What is a 1031 Tax-Deferred Exchange?
• An IRS 1031 exchange is a powerful wealth management tool that enables investors to defer tax consequences related to the sale of real property provided that all proceeds from the sale are reinvested in "like kind" property within a specified period of time and that certain other well-established procedures are followed.
• The numbers "1031" refer to the section of the IRS code (Section 1031) which stipulates the rules with which the exchanger must comply to successfully complete an exhange.
• IRS 1031 was adopted more than 30 years ago and has been utilized moderately over the years by both individuals and corporations in an effort to manage their taxes and property holdings. Absent the use of an IRS 1031 exchange, investors must pay taxes on both the appreciation in value and the recapture of depreciation taken on the property.
• Given the significant appreciation in many different types of commercial property over the past decade, the tax deferral benefit of a 1031 exchange is considerable, and its use has been accelerating in recent years. However, the very specific rules and tight time requirements which must be complied with to successfully execute a tax-deferred exchange have limited its use.
• It is estimated that more than $10 billion in IRS 1931 property exchanges fail every year. The introduction of the tenant-in-common legislation in 2002 exponentially expanded the utility and use of 1031 exchanges, as is more fully discussed in the sections following.
How Does a 1031 Tax-Deferred Exchange Work?
• To accomplish an exchange, the seller ("exchanger") deposits allof the proceeds from the sale of real property (known as a "relinquished property") into a special trust account designated for purposes of consummating a tax-deferred exchange.
• These trust accounts are normally administered by Qualified Intermediaries (known as QI's) or other financial institutions. The Exchanger has a maximum of 180 calendar days from the closing of the sale of the relinquished property to complete the acquisition of the new property (known as the "replacement property"). Within the first 45 days of this period, the Exchanger must designate and properly identify one or more replacement properties.
• An Exchanger, however, may not identify more than three properties, regardless of value, or a group of properties with a combined value that exceeds 200 percent of the value of the relinquished property. Use of the 95 percent rule is also possible.
• The funds deposited into the trust account can be used as earnest money for the replacement property once all IRS requirements for a §1031 transaction have been satisfied.
• If no replacement properties are identified in the first 45 days, or if the acquisition of the replacement property occurs more than 180 days following thesale of the relinquished property, the trust account will be disbursed, the proceeds will be returned to the Exchanger and the sale of the relinquished property will be taxed at the prevailing capital gains and/or ordinary tax rates.
What is a Tenant-In-Common Structure?
• A tenant-in-common is a form of estate in land, or ownership, whereby two ormore individuals own a fractional share of a whole piece of property (e.g., if 4 people own an asset as tenants-in-common, each may own a 25% fractional interest).
• While a tenancy-in-common has always been a common and longstanding form of joint ownership, the release of Revenue Procedure 2002-22 in March, 2002 by the Internal Revenue Service greatly enhanced the appeal and use of the TIC structure.
• The Revenue Procedure set forth a series of guidelines which, ifcomplied with by a sponsor or a TIC investment program, would allow the sponsor to seek and obtain a favorable tax ruling that the tenant-in-common interests created by the sponsor would be deemed "like kind" property for purposes of §1031 and, as such, a qualified investment as replacement property necessary to accomplish an exchange.
Major Participants in 1031/TIC Transactions?
• Accredited Investor
An individual investor with a net worth, or joint net worth withhis or her spouse, of more than $1 million (inclusive of real property), or an individual with income in excess of $200,000, or joint income with his or her spouse in excess of $300,000, in each of the two most recent years and with a reasonable expectation of achieving the same in the current year. Generally, only accredited investors purchase 1031/TIC investments.
• Qualified Intermediary (QI)
The intermediary (or middleman) required to hold, in a segregated trust account, the sales proceeds realized by the exchanger from the sale of relinquishedproperty. The QI retains the proceeds until the earlier of the date the exchanger is preparedto close the acquisition or the replacement property and the expiration of either the 45-day identification period or the 180-day closing period.
• Broker-Dealer and Registered Representatives
Broker-dealers are companies licensed to sell securities to investors, and Registered Representatives are licensed salespeople employed by or affiliated with the broker-dealers who are engaged to sell the securities, and perform due diligence onthe sponsoring firms and in selecting appropriate properties suitable to investors financialobjectives and situations
• TIC Sponsor
The entity, typically an experienced real estate owner and investor that structures the investment, conducts due diligence, and continues due diligence throughout ownership for both acquiring and selling the asset, arranges the debt, raises the equity from Accredited Investors (using the services of Broker-Dealers and their Registered Representatives), manages the property (either internally or by hiring a third party), provides asset management services and sells the asset to realize returns for investors.
The Experts in 1031
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The
material contained herein is for informational purposes only and
does not constitute an offer to sell or buy real estate or securities.
Investments suitable for accredited investors only. There are material
risks associated with the ownership of real estate.
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