Protecting Real Estate Equity: Is IRS 1031 Right for You?

As real estate equity makes a big comeback due to surging home prices, we are seeing more and more investors opting to sell their investment properties and 'move' their equity into another investment opportunity.

Note: a 1031 Tax Deferred Exchange allows an investor to take equity from one property and 'exchange' it into another. What is the reason the tax is deferred instead of actually paid? No funds are received by the investor. Receipt of funds is forbidden by the investor and is one of the essentials to a tax-deferred exchange.

Here's a typical 1031 exchange scenario:

1. Investor decides to sell an investment property through a 1031 exchange. S/he will contact a Qualified Intermediary (QI), entering into an agreement. Remember, investor cannot be in receipt of the proceeds after the close—the QI will 'hold' these funds.

2. Investment property is put on the market.

3. Offer(s) to purchase the investment property is accepted and signed by the QI.

4. Escrow for the sale is opened, and a preliminary title report is produced.

5. QI sends required exchange documents to escrow for signing at property closing.

6. Escrow closes.

7. Within the first 45 days after the close of escrow on the sale of the relinquished property, the investor identifies replacement properties as required by law. This is known as the "Identification Period".

8. Within 180 days after the close of escrow on the sale of the relinquished property, the investor closes on one of the replacement properties which he has identified. This is called the "Exchange Period". This completes the exchange. Remember, the 45 days runs 'within' the 180 days.

What is a Qualified Intermediary?

A Qualified Intermediary (QI) is the company or party who holds the funds until needed to close the escrow of the 'move-up' property. Many title companies have an exchange service as do private firms. Go with a major player in the QI field. Remember, the tax payer or 'exchanger' cannot have access or control over the funds realized from the sale of the 'relinquished' or original property in the exchange. The QI will receive funds from the escrow and hold the funds until needed to complete the exchange. The QI sends the proceeds to the new escrow on the 'move-up' property, it closes and then the taxpayer or 'exchanger' becomes the owner.

Remember the key: taxpayer or exchanger cannot have 'constructive receipt' of the funds. You violate this fundamental rule and your exchange becomes just a sale with inherent tax liabilities. Contact your tax attorney, CPA or accountant, who knows the ins and outs of conducting a tax deferred exchange.

Sounds fairly straight forward, right? However, some big wrenches can get thrown into the works of an exchange. The biggest problem can be finding the 'move-up' property within the 45 identification period. With super tight inventory across all investment fields, finding the elusive other 'leg' of the exchange could blow the whole deal. Enter the 'reverse exchange.' Those opting to use the 'reverse exchange' do so to avoid the dreaded time-lines for a normal exchange. It is much easier to find the 'move-up' property without all the pressure of the timeliness of a normal exchange. Or perhaps an enticing investment opportunity comes along and you have little time to prepare and sell your 'relinquished' property? These scenarios make a 'reverse exchange' worth the effort.

Remember, the rule of an exchange is not to have 'constructive receipt' of the funds from the sale of an exchanged property. In a Reverse 1031 Exchange the property you are buying cannot be in your name, no constructive receipt' of ownership and is 'owned' by and in the name of the 'exchange accommodator.' Your QI can arrange this service also.

Once again, this complicated strategy should be thoroughly investigated before attempting to purchase the 'move-up' property. Remember, receipt of sales proceeds or in this case, title to the 'move-up' property without completing the exchange is a big no-no. The issues compounds when you realize the 'exchange accommodator' will be holding title to the property and your lender is qualifying you for the loan. You need to make sure your lender is able to perform with this restriction. It is highly advisable to explore the ramifications and qualifications of using a 'reverse exchange' with your lender of choice and keep them in the loop on all steps of the exchange.

Lastly, you can 'exchange' into an upREIT or 'Umbrella Partnership Real Estate Investment Trust'. An upREIT is a 'securities' based investment vehicle with many properties in its portfolio. It needs a very precise set of steps to achieve. It's not for all investors and is an alternative to explore. Downside? You can't exchange out of an upREIT. It has its benefits and should be explored by certain investors. As always, talk to your real estate tax professionals before attempting any of the exchanges discussed in this column.