Section 1031 Exchanges: A Primer

Taxation

Section 1031 of the tax code allows taxpayers who hold property for either investment or productive use in a trade or business to swap such property for other property of “like kind” without incurring any federal income tax, which would normally be due without this special rule. Most real estate investors are familiar with the concept of a like-kind exchange, and many investors use like-kind exchanges to their advantage. Even so, like-kind exchanges can take on many forms and can even be used for non-real estate assets. You should be familiar with the way like-kind exchanges work to better identify opportunities to seize the benefits. Below, I provide some frequently asked questions about like-kind exchanges and my answers to those questions.

  1. How does a like-kind exchange usually work? The taxpayer will engage a qualified intermediary (QI), who serves as facilitator of the exchange and escrow agent for the money involved. The taxpayer will negotiate a sale of qualifying property, then assign the rights to the contract of sale to the QI at closing. The QI will hold the sale proceeds in an escrow account. Within 45 days of closing the sale of the “relinquished property,” the taxpayer must identify candidate replacement properties. Within 180 days of closing the sale of the relinquished property (135 days after the identification deadline), the taxpayer must close on any combination of the identified candidate properties. It is important to know that the taxes due on the sale of the relinquished property are deferred, not avoided entirely; when the replacement property is sold, all of the deferred income tax will eventually be due.
  2. What types of assets can I use in a like-kind exchange? Any asset held for either investment or productive use in a trade or business can qualify for a like-kind exchange, except inventory, securities, notes payable or receivable, or ownership interests in a business. Most people think of real estate as the only asset to use in a like-kind exchange, but other eligible assets include medical and dental equipment, construction equipment, business vehicles, intellectual property, computers, hard drives, servers, and office furniture. When it comes to real estate, keep in mind that primary personal residences and property developed for sale (such as “flips”) are not eligible. Vacation homes, sponsor units in co-op and condo communities, and dual-use property usually require planning to qualify. The same goes for artwork and other collectibles, such as classic cars.
  3. What property qualifies as “like-kind?” In the real estate world, “like-kind” is defined quite liberally to include almost any type of asset considered real property. Raw land can be exchanged for a brick-and-mortar office building and vice versa. Residential real estate can be exchanged for industrial real estate. Even air rights can be exchanged for any other type of real property, so long as the property is held for investment or productive use in a trade or business. For non-real estate assets, “like-kind” is usually defined narrowly. For instance, a truck should only be exchanged for a truck, and an MRI machine should only be exchanged for an MRI machine.
  4. Do I have to reinvest all of my sale proceeds in like-kind property? No. Any money not reinvested in like-kind property will simply be taxed as normal. For instance, if the relinquished property is sold for $3 million and the taxpayer reinvests $2 million in like-kind property, the remaining $1 million will be taxed, most likely as a long-term capital gain.
  5. How can an exchange fail, and what happens if an exchange fails? Exchanges can fail in many ways, such as:
    • Failing to meet the 45-day identification deadline or the 180-day closing deadline — these deadlines are absolute, so no extensions are available. If the taxpayer fails to identify and/or fails to close on time, the taxes from the sale of the relinquished property are due, regardless of whether the taxpayer actually closed a purchase of replacement property.
    • Defective identification — the taxpayer identifies the replacement property incorrectly. Taxes are due, regardless of whether the taxpayer successfully closes a purchase.
    • Closing on unidentified property — regardless of whether unidentified property would otherwise be considered like-kind, taxes are still due.
    • Prohibited use of escrow funds — while the relinquished property sale proceeds are in escrow with the QI, the taxpayer cannot access them, borrow or pledge against them, or otherwise have beneficial use of them.
    • Prohibited use of replacement property – if the replacement property does not meet the requirement of investment or business use, taxes are still due. For instance, a taxpayer cannot use a replacement property as a personal residence immediately after the conclusion of the exchange.
  6. When it comes to real estate, what possibilities exist that might help me if I have the right legal assistance?
    • One property may be exchanged into multiple properties, and multiple properties may be exchanged into one.
    • Even though partnership or LLC interests are not eligible for exchange, multiple partners can make different exchanges of ownership interests in the same property.
    • Exchange funds may be used to develop or construct real property.
    • Taxpayers may exchange into joint ventures, syndicated deals, and other investments with complicated structuring.
  7. Besides the format you described in Question 1, what other methods exist to complete a like-kind exchange? The most important alternative method to know is the “parking” or “reverse” exchange, in which a taxpayer may buy a property first and sell a property second. This format requires the assistance of tax counsel to execute properly, because a taxpayer may not buy property in his or her own name.

