1031 Tax Deferred Exchanges are a unique part of the current U.S. Tax Code that allows sellers of real property to sell and reinvest in replacement properties and defer the capital gains tax normally paid in connection with the sale of appreciated real property. Recent legislative changes, including the 2017 Tax Cut and Jobs Act (H.R. 1) retained the ability for landowners to exchange real property, while personal property exchanges were no longer available after December 31, 2017.
1031 Tax Deferred Exchanges take place in two general formats, with slight variations within the formats. The first, and by far the most common format, is what is termed a “Forward 1031 Exchange”, or also known as a “Deferred Exchange”. With a Forward Exchange, the owner of the real estate presently owned, (called the Exchangor) sells that property, called the “Relinquished Property”, and then acquires the “Replacement Property” within the statutory timeframe as provided in the tax code. A second format is a “Reverse 1031 Tax Deferred Exchange” in which the “Replacement Property” is acquired before the “Relinquished Property” is sold. Reverse Exchanges are more complicated and expenses paid by the Exchangor can be considerably more than that charged for a Forward 1031 Exchange.
All Tax Deferred Exchanges involve multiple parties, with the seller of the “Relinquished Property” and buyer of the “Replacement Property” referred to as the “Exchangor”. The independent party that coordinates the exchange, makes arrangements for the exchange documentation, holds the proceeds of the relinquished property transaction, and remits the exchange funds to the closing agent for the replacement property purchase is called the “Qualified Intermediary”. First Harvest Land Exchange, LLC serves our clients by serving as the Qualified Intermediary, or Q.I. for Exchange transactions. The other parties to the Exchange process include the buyer of the Exchangor’s Relinquished Property and the seller of the Exchangor’s Replacement Property.
If an Exchangor utilizes a Reverse 1031 Exchange, the “Exchange Accommodation Titleholder”, or E.A.T., the party temporarily holding title to the Exchangor’s real property also becomes part of the transaction. In a Forward 1031 Exchange, the real property is transferred direct between the Exchangor, the replacement property seller, and the relinquished property buyer and no E.A.T. services are necessary.
Two statutory timeframes involved in Exchanges are called the “45 Day Identification Period” and the “180 Day Exchange Period”. The 45 Day Identification begins on the day following the closing on the sale of the Relinquished Property, and extends for exactly 45 Days. During the Identification Period, at a minimum, the Exchangor may identify in writing to the Qualified Intermediary up to three separate descriptions of proposed replacement properties. These properties do not have to be under contract, the Exchangor does not even have had to initiate discussions with the current owner with regards to acquiring the property as part of his exchange. The individual identified properties may be changed as conditions change during the 45 Day Identification period, but at the end of the 45 Day Identification Period, the properties identified are locked, and the Exchangor may not make any changes to the identified properties once the Identification Period closes.
The other set of dates, which run concurrently with the Identification Period, is the “Exchange Period” which runs for 180 days also beginning on the day after the closing on the sale of the Relinquished Property. Both the “45 Day Identification Period” and the “180 Day Exchange Period” are fixed, and the Exchangor may not extend either of these dates. In cases where an Exchangor opens up a 1031 Tax Deferred Exchange on or after October 15 of a given calendar year, the 180 day Exchange Period is shortened, and the Exchangor must sell the Relinquished Property, acquire the Replacement Property, and wrap up the Exchange by April 15th, the tax filing date for the year the Exchange originates in, unless the tax return filing date is extended. Example: An Exchangor sells a “Relinquished Property” on October 20, 2021. His 45 Day Identification Period begins on October 21, and concludes on December 4, 2022. The Exchange Period, which also begins on October 21, concludes on April 15, 2022, the final date the Exchange can file his 2021 tax return without penalty. In order to take advantage of the entire 180 Day Exchange Period, the Exchangor can extend the filing of his income tax return, past April 15. When calculating the 45 and 180 Day dates, if the deadline occurs on a weekend or holiday, the deadline rolls backwards to the Friday (or last business day) right before the weekend or holiday in order to allow the Exchangor to properly Identify his Replacement Property, and or schedule a closing on the acquisition of his Replacement Property.
