1031: Tax-Deferred Barter
GRAND RAPIDS — Although many taxpayers may not be aware of it, the Internal Revenue Service is in the barter business.
In fact, there is an entire section of the United States Code dedicated to the taxation (and tax deferral) related to the friendly exchange of real property. The section number, 1031, has become synonymous with an intricate system of unloading everything from strip malls to computers without paying capital gains taxes.
The theory behind the tax-deferred, like-kind exchange, or simply “1031 exchange,” is elementary. In practice it can become infinitely complex.
To better understand the rules of exchange transactions, the Business Journal undertook a close reading of the code and discussed it with two local experts on the subject: Gary L. Vandenberg, broker with Real Estate Solutions/1031 Inc., and Paul R. Jackson, a partner with law firm Warner Norcross & Judd who specializes in structuring exchange transactions.
First of all, there are some basic ground rules. All properties involved in an exchange must be “held for productive use in trade or business or for investment.” Exchanged-for properties must be of “like-kind” with the original property. There are also specific timeframes within which certain parts of the transaction must take place.
The 1031 exchange breaks down into two categories: forward and reverse. In a forward exchange, a taxpayer decides to sell (or “relinquish”) a property. To protect his equity from capital gains tax, the seller must choose one new property (or several) that equates to a larger investment. He then, in effect, “rolls over” the equity from the first property into the new property (or properties) and his gains are not subject to tax. The forward exchange is very similar to the rules that applied to the sale of a taxpayer’s primary residence prior to the major restructuring of the capital gains tax in 1997.
In the reverse exchange, a seller may choose to purchase a new, more expensive property without having first relinquished his original property. So the term “reverse” refers to the fact that the new purchase transaction closes before the sale of the first property. In essence, the buyer structures the agreements such that he will roll the equity from the first property into the new investment at a later date (within a timeline set by the IRS).
In a hypothetical example, Vandelay Industries owns a latex-manufacturing plant without any associated debt. The facility is valued at $800,000. Vandelay is looking to expand its importing business by purchasing a $3.8 million waterfront warehouse facility.
Using a standard forward 1031 exchange, Vandelay would sell its latex plant. The proceeds would go to a special middleman known as a “qualified intermediary.” Within 45 days of closing on the sale, the company would have to identify the property in which it plans to reinvest the funds. Identifying the warehouse facility, Vandelay would arrange for traditional financing for the other $3 million of the purchase price and the qualified intermediary passes along the untaxed proceeds from the first sale. The company saves roughly $100,000 in capital gains tax.
Using a reverse exchange, Vandelay could state its intention to sell the latex plant, and buy the warehouse with other funds. Once the latex plant was sold, Vandelay could use the proceeds to pay off loans associated with the warehouse purchase.
There can also be a direct real-estate-for-real-estate swap between buyer and seller, deals involving both forward and reverse exchanges, exchanges of other business assets (such as computer systems or commercial vehicles), and purchases involving tenancy-in-common (TIC) ownership.
Vandenberg warns that the transactions can become very complicated and that anyone considering a 1031 exchange should seek help.
“They definitely need professional counsel,” he said. “That could mean an attorney, a CPA that really understands (exchange transactions) or a real estate agent. Sometimes it’s all three.”
Vandenberg also warns about the potential dangers of TIC ownership. Tenancy-in-common ownership essentially allows many investors to hold separate, and not necessarily equal, shares of an investment. The concept is often pushed as a way for investors to buy into a larger property than each could afford on his own. “It’s easy to get in, but it may not be easy to get out. While it’s a good deal for some people, I think (people) really need to think about the ramifications.”
Even in the most straightforward exchange transactions, one common gray area is the definition of like-kind. How like-kind is defined varies based upon what type of property is being exchanged. For example, any piece of real estate is considered like-kind to any other piece.
“It could be a farm and you could trade it for an apartment in Miami Beach,” said Jackson.
But when it comes to transactions not involving real estate, the rules are different.
“You’ve got to go vehicle-for-vehicle, computer-for-computer,” he said.
Of the 30 to 50 exchange transactions his firm handles each year, Jackson said, the vast majority involve real estate.
But regardless of the property to be exchanged, Jackson agrees with Vandenberg in recommending the services of professionals versed in the fine points of performing 1031 exchanges. Despite the complications and potential hazards, the tax-deferred like-kind exchange is a powerful investment technique that business owners would do well to investigate. “It’s a tremendous tool if you can do it the right way,” said Vandenberg.