What we hope you take away from this primer is that you can use Section 1031 advantages in more ways than you might think to achieve optimal tax outcomes. Not only can we assist in the real estate transactions involved in an exchange, we can also help you structure the exchange to comply with the tax laws.

Posted by Matthew Rappaport

Estate Planning For Your Kids Impacts You More Than You Think

Estate Planning

In my experience, most people below the age of 40 put off estate planning because they believe their chances of dying in the near future are unrealistic. Delaying estate planning can have catastrophic consequences for these clients and their families if the unlikely does occur, but their parents typically underestimate the havoc that the death of a child or a child’s spouse can wreak on their lives. While estate planning for young clients – even if they’re single – will protect their spouses and children, many fail to realize exactly how much planning will also protect their parents.

If you’re a parent of a child under 40, ask yourself how your life would change if your child or your child’s spouse experienced a catastrophic and unexpected event. If you’re retired, you might be prevented from moving to your dream home or taking your dream trip around the world. The assets you worked so hard to accumulate your entire life may be devoted to the care of your children and grandchildren. If a dispute occurs between you and your child’s spouse or his/her family, your resources may be wasted on legal fees to wage custody wars or battles over the fate of your child’s estate.

For these reasons and many more, I always encourage clients with children over the age of 18 to have a serious talk with them about estate planning. When an adult child has properly planned his or her estate, the following problems have been sufficiently addressed:

  • Health Care Decisions: Parents lose the automatic right to access the health care records of children over the age of 18. To grant parents this access, children must execute a Health Care Proxy that includes a Health Insurance Portability and Accountability Act (HIPAA) waiver.
  • Division of Assets: For a married couple with children, New York State law provides that a decedent’s assets will be split between the decedent’s spouse and his or her children about evenly. If the children are minors, they gain full access to their share of the assets at age 18. A proper estate plan would ensure the assets pass outright to the decedent’s spouse. If the decedent’s spouse does not survive, then the assets would pass to the children in a trust.
  • Designation of Fiduciaries: Speaking of trusts, a Last Will and Testament gives a client the opportunity to name the Trustee who would watch over the assets he or she leaves behind for their children. The document would also name an Executor responsible for administering the client’s estate upon his or her death.
  • Custody of Children: The Last Will and Testament would also specify the client’s preference for who would serve as Guardian of the client’s children in the event both spouses pass away prior to their children reaching the age of 18. While this designation would not be legally binding, the family court will look to any such designation when ultimately making its decision about custody. If both spouses discuss this issue beforehand and name the same Guardians (or a desire to split custody), any potential dispute between the spouses’ families would be cut off before it even began.
  • Availability of Money: The clients would secure life insurance and long-term disability insurance to better protect against the possibility of unexpected death or disability. When these policies are paying claims, they will serve as the primary source of income to continue the lifestyle to which the client’s family has become accustomed. Without these vital safeguards, a client’s other family members would be burdened with the task of providing income.

These concerns would be addressed with a variety of legal documents, which may include any of the following, depending on a family’s circumstances:

  • Health Care Proxy: A document giving an agent the authority to make health care decisions on your behalf in case you are not able to make your own.
  • Durable Power of Attorney: A document giving an agent the authority to make various financial decisions on your behalf.
  • Last Will and Testament: A document providing instructions for the distribution of your property upon your death, designations of individuals in fiduciary roles (Executor, Trustee, and Guardian for minor children), and protection of the assets you leave behind for your loved ones.
  • Supplemental Needs Trust: A document allowing a person to receive an inheritance while still qualifying for government benefits such as Medicaid and Supplemental Security Income (SSI).
  • Life Insurance Trust: A document setting forth the administration and distribution of the life insurance death benefit once the insured individual dies. For tax planning purposes, a life insurance trust is designed to exclude the death benefit from the owner’s taxable estate.

Each of these documents may be drafted for multiple generations to ensure optimal contingency planning for an entire family unit. The best estate plans are those addressing the holistic needs of all family members.

Although these issues are tough to think about and perhaps even tougher to discuss, anyone over the age of 18 (and his or her family members) should seriously consider setting up a comprehensive estate plan to prepare for the unexpected. We would be happy to guide you through the process and answer your questions. If you have any questions, please call me at 516-228-1300 or email me at mrappaport@swc-law.com.

Posted by Matthew Rappaport