The Commercial Real Estate Alpha Site

Can I sell my baseball card collection and roll it into a Flex space warehouse?

Like-Kind Exchange

Under section 1031 of the Internal Revenue Code, the owner of real property can sell that property and then reinvest the proceeds in a “like-kind” property, and defer paying any capital gains taxes. To qualify as “like-kind,” the exchange must be done according to the rules in the tax code; it doesn’t require replacing an apartment building with an apartment building, etc.

Rules for Qualification 

• The investment must be held for investment or business purposes.
• Proceeds from the sale must be passed through the hands of a qualified intermediary and must not be received directly by the investor or they will become taxable.
• All proceeds must be reinvested; any cash proceeds retained will be taxable.
• The replacement property must involve an equal or greater level of debt than the relinquished property (if not, the investor will have to either pay taxes on the difference or put in additional cash funds to offset the lower level of debt in the replacement property).
• All timelines must be met (property identification within 45 days; closing within 180 days from the closing date on the relinquished property).

Additional Notes

Qualified foreign investors may also participate in the 1031 tax exchange and are subject to the same rules of qualification.

An investor can’t defer capital gains taxes on a warehouse by purchasing a family home in which the investor intends to live.

Investors can exchange property that’s residential, commercial, industrial, or even leased property if the lease is for 30 years or more and includes ownership interest. Investors can exchange into vacant land, hotels, motels, etc., provided the exchange meets certain IRS rules.

Qualified Intermediary

An investor must use a qualified intermediary (QI) to conduct the exchange. This intermediary must be a disinterested person. Investors can’t do the exchange for themselves, and if they’ve worked with the investor in the past two years, neither can the investor’s attorney, CPA, or you—the real estate licensee. Any disinterested person qualifies as a QI.

The QI will coordinate the exchange between the parties and their attorneys or agents, coordinate documents and money transfer through escrow, and submit a 1099 to the taxpayer and the IRS for any proceeds paid.

Deadlines and Disclosure

The investor has only 45 days from the day of closing on one property to identify and commit in writing to the next property. The investor has 180 days from the date of sale of Property #1 to close on Property #2. These are firm dates, and there is only one way to extend those dates: the U.S. president has to declare a natural disaster area that affects the properties or parties involved.   

This time frame can get hairy if you’re in the middle of negotiations and the clock is ticking—your investor client has a lot more to lose than the seller of Property #2 at this point, so keep these deadlines in mind and identify early, negotiate expediently, and sew up the deal before you run into trouble.

The 1031 must be disclosed to the buyer. At the time of the sale and at the time of the purchase, you have to tell the parties to the transactions that you’re doing a like-kind exchange. 

If your client changes her mind about the property in the middle of the exchange, her tax deferral may be in jeopardy due to the deadlines involved. If the change of heart occurs during the 45-day identification period—and by the way, the 45 days includes Saturdays, Sundays, and holidays; this is 45 calendar days, period—and your client hasn’t yet closed on the sale of the property being exchanged, ask for an extension from the other party. Hopefully, though, you’ve identified a back-up property. If so, extricate yourself from the first one and quickly get the other in writing within that 45-day window. This formal identification has to be made with the QI through fax, mail, or courier. The investor has to do this in writing with the QI during that 45-calendar-day identification period. Once the 45 days is up, that’s it. Revoking and submitting a new property for exchange will not reset the deadline. In case you get a slippery QI who suggests changing or back-dating the paperwork, fire him on the spot. This is criminal income tax fraud.

Let’s say you fail to identify a property in 45 days, or the deal falls apart and you can’t put another one together within that 45 days. What happens? It’s not the end of the world, but it is the end of your investor’s chance to do a 1031 for that deal. Game over, capital gains tax must be paid.

The 180 days is also firm unless the deadline becomes shorter! The rule is that investors have to complete the 1031 exchange by the earlier of either midnight of the 180th calendar day following the close of Property #1 or the due date of the client’s federal income tax return for the tax year in which the relinquished property was sold, including any extensions they’re able to get. This only becomes a problem if Property #1 is sold between October 17 and December 31 of any given tax year, because that would mean that the 180th calendar day would fall after April 15, tax day.  

Three Rules of Identification

There are three more rules you should be aware of, and they have to do with identification of the replacement property. These are the 200% rule, the 95% rule, and the three-property rule.

First, let’s talk about the 200% rule. Your client could decide to exchange into more than one property. That’s perfectly permissible. Remember that the debt load has to be equal or more than the current debt load. There’s also a cap, in that, while your client can identify multiple properties to exchange into, the combined fair market value of the properties can’t be more than 200% of the value of the relinquished property. So if your client has a property worth $100,000, and can find 18 properties to exchange into, that’s fine, as long as those properties’ total value isn’t over $200,000. 

Then there’s the 95% rule, which says that your client can identify multiple properties with no regard to their value if the exchange they’re moving into has a total value of at least 95% of the value of the property they’re selling. So if your client has a property worth $1 million and identifies six properties with a total value of $950,000 or more, it works.

Because both of these rules can be a bit confusing, most people go by the three-property rule. The three-property rule says that the investor can identify up to three replacement properties and in this situation, fair market value doesn’t matter, provided the properties meet the debt load requirement we’ve already discussed.

• 200% Rule: Multiple properties are okay but may not exceed 200% of value of relinquished property.
• 95% Rule: Multiple properties are okay, as long as they total at least 95% of the value of the relinquished property.
• Three-Property Rule: Up to three properties are okay with no fair market value restriction.

For simplicity’s sake, you can think of these as just two rules. As long as investors meet the debt requirement, they may exchange up to three properties at any value. If more than three are exchanged, they have to have a value of 95 to 200% of the relinquished property.

Reverse Exchanges

If your clients find and close on an investment property and then decide to sell another property, they can do a tax deferral “backward.” This is called a reverse exchange. The investor must still meet the 45- and 180-day deadlines, however. No extension is possible.