By Michael Repka, Esq. (LL.M.—Taxation; NYU School of Law (’01))
The federal government and the state of California provide for the deferral of tax when a taxpayer exchanges investment or business real property for other real property that will be used as investment or business property. This is commonly referred to as a “1031 Exchange” or a “Like-Kind Exchange.”
Although a primary residence doesn’t qualify, a taxpayer may convert a home into investment property by renting it out for a sufficient period of time and then performing an exchange. While a number of strictly-applied rules and deadlines accompany this procedure, they are fairly easy to follow with the appropriate guidance.
By far, the most common variety of 1031 Exchange is the “Forward Triangular Exchange” also known as a Delayed Exchange or Starker Exchange. This is where a property owner sells a piece of business or investment property they own and then acquires a replacement property. Both transactions are done through an intermediary such that the client never has actual or constructive receipt (i.e., “touches”) of the money. This replacement property must be identified within 45 days of the closing of the property sold and the closing of the replacement property must take place within 180 days of the closing of the property sold.
If the taxpayer is unable to find and close on the replacement property within the abovementioned time frames, then the taxpayer will be subject to tax on the gain from the sale of the original property.
In a hot market, some sellers are less worried about selling their old property than they are about finding a replacement property. The more specific the client’s needs are for the replacement property, the more challenging the search. For example, if a client owns a 3 bedroom 2 bath ranch home in Palo Alto, which they have rented out for the past few years, but they think they would have a better financial result by owning a penthouse condo within 3 blocks of both a Starbucks and a Caltrain station, then they may have more concern about finding the right target property than they do about selling the old property.
The Reverse Exchange
To combat this acquisition problem, some taxpayers may wish to acquire the replacement property first and then sell the relinquished property. Unfortunately, there is limited legal authority to support this structure in its simplest form, which would be a straightforward purchase followed by identification and sale of the relinquished property.
As a result of the lack of legal certainty, most Reverse Exchange transactions are completed using the “Parking Structure,” which is where the taxpayer utilizes a third-party intermediary to acquire the property, purchase the replacement property, and then sell the relinquished property. As a result, the taxpayer avoids concurrent ownerships of both properties.
This type of transaction is complicated and intertwines the legal rights and finances of the intermediary and the taxpayers. As a result, the agreement often requires that the taxpayer provide the funds or the financing for the acquisition and usually includes a “put” option whereby the intermediary can require the taxpayer to purchase the property after a given amount of time. Thus, taxpayers should make sure that they are receiving sound legal and tax advice before entertaining this type of structure.
What is Right for You?
Like-Kind exchanges, whether forward or reverse, can result in the deferral of a substantial amount of gain. However, there are a number of practical or procedural hurdles that must be understood and considered. A simple miscalculation of a date or mishandling of funds could result in a very large tax bill. An experienced real estate agent should be able to connect you with the right people for advice and answer many of your questions.