This excerpt from the forthcoming edition of Tax Benefits of Ownership gives a brief overview of the fundamentals of Internal Revenue Code §1031 reinvestment plans.

Determining what an investment property owner wants   

A workable §1031 reinvestment environment exists when a property owner wants to sell a property and avoid diminishing their net sales proceeds by paying taxes on the profit they realize on the sale. Here, the owner’s listing agent is in a position to:

  • negotiate the sale of the owner’s property to a buyer who agreed to cooperate with the owner at the time of closing to instruct escrow to transfer funds into a §1031 reinvestment plan; and
  • coordinate the owner’s use of the net proceeds from the sale of their property to purchase like-kind replacement property.

An agent working with a property owner who wants to sell and is considering the use of the net proceeds from the sale to purchase replacement property, called a §1031 reinvestment plan, needs to prepare a client profile sheet in a counseling session with the owner.

The client profile sheet documents the owner’s needs and expectations for a replacement property the owner is willing to acquire with the net proceeds from a sale, also called §1031 money. With this information, the agent is best prepared to find property suitable for the owner to acquire as a replacement using the equity in the property for sale. [See RPI Form 350]

  • 1031 cooperation provision

When located, the buyer of the owner’s property needs to cooperate, allowing transfer of the owner’s net proceeds on the sale at the close of escrow into a purchase escrow set up by the owner or to a §1031 trustee for holding the funds until the replacement property is located. To bargain for this cooperation, the purchase agreement contains a §1031 cooperation provision. [See RPI form 150 sec 11.6]

Buyers typically agree to cooperate in the transfer of the seller’s net proceeds of the sale as part of negotiations to set the price and terms of payment. Most buyers, as investors or business owners, appreciate the benefits of avoiding the tax on profit, which the owner plans to do on the sale.

  • 1031 reinvestment benefits, as planned

The financial benefits available to a real estate owner when entering into a §1031 reinvestment plan on the sale of 1031 property and acquiring replacement property, include:

  • the exemption from reporting all or a portion of the profit on the sale;
  • an increase in income yield achievable by replacing the property sold with a more efficient and more productive property, usually one of higher value,;
  • an increase in the amount of depreciation deductions on acquiring a higher-priced replacement property by assuming (or originating) a greater amount of debt, or adding cash or other property;
  • an inflation and appreciation hedge by selling at the end of a recession and acquiring a more highly leveraged property to take maximum advantage during the recovery period of an anticipated rapid increase in cyclical rents and property values;
  • the voluntary buyout of a partner in a co-ownership of property by acquiring multiple replacement properties for an “in-kind” distribution to the partner during the following year to end the partnership;
  • a consolidation of equities held in several properties (owned by one or each by different owners to form a group acquisition) into a single, more efficient property for ownership and management;
  • 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-value property, or, alternatively, for the purpose of facilitating an orderly liquidation of a single, high-value property over a period of years;
  • the receipt of tax-free cash from sales proceeds by negotiating a carryback note as part of the terms for payment of the price to acquire the replacement property;
  • the replacement of a management-intense property under gross leases with a more manage-free property;
  • the avoidance of profit taxes on foreclosure of a property which has little-to-no equity by adding cash or other property in an exchange for replacement property taking on equal or greater debt;
  • the relocation of wealth, undiminished by taxes, by selling or exchanging the equity in property to acquire property in a different geographic location when the owner relocates;
  • the creation of a job for the owner who desires to undertake the management or rehabilitation of replacement property;
  • the coupling of an assignment of a trust deed note carried back in a prior sale of other property with the equity in the property to be sold or exchanged as consideration to acquire a replacement property; and
  • the $250,000 profit exclusion on the sale of a qualifying principal residence converted to a rental property coupled with the §1031 profit exemption on reinvestment of the net sales proceeds remaining after first withdrawing principal from the sale in the amount of profit excluded from taxes as a residence.

The cost basis carried forward

The primary tax advantage for an owner participating in a §1031 reinvestment plan is the ability to “transfer” the cost basis remaining in the property sold to the replacement property purchased.  The cost basis is adjusted for contributions or withdrawal of cash and the difference in mortgage balances due to debt relief on the property sold and mortgages on the property acquired.

The carry forward treatment of the cost basis to the replacement property is a result of the nonrecognition of gain in a §1031 transaction.  Thus, the profit or loss realized on the sale, which amount is not reported, is implicitly carried forward to the replacement property without a taxable consequence. Of course, when the replacement property is disposed of – transferred – in a taxable sale, the profit taken on that sale is taxed.  Only on a taxable sale is the amount of profit determined and taxed at rates applicable in the year of sale.