According to a number of experts involved with administering tax-benefiting property exchanges, commonly known as 1031 Exchanges, many professionals miss opportunities to take advantage of the process.

“In most instances,” says Julianna Clementi, vice president of the Chicago office of National Exchange Service, “there is a vague understanding of some of the benefits that can be gained through a 1031 Exchange and some people understand that it exists, but there are many professionals that do not know enough to take that next step.”

Part of the reason for its lack of utilization is due to the IRS mechanisms and interpretations on how and when 1031s can be used. Ironically, another hindrance to implementation is the absence of some safeguards in the process.

A Short History Lesson
The statute of the IRS code that permits exchanges has existed since the 1920s. [The exact citation is 26 USC § 1031(a).] However, due to the common interpretation that a simultaneous exchange was required, not much happened through the 1980s. However, a U.S. Supreme Court case changed all this.

Starker v. United States, 602 F.2d 1341 (9th Cir. 1979) challenged the simultaneous requirements. The argument was that the statute did not define simultaneous and that it was onerous. The challenge was upheld and as a result, deferred situations caused many difficulties.

In 1991, the U.S. Treasury adopted regulations which govern Section 1031 Exchanges. It also established deadlines for the exchange process by setting standards. It created a time restraint to allow for the two time periods: the identification period and the exchange period.

The identification period is 45 days. The taxpayer must identify replacement property within 45 days after relinquishing the initial property to a buyer. Then, the taxpayer is obligated to complete the acquisition of replacement property no later than 180 days from the date his property had been relinquished.

It is critical to understand that these two time periods are running simultaneously. Therefore, the reality is that someone wanting to utilize a 1031 Exchange must identify the replacement property within 45 days and then only an additional 135 days exist to complete the transaction.

One more fact must be understood. In general, there are no exceptions and extensions granted. In fact, if the deadline date falls on a weekend or holiday, it does not even carry over to the next business day.

In addition, the taxpayer is not permitted to benefit from the proceeds of the property sale before the exchange is completed with a purchase.

Defining the 1031 Exchange
Although the logistics of selling one property and buying another are virtually identical to any standard sale and purchase scenario, an exchange is different because the entire transaction is memorialized as an exchange and not a sale. And it is this distinction between exchanging and not simply selling and buying which ultimately allows the taxpayer to qualify for deferred gain treatment.

The main advantage of a 1031 is that it allows the recapturing of depreciation against capital gains. Basically, sales are taxable and exchanges are not. It is the sale of an asset of which the proceeds are used to purchase a “like” asset. Accomplishing this, however, is also where it can get complicated.

“First,” explains Clementi, “the asset must be held for requisite 1031 purposes. This means that property is held as an investment or in a trade or business of which the taxpayer is engaged.”

Clementi relates that many missed opportunities occur by simply not understanding that one sentence.

“Most people understand the concept of exchanging land for land,” she says, “but that phrase also permits 1031s to occur with other assets that are used for business purposes. For instance, construction equipment, machinery, automobiles, planes, and office buildings can also qualify – if the intentions are clear and the process is followed properly.”

Clementi also states that there are three popular questions that are raised when the replacement property is being located: 1) How much should the value of the replacement property be? 2) How much 1031 equity needs to be reinvested? 3) How much of debt can be obtained. The general answers to all of these questions are as follows: 1) that the replacement property must be even or up in value to the fair market value of the property that was relinquished; 2) 100% of the 1031 equity (i.e. net proceeds) must be reinvested into the replacement property and 3) you cannot over mortgage the property in an effort to receive 1031 equity without triggering boot.

Finding the Experts
As mentioned, there are some hurdles that must be overcome to accomplish a proper and successful 1031 Exchange. Finding trustworthy advisors and transaction specialists can be one of the major bumps in the process.

“The very first step – when you think you want to consider a 1031 Exchange – is to seek a trusted and knowledgeable advisor,” explains Gallivan. “This should be an accountant or attorney, preferably a CPA or professional who thoroughly understands the nuances of the exchange requirements.”

Most experts agree that the value of an exchange should be at least $10,000 for it to be beneficial, but, there can be exceptions.

The next important step is determining who will handle the 1031 procedural process. This person or entity, termed a “qualified intermediary,” (QI) will be entrusted with handling the paperwork, and perhaps more importantly, holding your equity until the exchange is completed. They are not permitted to provide advice because they are representing and conducting the process.

There is, however, an important stipulation on who the taxpayer can entrust with this process. While it should be someone that you trust is knowledgeable on the topic, it cannot be someone who has provided services (as an employee, attorney, accountant, investment banker or broker, or real estate agent or broker within two years prior to the exchange. Therefore, under virtually all circumstances, the person whom you seek advice from to move forward with an exchange is not permitted to serve as a QI.