Another type of Exchange is called an “Improvement Exchange” or “Build to Suit Exchange”. In this type of transaction, the Exchangor uses Exchange funds tax-deferred to make improvements to the Replacement Property acquired during the 180 Day Exchange Period. With this type of Exchange and similar to a Reverse 1031 Exchange, the Exchange Accommodation Titleholder (E.A.T.) is involved. This party is responsible to temporarily hold title to the Replacement Property while the improvements are being made, and upon completion of the improvement process, the title is transferred to the Exchangor. During a Build to Suit Exchange, the Exchangor stays involved and may line up the contractor, make arrangements to acquire the materials, etc., but the E.A.T. is the responsible party to ensure the improvements are made and works with the Qualified Intermediary to pay for the improvements and labor using Exchange funds. During a “Build To Suit” Exchange, the Exchangor may not actually hold the funds, or personally make the improvements as this is construed by the Internal Revenue Service as “Constructive Receipt of Proceeds”, a disqualifying event in any type of Exchange. “Build to Suit” Exchanges tend to be more expensive than a “Forward” or “Deferred” Exchange, and entail several additional steps to protect the integrity of the transaction.
The tax benefits of 1031 Tax Deferred Exchanges derives from the ability of the Exchangor to defer, or push the capital gains tax liability to some future point in time. The capital gains tax is based on the amount of realized gain that is calculated at the time of the sale of the Relinquished Property if there was no Exchange. “Realized Gain” is defined as the “Increase in the taxpayer’s economic standing as derived from the Exchange process”. Stated another way, if the Exchangor bought a farm for $1,000,000 and sold it for $2,000,000 (with no other cost basis adjustments), the Realized Gain going into a 1031 Exchange would be $1,00,0,000. If the Exchange is successful the original $1,000,000 cost basis is rolled to the Replacement Property, and the Exchangor defers the tax liability to some future point in time.
All 1031 Tax Deferred Exchanges require a documentation paper trail to show that the Exchangor entered into an Exchange. Serving as the Qualified Intermediary, unless the Exchangor requests his own legal counsel to prepare the Exchange documentation, First Harvest Land Exchange, LLC can prepare the paperwork for the Exchange on behalf of the Exchangor. Clients interested in 1031 Tax Deferred Exchanges are advised to involve their tax preparer and attorney in the process.
The IRS rules for Exchanges include requirements as to the length of time the relinquished and replacement property are held before a subsequent transaction involving the property takes place. In addition, in order to successfully complete a 1031 Tax Deferred Exchange, the property exchanged, as well as the property acquired must be held for productive use in a trade or business, or for investment purposes. Exchanges between related parties may also be disqualified if the IRS determines the transaction was designed to lessen or eliminate income taxes if there was no Exchange. A 1031 Tax Deferred Exchange involving a personal or weekend dwelling is not an eligible property for tax-deferral treatment.
1031 Tax Deferred Exchanges are sometimes called “Like-Kind Exchanges” for the simple reason that “Like-Kind” refers to the fact that real property is being exchanged for real property. The Exchangor cannot sell a farm and buy construction equipment for example, but the same Exchangor could sell a farm and buy an apartment complex for investment purposes.
Brief BIO on Joe
Joe Dierker, C.T.F.A. serves First Harvest Land Exchange, LLC as its’ Owner/Manager. He has more than 20 years’ experience coordinating 1031 Tax Deferred Exchanges, especially for commercial banks. He received a Bachelor in AgriBusiness Degree from Illinois State University; a Master’s in Business Administration from Quincy University and is an Accredited Farm Manager and Certified Crop Advisor, and a licensed Real Estate Broker in Illinois. He is also a graduate of the University of Wisconsin Graduate School of Banking.
Dierker can be reached at 217.248.1214 (cell) or at joe@fhlellc.biz