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How to Use the 1031 Exchange

Put the IRS on your side by learning how to benefit

from the real estate tax exchange loophole.

REVIEWED BY KELLY QUIGLEY

The Tax-Free Exchange Loophole by Jack Cummings (John Wiley & Sons Inc., 2005)

A loophole written into the U.S. tax code allows you and your clients to never pay capital gains taxes on a real estate sale, as long as the profits are reinvested into a similar property. But you can’t fully enjoy all of the benefits it provides unless you know the rules—which are intimidating, to say the least. This book attempts to make the intricacies of the 1031 tax-free exchange easy to understand and use in your own real estate deals. Written in what the author calls a building-block style, the book explains all the terms you need to know and uses real-life transactions to show how the 1031 exchange and other tax loopholes work. Although it reads much like a text book—requiring a fair amount of determination on the reader’s part—it is a good first step to grasping the complex rules that can save you lots of money.

Tips From the Book:

Plan 1031 exchanges well in advance. Using 1031 exchanges should not be a last-minute thing; it should be a major strategy in your arsenal of investment tools. If you know you’re going to sell a property in which there where will be taxable gain, then review your situation before you put the property on the market. Be careful about accepting an offer if you have not found a suitable replacement property; under normal circumstances, a 1031 exchange requires you to identify a replacement property within 45 days of closing.

Work with up-to-date experts. Because IRS codes are always in a state of flux, anything you learn today about 1031 exchanges can change tomorrow. To make sure you are using the laws properly, you need to make sure that the accountant and lawyer you use for your exchange deals are fully up to date. So-called experts who deal with just one or two exchanges a year may not have the experience to earn your trust.

Tap into a local exchange club. There are exchange groups scattered around the country that you can join to learn more about how to use 1031 exchanges. The clubs are made up largely of real estate practitioners and brokers and can be a great resource for the finer points of making exchanges. You also can use the clubs to find tax-free exchange experts in your area who can help you with your deals. Search the Web to find a club in your area

Can The Beneficial Interest In A Land Trust Be The Subject Matter Of A §1031 Exchange?

As many real estate investors know, Section 1031(a)(1) of the Internal Revenue Service Code provides that there is no gain or loss recognized when there is an exchange of property held for investment [if such property is exchanged solely for property of like kind that is to be held for investment]. However, section 1031(a)(2)(E) provides that section 1031(a)(1) does not apply to any exchange of certificates of trust or beneficial interests. In order to determine what constitutes a 'trust', the Procedure and Administration Regulations provides that it is an arrangement created by a will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in probate courts (beneficiaries do not share in the discharge of this responsibility).

Several states, including Illinois, Alabama, California, Florida, Georgia, Hawaii, Indiana, North Dakota, and Virginia, have laws that statutorily or judicially sanction arrangements that are similar to the Illinois Land Trust. Unlike traditional trusts, the beneficial interest in an Illinois Land Trust really directs the control and management of the real property. In fact, the beneficiary even claims the taxes on the income generated from the trust, rather than the trust paying the taxes.

The Internal Revenue Service has held that where an interest in a arrangement similar to an Illinois Land Trust is created under the laws of any state, pursuant to which:

1. the trustee has legal title to real property;

2. the beneficiary (equitable owner) has the exclusive right to direct or control the trustee in matters relating to the title to the property; and

3. the beneficiary has the exclusive control of the management, earnings and proceeds, and the obligation to pay any taxes and liabilities relating to the property,

it is subject to being exchanged under §1031 for a fee interest in other real property. In other words, you can exchange the beneficial interest in a Land Trust that owns Property A for a fee simple interest in Property B, and provided the requirements of section 1031 are otherwise satisfied, this exchange will qualify for non-recognition of gain or loss under section 1031.

When considering implementing a Land Trust in a state that has not judicially or statutorily recognized such a trust, you should also consider creating a back-up level of asset protection

Tax Deferred Real Estate Exchanges - Section 1031

To begin with it is imperative that you follow the 1031 Exchange rules outlined by the IRS exactly. Some important guidelines to follow are listed below:

Identify the Alternate Property for your 1031 Exchange
If you haven't already done so, identify replacement property. You have 45 days from closing on the relinquished real estate, the property you are selling, to identify up to three replacements. Your list must be sent to the intermediary in writing. The IRS is not flexible on this time period.

Pay Attention to the Real Estate Contract Wording
Your contract to buy or acquire the property must contain language that shows an intent to perform a 1031 exchange. A real estate attorney or your qualified intermediary can help you with the wording. According to the IRS, "A qualified intermediary is a person who enters into a written exchange agreement with you to acquire and transfer the property you give up and to acquire the replacement property and transfer it to you. This agreement must expressly limit your rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the qualified intermediary."

You (or your agent) should send the intermediary a copy of all the real estate documentation inluding the sales contract and any other information they require.

Closing Dates Are Critical
The closing date for the new property must take place within 180 days of the closing on the relinquished property.

Keep In Touch with All the Parties Involved
You or your agent should stay in contact with the intermediary, keeping them advised regarding closing dates. They will be responsible for most of the paperwork associated with the exchange, and may have specific lead-time or other requirements for each step of the process.

A Partial 1031 Exchange
If you plan to use only part of your proceeds for a 1031 exchange, consult with the intermediary to make sure your sales contract is worded correctly. You might also want to talk with an accountant to find out how the cash sale will impact your taxes.

Find and Research Your 1031 Exchange Intermediaries
Be sure to compare the services, costs, and references of several qualified intermediaries before selecting one to handle your 1031 exchange. The work they do is essential to the success of the exchange--make sure it's a trustworthy and experienced company or individual.
Ask as many questions as necessary to make you feel comfortable with the process. A tax deferred exchange is not difficult to do, but there are specific steps you must follow to make sure every aspect of the sale and purchase complies with US tax laws.

IRS Site: http://www.irs.gov/businesses/small/industries/article/0,,id=98491,00.html