Written by: Skylar Lathrop
Edited by: Dave Price
Do you know anyone who says that dealing with Internal Revenue Service rule changes is simple? Likely not but navigating changes to Section 1031 could be easier by keeping some simpler themes in mind as you move forward through the complexities.
Here’s a key change to remember: “The Tax Cut and Jobs Act eliminated personal property exchanges from 1031. Currently, 1031 is limited to real estate only,” said Chet Mellema, Exchange Officer at IPE 1031, a Des Moines, Iowa-based firm that specializes in exchange transactions and helps clients comply with IRS regulations.
Mellema is a contributing editor to the Iowa State Bar Association Income Tax Manual with nearly two decades of experience.
He reminds investment property owners following Section 1031 to reinvest proceeds from the sale of a currently owned property into a new “like-kind” property. This exchange allows property owners to defer payment of capital gains taxes.
What qualifies as like-kind property? “A lot of people think that land for land is like-kind or a single-family rental home for a single-family rental home is like-kind,” said Mellema.
“If you are doing an exchange, you can go from a rental house to an office building or from retail space to bare land. Your options are much broader than what you initially may think,” Mellema continued.
Many investment properties qualify as like-kind, including farmland, office buildings, retail spaces, and raw land. He said to qualify as like-kind, real estate must be considered real property. “If you are trying to determine what is real property versus what is personal property, look at how that is interpreted in state law.”
Mellema also underscored the importance of properly using the deferment of capital gains taxes. “When participating in an exchange where you want to defer 100% of that tax, you need to buy for at least as much as what you sell for.” says Mellema. “All of the value from that sale needs to be replaced if you want to defer the full tax amount.”
If you don’t replace the full value of an initial investment, you will be taxed on the amount that was not replaced. If you choose not to replace the full value of a previous investment with a new investment, you will be trading down in value, something that qualified intermediaries (QIs) try to avoid.
RELATED: Here is the definition of a qualified intermediary and explanation of QI withholding agreements, according to the IRS. Read that here.
“At the end of the day, you do have a lot of options when you are looking at exchanging one real estate property for another,” Mellema said.
He feels that participating in a 1031 exchange can be painless with adherence to a few basic rules. Mellema said, foremost, you the owner must designate a QI before the closing of any property agreement. The IRS requires that exchangers use a QI to ensure that all guidelines are properly met. Family members and former employees, like investment advisors, attorneys, and accountants, are not eligible to serve as a QI.
The 45-day rule states that “from the sale to the closing date, we have 45 days to identify all of your potential replacement properties for that exchange,” Mellema said.
ANOTHER VIEW: Investopedia offers this guidance if you are considering a 1031 or want more information. Find that here.
It is important to be aware of your property investment timeline, as replacement properties must be identified to a third party in writing. The 180-day rule states, Mellema said, that the exchanger must close on the selected replacement property by the 180th day from closing on the relinquished property.
Becky Petersen, Assistant Vice President of IPE 1031, highlighted the benefits of reverse and improvement exchanges. “Reverse exchanges are a powerful and often underutilized tool,” she said.
A reverse exchange occurs when a taxpayer uses an exchange accommodation titleholder (EAT) to close on the purchase of a replacement property. This occurs before the relinquished property sells. “That reverse exchange comes in and gives you the ability to close on that purchase first,” said Petersen.
To serve as an EAT, the individual must have a qualified indication of ownership. “The IRS requires that the EAT hold the actual title of the property,” Petersen said.
The EAT must be subject to federal income tax and cannot be a disqualified person, such as an attorney, accountant, realtor or family member.
ADDITIONAL INFORMATION: REtipster offers this information on exchange accommodation titleholders and their importance during a 1031 exchange or a reverse 1031 exchange of property. View that here.
“We set up an EAT as a single-member LLC, where our firm, IPE, is the sole member,” explained Petersen.
She said that after the creation of an LLC, there is an agreement between the taxpayer and EAT. In this phase, the property is considered to be parked. Eventually, a seller will be selected for the property and funds will be transferred into an intermediary account.
“As soon as that relinquished property sale closes and we have qualified intermediaries… we are ready to transfer that parked replacement property to the taxpayer so that they can complete the exchange,” Petersen said.
When the exchange is over, the EAT is dissolved.
Improvements to existing property are considered a separate entity and cannot be incorporated into a traditional exchange. However, she said that there are a few ways to work around this. “A seller can construct improvements before closing. This doesn't happen often because the seller is unwilling to make improvements before closing.”
Other options, Petersen said, include construction by a developer who owns the property. Finally, an improvement can be made by an EAT with an improvement exchange. If the decision to use an EAT is made, the same rules regarding the acquisition of the replacement title apply while the property is under construction. All these proceedings must occur within 180 days.
“This [reverse and replacement exchange] is a great tool and is not utilized as well as it should be,” Petersen said.
Chet Mellema and Becky Petersen led a session at the 2024 Land Investment Expo in Des Moines, Iowa.
