By Mark J. Woodward, Florida Real Estate Attorney
Over the years, Woodward, Pires & Lombardo, P.A. has worked with many clients who have sold property (the “Relinquished Property”), then placed the funds with a Qualified Intermediary to purchase like kind investment property (the “Replacement Property”), a 1031 Exchange.
Why a 1031 Exchange?
1031 Tax Free Exchanges are permitted under IRS regulations. The reason for doing a 1031 is best explained with an example: An investment property which may be held by an individual or the individual and his spouse, or a corporation, limited liability company or partnership likely has increased in value over a number of years, and this client wishes to sell the property, and realize the large gain. Property like this is likely to have been purchased many years ago for a low purchase price. The original purchase price of property is known as the client’s “Basis” in the property, and the Basis in a particular piece of property increases with improvements which were made to the property over the years, and decreases with the amount of depreciation that an client takes on their tax returns every year. The net result of this is the Basis is likely quite low, and the value of the sale price quite high resulting in a very large amount of taxable gain. If a 1031 Exchange is not utilized upon the sale of the property when a tax return is filed (likely capital gains rate would apply), and the tax would be paid to the IRS. The client of course retains the balance of the funds less the taxes paid to reinvest in some other property. The alternative to this is the use of a 1031 Exchange.
Types of 1031 Exchanges
There are varying types of 1031 Exchanges, the simplest of which is a simultaneous swap of one property for another. Although this is a simple way to do it, it is quite unusual because at the closing of the Relinquished Property the client would have to know somebody who owns another piece of property that they are willing to exchange resulting in a direct exchange. In all the years that I have practiced law our firm actually has never been involved with a direct exchange, although simple they are very rarely done.
The second more common 1031 Exchange is that upon the sale and closing of the Relinquished Property 100% of the sales proceeds after closing costs, commissions, etc. is paid to a third-party exchange company (known as the “Qualified Intermediary”). After the closing of the Relinquished Property, the first rule is the client has 45 days to identify potential Replacement Properties. Replacement Properties need to be “like kind”, which in general means property of the same nature, character or class. For example, most real estate would be “like kind” to other real estate, and generally these properties are held for investment. There are specific rules on the number of replacement properties, which needs to be discussed with either your accountant or attorney. The second rule is that the exchange must be completed no later than 180 days from the sale/closing of the Relinquished Property. The client would negotiate to purchase one or more of the identified properties and enter into a contract, move forward to a closing at which time the contact would be assigned to the Qualified Intermediary who would provide the funds to purchase the Replacement Property. The title to the property would be in the name of the client and not the Qualified Intermediary.
Effect of a 1031 Exchange
In summary, the effect of a 1031 Exchange is that there is no tax paid on the sale of the Relinquished Property, and the Basis that existed in the Relinquished Property is transferred to the Replacement Property. In essence this means that there is substantially more cash available to purchase the Replacement Property because no tax was paid and the funds that otherwise would have been used to pay tax have now been reinvested in the Replacement Property. Clients are always advised that when the Replacement Property is eventually sold, it now has a very low Basis, and at some point, the tax will have to be paid or the client will have to continue doing 1031 Exchanges reinvesting in future properties to delay the eventual payment of the tax due on the gain.
Anyone considering a 1031 Exchange should retain the services of an accountant or a Florida real estate attorney familiar with 1031 Exchanges, due to the number of specific requirements which must be complied with, and the complexities which are unique to each individual situation. This summary is intended to briefly explain why and when 1031 deferred like kind exchanges are or should be utilized and do not explain all details involving a 1031 Exchange, which anyone considering a 1031 Exchange should be familiar with.
About the Author
Mark J. Woodward is a Florida Real Estate attorney and is the Managing Partner of the law firm of Woodward, Pires & Lombardo, P.A. in Naples and Marco Island, Florida. He is double Board Certified in Real Estate Law, as well as in Condominium and Planned Development Law by The Florida Bar. Mark has over 40 years of experience in practicing law in the State of Florida. He received his Bachelor of Science degree in Finance from the University of Florida and his Juris Doctorate from Stetson College of Law.
Mark assists clients with his extensive experience in all aspects of Condominium Development Law and has worked on hundreds of various HOA’s and condominium projects (residential, commercial and mixed) throughout Collier and Lee Counties and in the panhandle of Florida. For more information, call (239) 649-6555 or email MWoodward@wpl-legal.com.