PRO AND CONS OF THE 1031 EXCHANGE

October 1, 2007


Pros and Cons of the 1031 Exchange

By Neil A. OHara


How would you like to exchange one appreciated asset for another without having to pay capital gains tax? In the world of stocks and bonds, that only happens within qualified accounts like IRAs or 401(k)s. But it's a different story if your clients own business-related or investment real estate. Section 1031 of the Internal Revenue Code permits owners to exchange one piece of real property for another of "like kind"—a term broad enough to encompass anything from raw land to office buildings or mineral properties—without paying capital gains tax as long as they reinvest the entire sale proceeds in the new property.

A few restrictions apply, of course. The owner has 45 days from the closing of the sale to identify one or more replacement properties, and must close the new purchases within 180 days of the original sale. The owner can't touch the sale proceeds, either. The money has to go into escrow at a "qualified intermediary"—typically a bank or title insurer—pending reinvestment. A 1031 exchange works only if the real estate is held directly or as a tenancy-in-common (TIC), an undivided fractional interest in a property. Interests in a partnership or real estate investment trust (REIT) don't qualify. Nor does property used by the owner as a residence, which rules out vacation homes unless they are rented out.

In a hot real estate market, owners must take care not to flip properties in 1031 transactions. "If you trade too quickly the IRS may say you didn't buy the property for investment, but for the purpose of resale," says Steve Mastbaum, a tax expert and shareholder in law firm Greenberg Traurig's New York office. The consequences are ugly. The IRS not only disallows the tax deferral but also treats the profit as ordinary income rather than as a capital gain.

For people willing to accept the constraints, 1031 exchanges can lay the foundation for significant wealth. Stephen Wayner, first vice president at Bayview Financial Exchange Services in Coral Gables, Fla., has a client who put down $300 on each of two $3,000 lots he bought 33 years ago. Four exchanges later his net worth is $4.3 million—and he never put in another penny. Wayner says clients often use the tax-free proceeds of one sale for the down payment on a replacement, which allows them to buy more property and leverage the return.

IRS figures show a dramatic increase in 1031 exchanges in recent years. In 2004, the most recent year for which data is available, 219,675 individuals reported transactions, more than double the number in 2000. For partnerships, the transaction volume almost quadrupled to 47,928. Wayner says a whole new industry has sprouted since a 2002 IRS ruling permitted up to 35 people to join together as TICs to buy a piece of property and still qualify for 1031.

Patricia DelRosso, president of Inland Real Estate Exchange Corp. in Chicago, expects the growth to continue, as baby boomers who have spent their lives managing small real estate portfolios approach retirement. "They no longer want to deal with the three T's: tenants, toilets and trash," she says. "We can meet that need by offering a 1031 TIC exchange." While the owner still participates in decisions to sell, rehab or refinance the property, a management company handles collections and regular maintenance. DelRosso says a TIC exchange provides an opportunity to diversify, too. The owner can trade a portfolio of single-family rental homes for fractional interests in up to three replacement properties—a shopping center, an office building and a multifamily apartment complex, for example. Although advisors don't get paid directly from 1031 exchanges, suggesting a way for a client to defer tax builds credibility. And as William Fleming of PricewaterhouseCoopers' private company services practice notes: "People with these kinds of properties often have big securities portfolios."


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