In the last podcast, Seth mentioned doing a 1031 exchange in the land business? Would love to know how to do this?
@trenya are you thinking of exchanging land for land, or land for a different type of real estate?
I donât fancy myself a 1031 expert, but I did meet one guy who seemed to know A LOT about the subject at REWBCON earlier this year. You could try reaching out to him to get your questions answered.
His name is Scott Saunders and his website is at https://apiexchange.com/
@trenya In general one can exchange like kind property, held for investment or production of income and defer paying taxes on the gain. Being the IRS requires reporting, there are lots of rules and guidelines and hoops to jump through. Some are general and a little mushy on the interpretation. Usually considered best to have held the property you are selling for at least a year or two. Required to identify the property you are buying in a delayed exchange within 45 days of closing your sale, and to close the sale of the property you are buying within 180 days. Those are exact days, not six weeks and six months. Miss one by one day, you are screwed.
Your sale proceeds will go to an intermediary, also known as an accommodator, that will hold them until you are ready to close on your purchase. If you take them or touch them, your exchange is dead and the gain is fully taxable. Think of it like an IRA custodian.
Like kind means trading investment real estate for investment real estate. You can sell land and trade into a rental house or sell an apartment building and trade into a subdivision. Investment real estate for investment real estate is like kind.
Sometimes it is best to control the property you identify up front with an option or a lease option to increase the likelihood you can find a suitable property to close on within the allotted time frame.
If your exchange does not close, your sale gain is fully taxable. Ouch.
Any cash taken out of an exchange is treated as taxable gain income. To be tax free the property you buy has to be the same or higher value than the property you sell and the financing has to be the same amount or a greater amount on the new property. If not, the difference is considered cash out, called boot, and it is fully taxable in the year of the sale. To take cash out you should refinance before or after the exchange. A year before or after is good, two years is better, even longer is best. Plan your moves.
An exchange is especially helpful when selling property that is greatly appreciated with a large gain or highly depreciated. Accumulated depreciation comes back, is recaptured, at ordinary income rates that could be 10% or 15% or more higher than capital gains rates.
With the exchange you avoid tax on the gain and get to keep all that equity invested and growing. Paying large tax bills takes all that money out of the investment. That part dies and no longer grows. Leaves you with fewer acres planted to provide a later harvest.
First American Title has a Section 1031 exchange intermediary company that has lots of good information available. Look them up. Good luck in your exchange.
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@sean-markey Wow! Thanks for those nuggets of information!
No problem. It is a good way to keep ALL your dough invested and paying you rent!
@sean-markey said in 1031 Exchange in the land business:
Required to identify the property you are buying in a delayed exchange within 45 days of closing your sale, and to close the sale of the property you are buying within 180 days. Those are exact days, not six weeks and six months. Miss one by one day, you are screwed.
Your sale proceeds will go to an intermediary, also known as an accommodator, that will hold them until you are ready to close on your purchase. If you take them or touch them, your exchange is dead and the gain is fully taxable. Think of it like an IRA custodian.
Such great info and of course more questions as a result:
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Do most title companies have intermediariesâor just big ones like First American Title?
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You mention itâs best to hold the land for one or two years, but is it still possible if we only hold the land for a few months?
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It seems the greatest hurdle is solidifying the new property within the 45 days (and closing within 180 days seems less worrisome). IF the timeline doesnât work out and you miss the cut offs, you mention being screwed with the whole amount being taxed fullyâisnât that the same as not doing the 1031? So same scenario as if we didnât try for it. Or is it somehow a greater penalty? Also if the property is less expensive, being taxed on the difference would also be better than the full amount. Risk seems like a no brainer.
Good questions -
There are many accommodators, not only big title companies. When there are large amounts of dollars available to be held and to get paid for it, many are interested. Beware of smaller private exchange accommodators. Look for a pristine reputation. Most are very good to excellent but a few have been crooks, stolen the money and left the exchanger without his sale proceeds and without the funds to pay the tax liability on the blown exchange - worst of both worlds so to speak.
The code does not specify a holding period. It mentions âuse for business or investmentâ. That does not include retail inventory. It is based on intent. If you go in to it intending to hold the property for investment then later change your mind, that has been accepted. There is case law where just a few months holding period was sufficient with a documented change of intent. Google the issue for lots of interesting tax law reading. That could be a change in the market, a change in business strategy or a change in your personal life situation. It should be based upon something sensible and logical and defensible. A longer holding period just supports your investment intent.
The tax effect of a blown exchange is I guess about the same and if one did not set up an exchange. There is some cost to setting up the exchange and if you intent to defer the gain and do not, you may miss a deposit deadline and incur some tax penalty and interest charges. I prefer to make a solid plan and make it work. You may consider using an option to control a target property before you even close on the sale leg of the exchange.
Correct that a partial exchange on a buydown is better than taking the hit for the full tax liability. Half a lunch is better than no lunch.
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Further to earlier comments. Web article sent by my FATCO exchange rep. More eloquent and clear writing than mine. Explains the basic concepts, rules and common pitfalls.
