IRC §1031 Like-Kind Exchange: Versatile Tax Deferral Strategy for Real Estate Investment Gains

Introduction

The income tax due on the proceeds of the sale of property held for investment purposes is generally payable during the applicable tax year. However, §1031 of the Internal Revenue Code (“IRC” or “Code”) provides a valuable mechanism to defer the payment of such taxes and is commonly referred to as a “like-kind exchange.” Real estate investors have used this mechanism to help build wealth for generations.

Overview

The basic rules required to complete a like-kind exchange are fairly straightforward. First, the property to be sold (“relinquished property”) must be held for investment purposes. Second, the proceeds from the sale of the relinquished property must be held by an independent party (“qualified intermediary”) during the exchange process. Third, the replacement property (or properties) to be purchased with the proceeds of the sale of the relinquished property must be identified within 45 days of the closing of the sale of the relinquished property. Fourth, the closing(s) generally must be completed on the purchase of the replacement property(ies) within 180 days from the sale of the relinquished property or by your yearly tax return due date, whichever is earlier.

Strategic and Practical

A properly structured IRC §1031 like-kind exchange can be an invaluable, flexible tool for re-investing the substantial gains often realized in commercial real estate. Some experts have referred to the like-kind exchange as an interest-free loan from the government because income tax is deferred until the final sale – with no exchange – of the last property. The like-kind exchange can also be viewed as an extraordinarily effective estate planning strategy that can reduce tax liabilities across generations.

There are also many practical business reasons to consider a §1031 like-kind exchange. For example, a multifamily property owner in a major metropolitan area may want to reduce management and other costs associated with such property and exchange it for property (or properties) in a secondary market with commercial tenants who are responsible for paying the majority of the expenses associated with owning the property pursuant to the terms of a triple net lease.

Case Study

Holm & O’Hara LLP recently represented a commercial real estate investor in connection with the sale of a fully depreciated commercial property and the purchase of several replacement properties. This enabled the investor to substantially reduce the time, effort and expenses associated with management of the relinquished property, diversify such investor’s portfolio and substantially increase the net income derived from such portfolio. The relinquished property was a multifamily apartment building in New York City that the investor owned for many years. The replacement properties purchased with the net proceeds of the sale are located in several states with a diverse portfolio of triple net leases.

As part of this complex group of transactions, attorneys at Holm & O’Hara LLP assembled a team of experts who helped ensure the efficient and successful achievement of the investor’s goals. The team included an accounting firm, a qualified intermediary, real estate brokers, engineers and mortgage brokers. The accounting firm, which specializes in complex multi-state like-kind exchanges, prepared potential income scenarios for the client, who was concerned about how the exchange would impact short term cash flow. The qualified intermediary held the proceeds of the sale of the relinquished property and facilitated the payment of exchange related expenses and the funds required to close on the replacement properties.

The commercial real estate brokers, who specialize in triple net lease properties around the United States, offered the client a broad range of potential replacement properties with diverse corporate tenants well before the sale of the replacement properties. The engineers evaluated the structural and environmental elements of each of the prospective replacement properties. Finally, the commercial mortgage brokers assisted the client to secure financing for one of the properties.

In summary, the §1031 like-kind exchange process enabled this investor to not only defer capital gains on sale of the relinquished property, but also meet such investor’s immediate financial goals.

~ Michael L. Landsman, Esq.