5 Required Elements for a Valid 1031 Exchange Property Identification

As we’ve discussed many times before, there are numerous rules you have to abide by in order to execute a successful 1031 exchange and defer your capital gains taxes. One of the most important areas to be aware of in this realm is property identification. In this article, we are going to discuss five required elements for a valid property identification in a 1031 exchange of real estate.

1031 Exchange Property Identification

In a 1031 exchange, your replacement properties should be:

1. Clearly and specifically (unambiguously) designated

2. In writing

3. To the qualified intermediary (or other person involved in the exchange who is not disqualified)

4. Using the postal address(es) of the property (including House/Building Number, Street Name, City, County, State, and Zip Code), and/or the complete legal description (including the Metes and Bounds description, or Lot and Block or Other Subdivisions, or Condominium Unit Number and Name) and/or the County Tax Assessor's Parcel Number (APN, PID or Property Tax Identification Number) or you can use the property’s distinctive name, such as “The Empire State Building”

5. Sent before Midnight of the 45th day after the closing of the sale of your relinquished property

Generally, the more specific the identification the better. The more general or less specific, the more risk that the 1031 exchange could be disallowed during a federal or state audit.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

How Exactly do Build-to-Suit Construction Exchanges Work?

In a normal real estate transaction, if John Doe sells a property worth $500,000 and purchases a new piece of land with nothing on it for $100,000, the IRS takes the position that once John Doe owns that land. His exchange is complete and any improvements that he makes on top of that land that he now already owns won't count towards his 1031 exchange.

A Work-Around

A work-around for this type of situation is a mechanism under rev proc 2037 that allows the qualified intermediary to form an LLC and buy the new land using $100,000 of John Doe's exchange funds and holds title to that dirt during the remainder of the 180 day exchange period.

During this time, improvements can be constructed on that new land and still count towards the 1031 exchange. So if you can build up quickly, you can potentially construct another $400,000 property value on top of that dirt so that you receive replacement property of equivalent or greater value. Remember, in a 1031 exchange, you want to buy property of equal or greater value so you continue your investment. You want to reinvest all of your equity, your proceeds, and to the extent that you pay off debt on the old property you want to offset that debt either with the replacement property itself or cash from your own pocket.

Constructing Improvements

A build-to-suit exchange is a great way to construct the improvements to your specifications and get new property that qualifies for 1031 exchange treatment, but you only have 180 days total so make sure you have all of your ducks in a row and ready to go before you begin the process.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

How 1031 Exchange Restrictions Would Slow Down Velocity in the Marketplace

Even before he took office, President Biden had proposed a cap on 1031 exchanges that would cap the deferral at $500,000 per year. There was a very strong pushback on that from people who do conservation easements, people in the banking sector, developers, and a whole spectrum of real estate related trade associations. The bottom line is that restricting 1031 exchanges would really hurt the economy and the expected increased revenue is a fallacy because people will simply choose not to sell their real estate if this 1031 incentive is taken away.

Incentivizing Investment

Essentially, this added tax would act as a disincentive for velocity in the real estate marketplace. It wouldn't be a very good Revenue raiser and it would have a really adverse effect on real estate values and redeployment of cash in the marketplace.

There is also a compelling argument that real estate owners, unlike owners of stocks and bonds, are paying taxes the entire time they're owning a piece of real estate, because at the state and county levels they're paying property taxes. They may also have to pay mortgage registration tax and other assessments that may be applied.

So unlike other vehicles of investment, an investor in real estate is being taxed while they're owning the property - just not by the federal government.

100 Years of 1031 Exchanges

This year marks the 100-year anniversary of the 1031 exchange. This provision has been in the tax code for a long time to facilitate the transfer of capital to those segments in the marketplace where we need infrastructure.

1031 exchanges provide private infrastructure, whether it is housing, warehouse, retail stores, etc. We need to encourage this type of private infrastructure just as much as we need public infrastructure like roads and bridges.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

Can You Gift Your 1031 Replacement Property to Someone Else?

After you have completed a 1031 exchange and have your new like-kind replacement property, you may want to give it away as a gift. This is a huge trap for the unwary, because many people think it is their property, and they should be able to do what ever they want with it.

Satisfying the 1031 Exchange Requirements

Well, if you want to satisfy the requirements of your 1031 exchange, then you should probably not do anything (including gifting) that is inconsistent with holding the new replacement property for investment or use in their trade or business.

The argument can and has been made successfully by the IRS that if you gift the property away shortly after completing a 1031 tax deferred exchange, then you did not have the requisite intent. Your immediate intention to give away property you received in an exchange could undermine your ability to prove your investment or business intent.

Treasury Regulations

Treasury Regulation 26 CFR 1.1002-1(b) and (c) indicates that the IRS can look at surrounding facts and circumstances such as post-exchange transfers of your replacement property as circumstantial evidence that you did not have the proper intent to hold for business or investment purposes.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

When is a Failed 1031 Exchange Taxed if it Crosses Over into the Following Year?

In some cases, taxpayers who engage in a 1031 exchange will get back unused 1031 proceeds in the year following the sale of their relinquished property. This could happen at the end of their 180 day exchange period because they were not able to (or decided not to) purchase all of their identified replacement properties.

For example, a person may start their exchange in August of 2021 and later receive their unused 1031 funds in January of 2022. When this happens they may wonder when they are going to be taxed on the money - in 2021, the year that the sale occurred, or in 2022, when they actually received the money.

Treasury Regulations

The Treasury Regulations for Section 1031 allow people to elect to treat a tax deferred exchange as an installment sale to the extent that the person receives cash (known as “boot”) in a subsequent tax year. This can happen if the exchanger fails to acquire some or all of their replacement properties, leaving cash boot in the hands of the qualified intermediary until the year following the sale. The cash received from the qualified intermediary at the end of the exchange period may be treated as a payment in the year it is actually received by the person for purposes of the installment sale reporting rules rather than in the year the relinquished property was sold.

On the Other Hand...

Any liens, deeds of trust, mortgages or other debts that were paid off on the sale of the relinquished property are treated as a payment in the year of the sale (when they were discharged or assumed by the buyer). Nevertheless, the tax deferral allowed by the interplay between Section 1031 and the installment reporting rules under Section 453 can produce a really nice tax advantage where gain must be recognized as the result of a wholly or partially failed exchange resulting in some unused 1031 funds going back to the seller.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved