“Gotcha” Rules in 1031 Exchanges

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What many people fail to realize is that a 1031 like-kind exchange is not a tax avoidance, it’s a tax deferral. It’s commonly referred to as a “tax-free” exchange when it’s really a tax-deferred exchange. Eventually, you’ll wind up paying capital gains taxes. It’s only a question of when. And if you’re not careful, sooner than you think. Since the federal government provided the 1031 exchange as a mechanism for tax deferral, there are many rules to follow to take advantage of that mechanism. Most are intuitive, but some are “gotcha” rules that can trip up the exchange and require the taxpayer to pay capital gains taxes within the year of the sale of the property.

Which do you think are the “gotcha” rules? Most of the rules are pretty straightforward and not at all tricky for most practitioners. I think most practitioners understand that the relinquished and replacement properties must be income-producing properties (or at least capable of generating income), and that they must be of “like-kind,” meaning you can’t exchange widgets for shipping containers, but you can exchange any type of income-producing real property for any other type of income-producing real property (i.e., a shopping center for an office building or an apartment building for an industrial building). I would assume that everyone knows the 45-calendar day identification period and the 180-calendar day exchange period are strict deadlines that are not tolled by weekends, holidays, and (usually) natural disasters and other calamitous events.
So what trips up many people? I think the answer is boot. I think people understand that you can’t take any cash or cash equivalents at the closing. But they assume that it means that they can’t walk away with a check or a promissory note. What people don’t understand is that there are other ways to receive boot. For example, which closing costs can be paid for using exchange proceeds and which cannot? In a client’s view, any expenses incurred are transaction costs should be paid for using exchange funds, because, it’s only the bottom line number, the “net proceeds” that counts. But that’s simply not the case. Due diligence costs, title fees, and recording charges may or may not be permitted uses of exchange proceeds. If the exchange proceeds are used to pay purchase-related expenses (but not those related to the loan financing) – it’s permitted. If they are used to pay loan related expenses- it’s not permitted. That’s where it gets tricky. If the buyer hires a structural engineer and environmental consultant, he or she can pay those fees with exchange funds. But if the bank hires them, it’s a no go for the use of proceeds. Title insurance? Owner’s policy – yes, but loan policy – no. Recording fees? Deed – yes, but mortgage – no. Bank fees, points, pre-paid interest, tax escrows, or insurance premiums – a definite no. I tell a client who wants to maximize his or her exchange to come with a checkbook to pay those charges without using exchange proceeds.

Here’s something you may not have considered. What do you do when your client is buying real property to complete a like-kind exchange and it includes some personal property? I’m not really talking about the garbage cans, recycling bins, and brooms that are left behind and therefore “included” in the sale. Let’s say your client buys a hotel building. How do you pay for the beds, lamps, and tables in the hotel rooms, as well as the tables, bar fixtures, etc. in the hotel restaurant? If your client uses exchange proceeds, then he or she has a boot problem. The beds, lamps, tables, gaming tables, etc. are personal property and you can’t use exchange proceeds from the sale of real property to buy it. So what do you do? The best way to go is to have two contracts, one for the personal property and one for the real property. But if you prefer to have one contract, then you need to allocate the price between the real property and personal property. Then, your client needs to pay for the purchase of the personal property separately.

What do you think are some of the “gotcha” rules in like-kind exchanges?



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