As the value of your property increases, so too does its tax liability. And when it comes time to sell, you may face a substantial tax on your capital gains, even if you intend to use the proceeds to buy equivalent property. Under U.S. tax law, however, an alternative exists. To paraphrase a bygone ad slogan: there’s a tax code for that. Pursuant to Section 1031 of the Internal Revenue Code, parties involved in a property transaction can defer the capital gain tax by participating in a like-kind exchange, also called a 1031 exchange or simply a “1031.” In legal terminology, “like-kind” refers to comparability; like-kind properties are near-equal in quality and purpose. By swapping an office building, for instance, with another complex of similar value down the road, you can defer your capital gain, avoid the associated tax, and thereby keep your original investment.
How Does a Like-Kind Exchange Work?
Property sellers interested in deferring capital gains should consider like-kind exchanges prior to signing the deal. During the buyer’s study period, you will be able to calculate the ultimate sale price (and thus its tax rate): That amount is the value of the property you will need to buy in order for the exchange to succeed. Once you are ready to take the next step, ensure you have written a proviso in the sale agreement that the buyer will comply with your intention to sell under Section 1031. Following closing, you have 45 days to designate up to three replacement properties, one of which you will have to settle on 180 days after closing. During the interim period, the proceeds of the sale are held by a third-party qualified intermediary overseen by the title companies. This intermediary will charge a fee (usually in the range of $1,500) to deposit the proceeds in a national bank, where the amount earns interest. When you are ready to purchase the exchanged property, you will have to notify the intermediary, fill out some paperwork, and—presto—you’ve deferred the capital gain. You can hold onto your “replacement” property for 5, 10, 20, or an indefinite number of years, and your gains are deferred until you sell again—at which point can start the process anew… and again, and again, continually deferring the gains tax. In fact, I have used this method to perform 1031s for half a dozen properties over the past five years. Note that to qualify for a 1031 exchange, a property must be tied to investment or business use. So, for example, you could exchange a residential property if you rent it out and don’t use it, but you must be able to prove as much during an audit. Whatever the case, it is the business entity that has the right to exchange—not its members: a point clients who lack full ownership of their property should carefully consider.
The “Reverse 1031”
Like-kind exchanges can work in reverse, too: you can sell your current property after purchasing the new one and still defer the tax. Say you find a property you want to buy. You can make the decision to buy it if you own a salable property of equal value—and if you have the money for the purchase—and then sell your original property to reimburse yourself.
The Rams–Colts Example
To understand the financial magnitude of a like-kind exchange strategy, consider this (in)famous example from NFL history: In 1953, Maryland businessman Carroll Rosenbloom became the first owner of the Baltimore Colts. Under his direction, the Colts grew into a formidable team, competing in two of the first five Super Bowls and winning Super Bowl V. But by 1971, Rosenbloom had grown fed up with hometown’s legislature and lifestyle, and sought a way out. He found his opening in the Los Angeles Rams, a franchise of similar value that would soon pass into the ownership of Robert Irsay. In a historic deal, Rosenbloom and Irsay worked out a like-kind exchange. They would swap teams on the same day: the Rams would go to Rosenbloom and the Colts (along with an additional $3 million) to Irsay. By structuring the $19 million sale under Section 1031, Rosenbloom deferred a sizable capital gains tax. He not only got his money back, but secured a property worth considerably more. The real estate market is currently booming, and more property owners are considering the 1031 option. A like-kind exchange can be beneficial to buyer and seller alike, but several complex factors are always in play, so make sure to speak to a real estate attorney before taking action.
About Bernard S. Denick
email@example.com | 443.738.1526 Working as both a real estate attorney and business attorney at Offit Kurman, Bernie Denick provides strategic and comprehensive advice to domestic and foreign entities as well as their owners. His legal expertise covers a wide variety of business, transactional, real estate and generational issues. Mr. Denick has more than 40 years of experience in counseling family-owned businesses on topics such as business formation and governance, and balancing family goals with business goals. Mr. Denick has served as counsel to local quasi-governmental and nonprofit entities involved in the revitalized economic development of Baltimore and has represented foreign companies doing business in Maryland.