Five Ways to Ruin Your 1031 Exchange
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Some people are surprised at how many grey areas there are when structuring an exchange. There are some important rules that are generally clear; however, itâs important to pay attention because a simple mistake can ruin your entire exchange. Hereâs what not to do:
- Miss the 45-Day Identification Deadline
Once you close on your relinquished property, you have 45 days to identify in writing what you intend to acquire in the exchange. The only exception to this rule is that no identification is needed if you acquire the replacement property before the end of the 45-day period.
The rule also states that property that is not identified will not be âlike-kindâ to the relinquished property; therefore, you are only able to acquire replacement property that you have identified. If you do not identify or acquire the replacement property within the 45 days, you are not able to complete a valid exchange.
- Fail to Clearly Identify What You Are Going to Buy
In addition to making sure you identify replacement property within 45 days, you must identify it unambiguously. That generally means using a legal description or street address. If you are going to acquire a tenancy-in-common interest in the property, you should try to identify as closely as possible the percentage interest you will be acquiring. If you are acquiring a condominium, you need to also identify the unit number. Moreover, if improvements will be constructed on the replacement property between the date you identify it and the date you acquire it, you must identify what will be constructed on the property in addition to the legal description or address. You should provide as much detail about the improvements as is âpracticable.â
- Miss the 180-Day Deadline
Another crucial deadline is the 180-day exchange period. This rule states that you must acquire (close, or transfer) all replacement property(ies) by the 180th day. If the relinquished property closes escrow towards end of a tax year such that the 180th day falls after your tax filing date of the following year, youâll need to complete your 1031 Exchange before filing your income tax return, or request an extension. The Exchange timelines begin from the date the relinquished property closes escrow, and includes weekends and holidays. Should your 180th day fall on Saturday or Sunday, the last day to acquire the replacement property(ies) will fall on the previous business day. For purposes of both the 45-day and 180-day periods, if there are two or more relinquished properties in the same exchange, the deadlines are measured from the date of the first relinquished property closing.
- Close Before You Sign Exchange Documents
Initially, exchanges could only be accomplished by two people simultaneously swapping properties. Eventually, the deferred exchange rules permitted taxpayers to use a qualified intermediary, such as First American Exchange Company, to act as an accommodator. The rules convert what looks like a sale followed by a purchase into an exchange. A basic requirement of this process is that an Exchange Agreement and Assignment Agreement must be signed by the taxpayer before the date the relinquished property closes escrow. In addition, the taxpayer must notify the buyer the contract has been assigned to a qualified Intermediary. The qualified intermediary will also be assigned into the replacement property contract, thus allowing the funds to be transferred within the âsafe harborsâ.
- Take Possession of Your Exchange Funds
Another important rule for a successful 1031 Exchange states that the taxpayer cannot have possession, or control, of the proceeds from the sale of the relinquished property. Upon closing of the relinquished property, the escrow holder will transfer the funds directly to First American Exchange Company, thus keeping the taxpayer from having receipt of the funds. One of the reasons it is so important to choose an intermediary wisely is that they hold the proceeds of your sale until you are ready to acquire the replacement property. First American holds these funds only in FDIC-insured bank accounts, and we never invest them in securities. Furthermore, funds are placed in a segregated account specific to the taxpayerâs tax ID number.
Paying attention to these important issues will eliminate most reasons that exchanges can fail. When you are ready to open an exchange or have questions, call us at First American Exchange.
Have additional questions for us? Ask your question here. Want to get started with your exchange? Start yours here.
Stay up to date on the 1031 exchange industry, sign up for updates here.
@sean-markey I had the opportunity to chat with Scott Saunders @ REWBCON as well. Really interesting conversation. One of my concerns was always needing to have a Title company be the custodian for your funds while going through 1031 exchange process. Interesting take away was that all you really need is a Trust account. Doesnât have to be held by a Title Co. That was news to me.
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I am not sure what it takes to qualify as an exchange accommodator. Title Company is used loosely. Here in the Golden State, at least in the upper part, we have escrow companies that handle transactions and conduct closings, usually without lawyers. They buy title insurance from a title insurance company. Often they are affiliated, sometimes not at all and sometimes independent but âcaptiveâ in that they use only one insurer. An exchange accommodator is a completely separate entity. All three parties - escrow, insurer and accommodator may be separate companies related under common ownership, like First American Escrow, FATCO Title Insurance and FATCO Exchange. Or all three may be unrelated.
I would not go so far as to say âall you need is a trust accountâ. Most lawyers have trust accounts but I do not believe all or most or even more than maybe a few can conduct an exchange. I run all my deals through a Grantor Trust with a checking account. I am certainly not qualified to conduct an exchange. Buyer beware on that one. Check with the IRS re qualification to be an intermediary before you jump into the exchange business. I do not know but suspect you will find some rigid guidelines and hurdles to overcome.
@sean-markey if I recall correctly this needs to be a Real Estate Trust account, which I believe can only opened by Brokers, Title Coâs, and RE Lawyers.