“Here is where some unnecessary and substantial risk can unknowingly be taken by taxpayers,” reveals Clementi. “Since there is not a governing body over qualified intermediaries, virtually anyone can claim to be a qualified intermediary. Many are independently owned and do not always offer or follow the proper procedures which could jeopardize their exchange status.”

Gallivan agrees that taxpayers should be careful.

“There are many types of qualified intermediaries,” states Gallivan. “Fortunately many qualified intermediaries include specialists at most major title companies and several of the larger banks, developers and other professionals wanting to utilize the 1031 Exchange must understand that they need to ensure the safety of their funds.”

Both Clementi and Gallivan work for companies that are subsidiaries of financial institutions that not only utilize escrow accounts to hold the funds during an exchange process, but the funds are also secured through surety bonds.

One resource that taxpayers have available to find a QI is the Federation of Exchange Accommodators (FEA), of which Gallivan is a board member.

To increase the professionalism of the exchange industry and foster public confidence when selecting an exchange accommodator, the FEA administers a Certification and Continuing Education Program. The Program bestows the designation of Certified Exchange Specialist® (CES) upon those professional individuals who meet specific work-experience criteria and pass an exam on exchange laws and procedures. The FEA also provides training and bonding opportunities.

Myths, Facts, and Examples
Many organizations involved in exchanges provide some guidance on their Web sites, including the IRS.

According to the IRS, if, in addition to giving up like-kind property, you pay money in a like-kind exchange, you still have no recognized gain or loss. The basis of the property received is the basis of the property given up, increased by the money paid. The IRS provides this example:

Bill Smith trades an old cab for a new one. The new cab costs $30,000. He is allowed $8,000 for the old cab and pays $22,000 cash. He has no recognized gain or loss on the transaction regardless of the adjusted basis of his old cab. If Bill sold the old cab to a third party for $8,000 and bought a new one, he would have a recognized gain or loss on the sale of his old cab equal to the difference between the amount realized and the adjusted basis of the old cab.

Another situation explained by the IRS is also likely to be applicable to our industry. For instance, if you sell property and buy similar property in two mutually dependent transactions, you may have to treat the sale and purchase as a single nontaxable exchange to qualify as an exchange.

You used your car in your business for two years. Its adjusted basis is $3,500 and its trade-in value is $4,500. You are interested in a new car that costs $20,000. Ordinarily, you would trade your old car for the new one and pay the dealer $15,500. Your basis for depreciation of the new car would then be $19,000 ($15,500 plus $3,500 adjusted basis of the old car).

You want your new car to have a larger basis for depreciation, so you arrange to sell your old car to the dealer for $4,500. You then buy the new one for $20,000 from the same dealer. However, you are treated as having exchanged your old car for the new one because the sale and purchase are reciprocal and mutually dependent. Your basis for depreciation for the new car is $19,000, the same as if you traded the old car.

Another company that provides 1031 Exchange services is All States 1031. The company lists and refutes 14 myths concerning 1031 Exchanges on its Web site, including the myth that 1031 exchanges are only available and/or benefit large investors:

“Actually, anyone who owns investment property should consider a §1031 exchange before selling. Whether they are selling a small rental unit or an office building, they can simply pay the gain and throw away their hard earned money, or effect a §1031 exchange preserving their capital. Any investor should consult a tax adviser who is familiar with §1031 exchanges to determine the most beneficial strategy.”

One of the common situations that may be of interest to land developers which is not typically permitted is the exchange of land that has been partially or fully developed for undeveloped raw land. In this instance, the land being sold (exchanged) is not typically an investment, but a commodity that has been improved upon and being “flipped” in an effort to purchase additional land inventory.

“The IRS considers a developer’s land that is going to be subdivided and built upon as inventory,” explains Kate Gallivan, senior vice president with JP Morgan Property Exchange in the Boston office.

However, according to the IRS, like-kind properties are properties of the same nature or character, even if they differ in grade or quality. The exchange of real estate for real estate and the exchange of personal property for similar personal property are exchanges of like-kind property. For example, the trade of land improved with an apartment house for land improved with a store building, or a panel truck for a pickup truck, are like-kind exchanges.

An exchange of city property for farm property, or improved property for unimproved property, is also a like-kind exchange.

The exchange of real estate you own for a real estate lease that runs 30 years or longer is a like-kind exchange. However, not all exchanges of interests in real property qualify. The exchange of a life estate expected to last less than 30 years for a remainder interest is not a like-kind exchange.

While it should be clear that there can be benefits to utilizing a 1031 Exchange, however, it should be equally easy to understand why a tax advisor should be consulted prior to beginning the process.  SLDT