Section 1031 states "No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment" (Title 26, Subtitle A, Chapter 1, Subchapter O, Part III, Sec. 1031). Basically, this means certain investments are eligible for exchange treatment, whereby the gain that would be recognized on a sale can be transferred to a new investment of like-kind without payment of tax on the sale.
For example, if you construct a self- storage facility for a total cost of $2 million, hold it for 10 years so its basis is $1 million, and it then sells for $3 million, you would have a taxable gain of $2 million. Section 1031 provides a vehicle for avoiding taxes on this gain until a later date by allowing you, the taxpayer, to purchase another investment with the proceeds. The new investment's basis, in our example, would be deemed to be $1 million, which preserves any gain until the sale of the new investment.
Which investments are permissible as exhange vehicles? Can you sell a self-storage facility and purchase a ranch house in Colorado? Not unless the ranch house is an investment and leased out to guests to produce income. Can you purchase stocks and bonds? No. Stocks and bonds are specifically excluded from Section 1031. Can you sell your interest in a partnership that owns a facility and exchange it for an interest in a partnership that owns an apartment building? No, because exchanges of partnership interests are also specifically excluded from Section 1031. Essentially, though, exchanges involving any type of real property assets, whether land, apartments, office buildings, shopping centers or storage facilities, are permitted if they are held for investment and are not inventory.
Not surprisingly, it is difficult to transact a true exchange where, on the date of closing, the taxpayer sells his facility in exchange for a real property investment. For a true exchange, the purchaser would need to buy a new facility for the selling taxpayer and instead of paying a purchase price, pay with the new investment. These transactions can be accomplished, but only with great effort. After losing a series of tax cases, the Internal Revenue Service was forced to recognize the validity of a delayed, or deferred, exchange, whereby a taxpayer sells his property, puts the sale proceeds in some sort of escrow account, and then uses those proceeds to purchase the new investment.
Thankfully, these rules are now codified by the Treasury Regulations and provide for a 45-day window following the sale to select the new property with a closing within 180 days from the first. The rules are complicated but have been streamlined by professional services--either title companies, banks or other qualified intermediaries--so the process is now rather smooth and not very costly. It is important to remember that the selling taxpayer may not have use of the sales proceeds until expiration of the 180-day period.
If deferred exchanges are permissible, what about purchasing the new property before the old property is sold? Close reading of Section 1031 does not reveal any indication these so-called "reverse exchanges" are prohibited, and clever real estate developers have been engaging them for some time. The trick is to figure out a way to finance the acquisition and have use of the property prior to the time of the sale of the old, since the developer is not permitted to own title to the new property until after the sale of the old one.
One way it has been done is to have an unrelated third party, an "accommodation party," purchase the new property. An affiliate of the taxpayer can lease from the accommodation party and have full use and benefit of the new property, including the right to construct improvements. Also, a financial institution can loan funds for acquisition, development and construction to the accommodation party. The loan can be nonrecourse to the accommodation party but guaranteed by the principal equity owners of the taxpayer. This is important because the Treasury Regulations provide that the new investment must be the same amount or more than the old, or tax must be paid.
Using the previous example, the selling taxpayer will sell his self-storage facility for $3 million and must purchase an asset for at least $3 million. If he intends to purchase raw land worth $1 million to construct a new facility, he will need to spend at least $2 million on the new improvements to comply with Section 1031. In a reverse exchange, the best way to do this is with borrowed funds. (In a deferred exchange, he would use the sales proceeds to finance construction.) The rules of reverse exchanges, like those of deferred exchanges, have recently been codified and provide for similar time periods.
The 1031 like-kind exchanges are complicated, requiring the advice of experienced professionals. At the same time, they are so well formalized that prudent landowners should take advantage of the tax benefits the exchanges provide. This article is intended as a very brief primer on 1031 exchanges to increase your awareness of their applicability. As with any tax planning, you should consult with your professional advisor prior to engaging in a 1031 exchange. Its rules and regulations are specific and complex, even though the actual exchange can be accomplished with little hassle.
David A. Weissmann is a partner in the law firm of Weissmann & Zucker PC in Atlanta, which specializes in commercial property, business and finance. Mr. Weissmann is a frequent lecturer and writer of self-storage topics. For more information, call 404.364.4620; e-mail [email protected].