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.
The tax-exempt sale by reinvestment
An owner who sells real estate they use in the operation of their business or hold as income or long-term investment property — called like-kind property — will realize a significant profit on the sale.
The owner’s broker advises them on available options for the tax treatment of those profits. The broker explains those options are based on how the owner uses the net proceeds from the sale.
One option available to the owner is recognition of the profit taken, where the owner will pay taxes on the profit as a “cash out” sale.
This tax liability reduces the net sales proceeds to a disposable after-tax amount. Here, the net sales proceeds are used for purposes other than the purchase of another business or investment property.
However, a second option is available: the owner may use the net sales proceeds to purchase business or investment real estate as a replacement for the property sold, called a §1031 reinvestment plan.
By purchasing replacement property using the net proceeds from the sale, the owner commits to a continuing investment in business or investment real estate. This commitment to ongoing ownership, including observance of property identification and periods for delayed closings and the use of a §1031 trustee to avoid receipt of the sales proceeds qualifies the profit realized on the sale as exempt from income taxes under Internal Revenue Code (IRC) §1031. The IRS classifies this as nonrecognition of profit.
A broker or agent who knows the tax advantages and procedural steps of §1031 transactions, and demonstrates the financial benefits of buying replacement property using the net proceeds from a sale, is able to:
- advise their client about the benefits of §1031 tax treatment;
- locate and arrange the timely purchase of a replacement property and ensure the client’s avoidance of actual or constructive receipt of the net proceeds prior to closing escrow on the acquisition; and
- receive brokerage fees based on a percentage of the value of both the property sold and the property acquired — in consideration for giving advice, conducting negotiations and preparing documents in a §1031 reinvestment plan.
Determine what the owner wants in a replacement property
A workable §1031 reinvestment environment exists when an owner is motivated to avoid paying taxes on profit from the sale of business or investment real estate by buying replacement property and continuing their investment in like-kind real estate. Here, the owner’s broker is positioned to negotiate both:
- the sale of the owner’s property to a buyer who agrees to cooperate with the owner on closing to transfer the owner’s net sales proceeds (to a §1031 trustee, or to escrow for purchase of the replacement property); and
- coordinate the reinvestment of the owner’s net proceeds to escrow for the purchase of replacement property — avoiding the client’s actual or constructive receipt of the proceeds.
When working with an owner who agrees to purchase replacement property in a §1031 reinvestment plan, the broker needs to prepare a client profile sheet in a counseling session with the owner prior to the location of replacement property. [See RPI form 350]
The client profile sheet documents the owner’s expectations — location, property type, mortgage amount, management, capitalization rate pricing, partial cash-out — for a replacement property the owner is willing to acquire with the net proceeds from the sale of a property, often called §1031 money. [See RPI Form 350]
§1031 cooperation provision in purchase agreements
The buyer needs to cooperate in the disbursement of the owner’s net sales proceeds on closing. To obtain this cooperation, the broker’s purchase agreement contains a simple boilerplate §1031 cooperation provision.
Buyers normally agree to cooperate with an owner as part of written negotiations to set an agreeable price and terms of purchase. Buyers of business and investment properties appreciate the benefits of avoiding profit taxes. In fact, many buyers of such property have experience closing out their own §1031 reinvestments, and may even be doing so by acquiring the owner’s property.
§1031 reinvestment benefits
The extensive and varied financial benefits available to a real estate owner when entering into a §1031 reinvestment plan on the sale of like-kind property include:
- the profit exemption which allows the owner to avoid taxation on most (if not all) of the profit realized on the sale;
- an increase in income yield achieved by acquiring a higher-priced, more efficient and more productive property than the property sold;
- an increase in depreciation deduction schedules by assuming (or originating) a greater amount of debt to acquire higher-priced replacement property;
- a greater inflation and appreciation hedge from acquiring highly leveraged property in a high-density location to take advantage of anticipated cyclical increases in property values;
- the voluntary elimination of a partner from co-ownership of a property by acquiring multiple replacement properties for an “in-kind” distribution to the partner during the following tax reporting year;
- a consolidation of equities in lesser-valued properties (with one or more owners) into a single, more efficient high-valued property;
- the acquisition of lesser-valued replacement properties to diversify an 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 through the execution of a carryback note on acquisition of the replacement property to offset unused cash from the sale;
- the replacement of a management-intense property with a property better suited to the owner;
- the avoidance of profit taxes on foreclosure of a property with little or no equity by adding cash in an exchange for replacement property with equal or greater debt;
- the relocation of the equity in a property, undiminished by taxes, by acquiring property in a new geographic location;
- the creation of a job for an owner who will either manage the replacement property full-time or personally rehabilitate it to increase its value; and
- the use of a carryback note on the sale of a property as all or part of the down payment on the purchase of replacement property — with taxes avoided on the profit being allocated to the carryback note.
The cost basis carried forward
To establish the cost basis for the property acquired in a §1031 reinvestment plan, the cost basis remaining in the property sold is “transferred” to the replacement property.
The transferred basis is then adjusted for differences in the amount of mortgage and net proceeds on the property sold from the mortgage and cash amounts used to purchase the replacement property.
Accounting for nonrecognition of gain implicitly allows the profit (or loss) actually realized on the sale to be carried forward to the replacement property without any bookkeeping entry or other notation about the profit taken on the property sold.
However, profit taxed on any cash-out sale of the replacement property will be in the amount of profit taken on its sale, reported under the tax formula of “price minus basis equals profit” — unless it too is replaced by property in a §1031 reinvestment plan, continuing the owner’s investment in real estate.