When you own a piece of highly appreciated investment real estate that you’d like to dispose of, you normally face paying substantial capital gains tax on the sale. However, one way to defer those taxes is to do a 1031 exchange for another like-kind property instead of an outright sale.
Named for Internal Revenue Code Section 1031 that authorizes them, classic 1031 exchanges, which are rare, consist of an actual swap of properties at the same time, i.e., you acquire the new property at the same time you dispose of the relinquished property. In real life, most 1031 exchanges are deferred, meaning that you must find a qualified intermediary to hold the proceeds of your sale while you find your replacement property.
The IRS has strict rules about who cannot qualify as a 1031 exchange intermediary. Such people include the following:
- Your attorney
- Your accountant or CPA
- Your real estate agent
- Your broker
- Your investment banker
- Your employees
The IRS does not define the term “like-kind property,” saying rather that it must be “property of the same nature, character or class.” Examples of property that do not meet these criteria include the following:
- Property located outside of the United States
- Stocks, bonds or notes
- Other securities or debts
- Partnership interests
- Inventory or stock in trade
- Certificates of trust
The IRS has two very specific time limits regarding how you must conduct your 1031 exchange. Failure to adhere to either rule will result in disqualification of 1031 status.
You must, within 45 days of relinquishing your property, designate a potential replacement property. The IRS allows you to designate more than one of these, but your designation must be written, clearly identify the property, signed by you and delivered to the person or persons so designated.
You also must, within 180 days of relinquishing your property, complete the exchange with one of your designated replacement property owners and receive the property. Keep in mind that the 45-day rule and 180-day rule run concurrently. Thus if, for instance, you don’t designate one or more potential replacement properties until 45 days after relinquishing your property, you have only 135 days left to complete the exchange.
Rescuing a Failed 1031 Exchange
As you can see, a 1031 exchange has many moving parts and is therefore subject to failing at any given point. If you find yourself in this unfortunate position, take heart. All is not lost. A Deferred Sales Trust (DST) can rescue you from your failed 1031 exchange. This legal, safe and trusted tax strategy allows the funds held by your qualified intermediary to revert to your DST rather than to you personally. You therefore do not take constructive possession of them, which triggers a taxable event for which you must pay capital gains taxes.
Keep in mind that there are hundreds of 1031 Exchange Accommodators in the US and many of them have still not heard of or taken the time to do their own vetting of the Deferred Sales Trust as a means to successfully convert your 1031 Exchange into a Section 453 Deferred Sales Trust. This means your safest course of action when testing the waters of a 1031 Exchange is to select a 1031 Exchange Accomodator who has already vetted the strategy and has successfully accommodated exchange clients where needed or desired. The alternative is to have our DST Team help your accommodator in the education about the legal and approved tax citations confirming for them their ability to cooperate in your 453 DST conversion, if needed.
To find out exactly how the DST can rescue you from your particular failed 1030 exchange, contact Reef Point today. We’ll be happy to fully explain how the DST can give you many benefits in addition to a 1031 rescue and capital gains tax deferral.