The Internal Revenue Code (IRC) §1031 reinvestment plan, also called a §1031 transaction or exchange, allows an owner to sell business-use or investment real estate and use the sales proceeds to purchase replacement business-use or investment real estate, called like-kind properties, without a tax on the profit. The reinvestment transfers the cost basis –– the original cost incurred to purchase and improve the property less deductions for depreciation and destruction –– remaining in the property sold to the replacement property purchased. This is an accounting matter of concern only to the investor and the Internal Revenue Service (IRS). [See first tuesday Form 171 and 354]
Implicitly, the §1031 reinvestment plan shifts the untaxed profit (or loss) on the sale forward to the replacement property purchased. Only on a later resale of the replacement property will the owner report (and pay taxes) on profit or loss, and then only based on the price received on the resale. Of course, on the resale of a replacement property, the net proceeds may again be reinvested to purchase other §1031 real estate and further defer profit reporting and taxes. [See first tuesday Form 301-1]
The profit taken on the sale of real estate qualified as §1031 like-kind property –– business-use or investment property –– is exempt from state and federal income taxes when the owner purchases §1031 like-kind property as a replacement.
Two classifications of real estate make up §1031 like-kind property:
- investment property, called capital assets [IRC §1221]; and
- business-use property, which is trade or business property held for productive use. [IRC §1231]
Investment property includes:
- rental real estate, residential and commercial;
- vacation homes held for profit or resale; and
- investment (portfolio) real estate. [IRC §1221]
Business-use property is real estate used to house an owner’s trade or business and includes hotel or motel operations.
However, before business-use property qualifies as like-kind property, it must be owned for at least one year before it is sold or exchanged. Business-use property is unlike investment property, which has no holding period requirement. After one year of ownership, the business-use property may be sold and replaced in a §1031 reinvestment plan by purchasing either business-use property or investment property. [IRC §1231(b)(1)]
Similarly, investment property may be sold and replaced by either business-use property or investment property in a §1031 reinvestment plan.
Conversely, while a principal residence is a capital asset, it does not qualify as §1031 property since it is neither used in a business nor held for investment purposes.
Further, properties transferred –– exchanged –– between related persons in a §1031 transaction must be held by both persons for a minimum of two years after acquisition. Only then do business-use properties qualify as §1031 property for resale on a cash out or further §1031 reinvestment. [IRC §1031(f)(1)]
The benefits and advantages opened up to real estate investors by a §1031 reinvestment plan include:
- the avoidance of reporting all or a portion of the profit on a sale;
- the purchase of higher-valued, more efficient real estate with a greater income yield than the real estate sold, funded by an increase in mortgage debt or cash;
- an increase in the annual depreciation deduction by purchasing a higher-priced replacement property and setting a new allocation of basis to depreciable improvements;
- an inflation hedge to take maximum advantage of an anticipated rapid increase in cyclical real estate values by purchasing highly leveraged property to replace a lower-leveraged property;
- a consolidation of equities in several properties, held by one or more owners, into a single, more efficient property;
- the sale of a high-valued property and the purchase of several replacement properties, each of lesser value than the property sold, to either reduce the inherent risk of loss by diversification or facilitate an orderly liquidation of a single asset over a period of years;
- the tax-free receipt of cash from a sale when the purchase of a replacement property is financed by the execution of a carryback note in part for payment of the price;
- the replacement of a management-intense property with a more manageable property; and
- the relocation of the equity in a property, undiminished by taxes, from one geographic location to another by an investor who themselves move or determines another location offers a better investment opportunity.
The sale of §1031 property is the first step in a reinvestment plan designed to maintain a continuing capital investment in §1031 real estate. Remember, for business-use property to qualify as §1031 property, it must be owned for one year prior to its sale.
To ensure the investor has the ability to complete a §1031 reinvestment by purchasing replacement property, the agreement to sell, grant an option or exchange, prepared to document the investor’s sale transaction, needs to include:
- a provision stating the buyer agrees to cooperate in a §1031 transaction [See first tuesday Form 159 §10.6 ]; and
- supplemental escrow closing instructions, worded to prevent the investor’s receipt of the net sales proceeds on closing and signed by the buyer. [See first tuesday Forms 172-2 and 173-2]
The second step is the location and acquisition of a replacement property. The investor enters into a purchase agreement with the seller of the property that will become the replacement.
An investor must avoid actual or constructive receipt of the net sales proceeds on the sale of their property to qualify for the §1031 exemption. Thus, they may not receive their net sales proceeds themselves and in turn deposit the funds into the purchase escrow for the replacement property.
To avoid receipt of sales proceeds, a trust arrangement is set up appointing a §1031 trustee to receive and hold the net proceeds from the sale. The investor choses the trustee at the same time the documents are prepared establishing the trust, prior to closing escrow on the sale. The trustee, on receipt of the net sales proceeds, places the funds in an interest-bearing trust account. In turn, the investor uses the funds to purchase the investor’s replacement property, as well as to pay the costs of any construction to be completed prior to taking title.
