Tax Deferral for Real Estate Investors with a 1031 Exchange
At PENSCO, we know our clients are tax-savvy and enjoy the tax-deferred or tax-exempt benefit that comes from investing with retirement dollars. We also know that one of the most popular asset classes for our clients’ self-directed IRAs is real estate.
So, what about tax strategies for real estate based on taxable/non-retirement dollars? To learn more about what real estate investors can do outside of their IRA to realize tax benefits (with their post-tax dollars), we caught up with our colleague, Robert Minsky, who runs the 1031 Exchange division, RPM Investments, at our parent company, Opus Bank. Robert’s father founded RPM Investments in 1983 to help real estate investors with 1031 Exchange options.
TC: First of all, because PENSCO does not work with 1031 Exchanges in self-directed IRAs, I need you to describe a 1031 Exchange.
RPM: A 1031 Exchange enables the seller of investment property to defer, not avoid, paying capital gains taxes through Section 1031 of the Internal Revenue Service’s Tax Code, if the seller, through a Qualified Accommodator, purchases a like-kind replacement property within 180 days of the original sale date.
TC: What is an Accommodator?
RPM: To qualify under IRC 1031, the sale’s proceeds need to be separated from the seller, by the use of what’s called an “Accommodator” also known as a “Qualified Intermediary.” In the simplest description, an Accommodator is someone who facilitates a 1031 Exchange in an authorized role as defined by Treasury Regulation §1031.1031(k)-1(g)(4)(iii). The Accommodator receives the proceeds of the sale directly from the closing agent at the closing of the sale property, the “relinquished property,” and then holds those funds to be used for the purchase of a like-kind replacement property within the regulations of Section 1031.
And, no, the seller cannot act as its own “Accommodator.”
TC: Who qualifies for the Section 1031 Exchange?
RPM: Owners of investment and business property may qualify for a Section 1031 deferral.
TC: What kinds of property can be exchanged?
RPM: Great question. It is not just investment real property (like an apartment building, or a shopping center); IRC 1031 Exchanges also can be used to sell personal property (like artwork) if they are held for use in trade or business, or for investment. But you cannot exchange investment “real property” for “personal property.” It must be like-kind for like-kind, real property for real property or artwork for artwork.
There are, of course, devils in the details: For instance, real property in the U.S. cannot be exchanged for real property outside the U.S. A client should always involve and consult their own CPA or tax attorney when proceeding with an exchange to guide them on the details to their specific situation.
TC: Are there other ways to structure the Exchange?
RPM: Yes, another popular form of 1031 Exchange is called a Reverse Exchange. It is more complicated.
In this scenario, you might actually be able to buy the replacement property before you sell the original property. The rules you need to follow are more complicated than this interview would allow for, and are dependent on each unique situation. It’s best to get legal and tax advice for your particular situation.
TC: At PENSCO, we open many accounts as a result of an IRA rollover, which requires a taxpayer to roll funds from a workplace retirement plan or an IRA back into an IRA within 60 days without it becoming a taxable distribution.  Is the 1031 Exchange similar in that it becomes a taxable event if you miss the 180 day “exchange period”?
RPM: It’s somewhat similar, yes. With a 1031 Delayed Exchange, the Exchange Period commences the day he/she closes escrow and transfers/relinquishes the property being sold to the Buyer. The seller then has 45 days from that date to submit a form that identifies the replacement property or properties. The 45 day period is not extendable — even if the 45th day falls on a Saturday, Sunday or legal holiday. In that case, the seller should plan on having his/her 45 day letter into the Accommodator on the business day prior.
The outside date for the Exchange Period is exactly 180 days after the date on which the person transfers the relinquished property or the due date for the person's tax return for that taxable year in which the transfer of the relinquished property has occurred, whichever situation is earlier. Like the 45 day rigidity, the 180-day timeline has to be adhered to under all circumstances and is not extendable.
Because it is not always possible to know if the “target,” “replacement,” or “up leg” property will pass inspections during the escrow period, the seller is allowed a few different options on how many properties they can identify.
TC: What are those identification options?
RPM: There are three options that a client can choose from in order to designate the replacement properties.
- You can identify up to three properties regardless of their value.
- You can identify as many properties as you want as long as the combined value of the properties does not exceed 200% of the sales price of the relinquished property.
- You can identify as many properties as you want as long as you acquire 95% of the identified properties.
If all the properties fail to pass inspection, and none of them are actually purchased, the seller must pay the capital gain taxes on the sale of the relinquished property. That’s why it is very important to pick the target properties carefully.
TC: What are some of the misconceptions with the exchanges?
RPM: Similar to a prohibited transaction with a self-directed IRA, taking control of cash (or other proceeds) before the exchange is complete may disqualify the entire transaction from a like-kind exchange treatment and make all gain immediately taxable.
I’ve mentioned you cannot act as your own facilitator; but you also cannot use your agent or anyone who has worked for you within the previous two years (including your investment banker or broker, accountant, attorney).
Another important thing to note is that you cannot do a 1031 Exchange on your principal residence.
Finally, while an investor can exchange from one property to the next, and even from the next to yet another — and another, and another — when the last of the exchanges is sold, the taxes are due. And the tax amount is based in part on the basis of the very first property exchanged!
TC: What other risks are there?
RPM: There are always risks in the buying and selling of investments: One risk unique to a 1031 Exchange is the choice of an intermediary. The IRS warns investors to be careful in their selection of a Qualified Intermediary and be wary of individuals promoting improper use of like-kind exchanges. Since the rules are that the seller cannot take receipt or control of the sale proceeds which is deemed as “constructive receipt,” the monies have to go to the exchange intermediary.
But just like Indiana Jones, you must “choose carefully.” There have been instances when an exchange intermediary has filed bankruptcy in the middle of a deal, and the seller has lost all the money under the care and custody of the intermediary. This is why it is important you choose a company you can trust like Opus Bank to hold your funds while it awaits your next investment.
[i] There is a limit to one rollover of IRA distributions per 12-month period. See IRS Publication 590 for more information.
THE FORGOING IS NOT INTENDED AS LEGAL OR TAX ADVICE. PLEASE CONSULT YOUR CPA OR TAX ATTORNEY REGARDING THE FACTS OF YOUR PARTICULAR SITUATION.
CIRCULAR 230 DISCLOSURE: Pursuant to Regulations Governing Practice Before the Internal Revenue Service, any tax advice that may nevertheless be contained herein is not intended or written to be used and cannot be used by a taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer.
This Blog does not provide investment, tax, or legal advice nor does it evaluate, recommend or endorse any advisory firm or investment vehicle. Investments are not FDIC insured and are subject to risk, including the loss of principal.
PENSCO Trust Company performs the duties of an independent custodian of assets for self-directed individual and business retirement accounts and does not provide investment advice, sell investments or offer any tax or legal advice. Clients or potential clients are advised to perform their own due diligence in choosing any investment opportunity as well as selecting any professional to assist them with an investment opportunity. Alternative investments are not FDIC insured and are subject to risk, including loss of principal. PENSCO is indirectly affiliated with a registered broker dealer and with a licensed small business investment company through Opus Bank (“Opus Affiliates”). Other than the Opus Affiliates, PENSCO is not affiliated with any financial professional, investment, investment sponsor, or investment, tax or legal advisor.