031 Exchange?
These include:
Loan Amount: the amount used for the RLP should be equal to or greater than the amount of debt extinguished upon the sale of the RLQ;
Acquisition price: of the RLP should be equal to or greater than the sale price of the RQP;
Timing Requirements:
Forward Exchange: the LLC partnership (taxpayer) has 45 days to formally identify and 180 days from the date of sale of the RQP to acquire the RLP, such periods running concurrently;
Reverse Exchange: the LLC partnership closes on the acquisition of the RLP before closing on the sale of their RQP.
These types of exchanges are more complex to execute as, obviously, funds are needed to acquire a RLP before selling the RQP and there must be a lender willing to finance the property using this ownership structure.
The LLC partnership, again, has 45 days to identify which property(ies) they will sell and 180 days to complete the sale, both dates running concurrently.
An ideal scenario is to have located a RLP and completed physical inspections and other due diligence prior to the time when the RQP is to be sold.
What are some of the key considerations when undertaking a 1031 Exchange?
Sponsor’s strategy: to execute a 1031 Exchange, this must be undertaken with the same LLC partnership from the commencement of the original syndication. Therefore, obviously, the sponsor and the existing investors must also want to execute a 1031 Exchange. However, a number of sponsors are not willing to use 1031 Exchanges because they prefer to secure their incentive fee and receive their profits upon sale, irrespective of any tax implications. It is wise, therefore, to clarify at the outset of the syndication the investing strategy, and if the sponsor is willing to perform a 1031 tax deferred Exchange;
Knowledge of processes and options: executing a 1031 Exchange requires specialized knowledge, as well as the ability to generate high-quality deal flow within a short period of time. In order to always have a potential new investment property readily available. A high-quality GP is of particular value in such case will be advantageous as they have the expertise needed to execute such a strategy;
Deal pipeline and selection: a good potential deal pipeline is important if a 1031 Exchange is to be arranged as, otherwise, it may be difficult to find another suitable investment opportunity in the relatively short timeframes mentioned above. The danger here is that investors may be forced to rush and/or overpay for another investment they otherwise would not have considered;
Reduced Depreciation Deduction: if a property was acquired without a 1031 Exchange, the taxpayer’s depreciable basis in the property will be lower than with and, as such, there will be a reduced depreciation expense over the life of the RLP investment.
There are other, additional tax strategies which a property owner can execute to minimize their tax obligations even further, and these will be discussed in a later article.
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