As an alternative to the use of a trustee, the net sales proceeds available on closing the sale may be deposited by escrow directly to the investor’s account in the purchase escrow opened by the investor for acquisition of the replacement property. Thus, the investor funds the purchase escrow for the replacement property either directly from the sales escrow for the property the investor sold or from the §1031 trustee who holds the proceeds. The investor, by all these agreements, cannot be contractually able to demand and receive the proceeds allocated for reinvestment from the sale of their property.
If additional funds are required beyond the amount of the net sales proceeds, the investor may advance them as part of the purchase price by deposit into the escrow opened for the purchase of the replacement property.
Two types of §1031 reinvestment plans exist:
- a fully qualified §1031 reinvestment plan;
- a partially qualified §1031 reinvestment plan.
Under a fully qualified §1031 reinvestment plan, all the profit in the property sold or exchanged is tax exempt.
The entire cost basis in the property sold is always carried forward to the replacement property acquired in the transaction. As a result, the exempt profit on the sale of the property is shifted –– untaxed –– to the replacement property. No accounting for the profit is required.
The timing for the closing of the purchase escrow to acquire the replacement property in a §1031 reinvestment plan may be:
- concurrent with the closing of the investor’s sales escrow, called a simultaneous closing; or
- not more than 180 days after the closing of the sales escrow, called a delayed §1031 exchange.
Taxwise, a fully qualified §1031 reinvestment plan requires the financing of the price paid for the replacement property to replicate at a minimum the amounts of debt and equity in the property sold. Thus, to financially structure a fully qualified §1031 transaction, the price paid for the replacement property must be funded by equal or greater debt and equal or greater equity than the property sold (or exchanged).
No limitations are placed on size, value or location of the properties involved in a §1031 reinvestment plan, as long as the properties are located within the United States.
For a partially qualified §1031 transaction, a portion (but not all) of the profit is exempt from taxes. Part of the profit on the sale is reported and taxed. While the entire remaining cost basis in the property sold is carried forward to the replacement property, only the portion of the profit untaxed is shifted to the replacement property. In a partial §1031, the investor withdraws some capital. Thus, capital withdrawn in a §1031 reinvestment plan includes:
- cash or a carryback note received by the investor at closing on the sale of the property sold, or by the receipt of unqualified property, called cash items or cash boot; and/or
- a lesser amount of mortgage debt assumed or originated to finance the acquisition of the replacement property than the amount of the mortgages on the property sold (and not offset by the investor’s contribution of cash), called net debt relief or mortgage boot. [IRC §1031(b)]
A delayed §1031 exchange results when the investor’s purchase escrow for the replacement property will close after the closing of the investor’s sales escrow.
To qualify the investor’s profit on their sale for the §1031 exemption in a delayed exchange, the investor needs to:
- avoid receipt of the net sales proceeds from the property sold when the sales escrow closes;
- identify the replacement property within 45 days after closing the sales escrow; and
- close the purchase escrow acquiring the replacement property(ies) within 180 days after the sales escrow closes. [See first tuesday Form 174]
Prior to closing the sales escrow, the buyer is requested to cooperate and establish a trust naming a trustee appointed by the investor, the reason for the provision calling for buyer cooperation in the sales agreements. The trustee will receive and hold the net sales proceeds from the property sold. The investor selects an unrelated person as the named §1031 trustee to administer the funds. Thus, the trust arrangement prevents the investor’s constructive receipt of the net sales proceeds on closing. The net sales proceeds of cash and any note carried back on the property sold by the investor are made payable by escrow to the §1031 trustee and delivered to the trustee on closing.
The §1031 trustee, under the trust agreement, impounds the cash funds in an interest-bearing trust account and collects installments on any carryback note.
Later, on the investor’s instruction, the §1031 trustee disburses the money and assigns any carryback paper used by the investor to fund the purchase of the replacement property.
To close out the §1031 reinvestment plan, the replacement property purchased is deeded directly to the investor.
Prices, and thus the equities and mortgages on properties sold and purchased in a 1031 reinvestment plan, rarely are of the same dollar amount. As a result, the investor purchasing replacement property which has an equity greater than the net sales proceeds from the property sold needs to contribute money (cash or execute a carryback note) or other property, collectively called cash boot. The process is called balancing the equities –– when an actual exchange of properties between owners takes place. Cash contributions come from savings or mortgage financing taken out on the property purchased, including executing carryback notes.
Cash boot received on the close of the escrow for the property sold, which cannot be offset on the purchase of a replacement property, includes:
- the receipt of cash proceeds from the investor’s mortgage refinancing of the property sold in preparation for its sale or exchange; or
- the investor’s receipt of some or all of the net sales proceeds from the property sold prior to acquiring the replacement property. [Revenue Regulations §1.1031(k)-1(f)]
Mortgage debt relief on the closing of the sales escrow may be offset on the acquisition of the replacement property on a delayed 1031 transaction, unlike cash boot which cannot be offset if received on closing the sale in a delayed exchange.