This article sets out the benefits of the §1031 profit tax exemption, and discusses how a broker coordinates exchanges comprised of buyers and sellers with differing §1031 motivations.

The tax-exempt sale and reinvestment

Numerous benefits and advantages are available to sellers of §1031 like-kind properties who, rather than “cash out” on the sale of their property, couple the sale with the purchase of replacement property(ies). Thus, a reinvestment is arranged which establishes the seller’s continuing investment in the ownership of like-kind real estate as is needed to qualify the sale for profit tax exemption under Internal Revenue Code §1031.

One or more of these benefits and advantages becomes the motivating factor influencing an owner’s decision to sell and buy replacement property in a tandem transaction called a §1031 reinvestment plan.

If a broker knows the advantages of buying and selling under §1031 rules, the broker:

  • may undertake the duty to determine how his client might benefit from §1031 tax treatment and advise his client on the benefits;
  • will be able to arrange a §1031 transaction where the motives of opposing parties to buy or sell may differ; and
  • will be rewarded by receiving two fees for giving advice and assistance in the negotiations of the two related transactions.

Determining the client’s needs

A workable §1031 reinvestment environment exists when the owner’s motivation for selling property includes his ability to avoid reporting profit on the sale by buying replacement property.

The broker who knows the owner intends to buy replacement property with the net proceeds from the sale of his property and qualify the sale and reinvestment as a §1031 tax-free transaction, is in a position to:

  • negotiate the sale of the owner’s property to a buyer who will enter into a purchase agreement with a provision calling for the buyer to cooperate with the owner regarding the transfer of funds in a §1031 reinvestment plan; and
  • coordinate the owner’s use of the net proceeds from the sale of his property to purchase replacement property from a seller who enters into a purchase agreement with a provision calling for the seller to cooperate in the owner’s §1031 reinvestment plan.

The broker working with a seller who has an interest in acquiring other real estate with the net proceeds from a sale should prepare a client profile sheet as the result of a counseling session with the seller.

The client profile sheet documents the seller’s needs and expectations in a replacement property the owner would like to acquire to complete a §1031 reinvestment of his net sales proceeds. [See Form 350 accompanying this article]

§1031 cooperation provision

An investor’s future need for the buyer to cooperate in the investor’s reinvestment of the net proceeds of a sale is best negotiated with a buyer by using a purchase agreement that contains a §1031 cooperation provision. [See Figure 1 below]

Purchase agreements designed to document the sale of a single-family residence by a seller who occupies the property to a buyer who will occupy the property do not usually contain provisions which implement tax avoidance.

For the investor selling property, most buyers will agree to a cooperation provision so long as the price and terms of purchase are agreeable – they too appreciate avoiding the tax on profit.

Figure 1 
 

Excerpt from first tuesday Form 150 §11.10

 Both Parties reserve their right to assign and agree to cooperate in effecting an Internal Revenue Code §1031 Exchange prior to close of escrow, on either Party’s written notice.

§1031 benefits

The benefits and advantages available to sellers of real estate, one or more of which may influence the seller’s decision to enter into a §1031 reinvestment plan, include:

  • an exemption from reporting all or a portion of the profit on the sale;
  • an increase in debt leverage and income yield by replacing the property being sold with a higher-priced and more efficient and productive property;
  • an increase in the depreciation deduction schedules by assuming larger amounts of debt on higher priced replacement property to provide a fresh start for the allocation of basis between buildings and land;
  • the avoidance of costs incurred to originate new financing by assuming or taking title subject to the existing loans on the properties sold or acquired;
  • an inflation and appreciation hedge to take maximum advantage of an anticipated rapid increase in cyclical property values by acquiring highly leveraged property to replace a lower-leveraged property;
  • the voluntary elimination of a partner from the co-ownership of a property by acquiring multiple replacement properties for an “in-kind” distribution the following year;
  • a consolidation of the equities in several properties (by one or more owners) into a single, more efficient property;
  • the acquisition of several lesser-valued replacement properties to diversify the investment and reduce the risk of loss inherent in the ownership of one high-valued property, or, alternatively, to facilitate an orderly liquidation of a single, high-value property;
  • the receipt of tax-free cash through the execution of a purchase-money carryback note on acquisition of the replacement property;
  • the sale of management-intense properties which are replaced with more manageable properties;
  • the avoidance of profit taxes on foreclosure of a property with little if any equity when loan amounts exceed the remaining cost basis, by adding cash to an exchange of the property for replacement property with equal or greater debt which is financially more manageable and owned by someone interested in taking on a seemingly over-encumbered property which may require a pre-foreclosure workout with the lender;
  • the relocation of an equity in property, undiminished by taxes, by an owner who himself moves to a new geographic location;
  • the creation of a job for the owner who desires to undertake the management or rehabilitation of a replacement property; and

  • the coupling of a carryback note retained on a sale with the reinvestment of the cash down payment from the sale in a replacement property.