By Denis R. Caron
Although Section 1031 of the IRS Code has long been available as a tax-deferral tool for persons selling business or investment property and replacing it with like-kind property, it has been grossly underutilized in the Northeast. Frequently, persons who would clearly benefit from arranging their transactions as an exchange will fail to do so, either out of ignorance of the shelter’s existence or because of a misunderstanding of the scope of its provisions. Lenders may often find themselves working with a borrower on a project that could qualify for Section 1031 treatment, and they may well be doing themselves and their customer a disservice by not fully exploring the advantages an exchange might offer.
The federal tax on long-term capital gains is presently 15 percent; since the capital gain becomes part of the taxpayer’s adjusted gross income, the gain then becomes subject to Connecticut state income tax. Thus, the aggregate tax liability resulting from the sale could be in excess of 20 percent of the gain. Frequently, the taxpayer has also depreciated the relinquished property, adding even more to his tax liability. By structuring the sale as part of an exchange, the taxpayer avoids having to set aside funds to pay those taxes, and consequently has more equity available to invest in the replacement property. Of course, this enhances the loan-to-value ratio on the replacement property, and may well be the factor to tilt the balance for a loan proposal that otherwise might be rejected.
Although Section 1031 does contain its fair share of complicating factors and issues, fundamentally the process is quite simple. Before actually transferring title to the relinquished property, the taxpayer must enter into an exchange agreement with an accommodating middleman known as a qualified intermediary (QI). The use of a QI is one of the “safe harbors” created by the IRS Code, meaning that the use of a QI will serve to make the transaction immune from challenge on the grounds that the accommodator was acting as an agent of the taxpayer.
The exchange agreement sets out the terms and chronology of how the exchange is to proceed. The QI agrees to: acquire the relinquished property from the taxpayer and convey it to the buyer; hold the proceeds from the sale of the relinquished property; and acquire the replacement property and convey it to the taxpayer. Thus, the taxpayer’s transactions are solely with the intermediary, and not with the buyer of the relinquished property or the seller of the replacement property.
The exchange process is simplified by the fact that IRS rules permit “direct deeding”; that is, the taxpayer can transfer title to the relinquished property directly to the purchaser without first transferring title to the QI. This keeps the cost of exchanging reasonably low, since dual transfer taxes are avoided. The same holds true for the purchase of the replacement property.
To be sure, there can be complicating factors in an exchange. One of the most common involves partnership or LLC dissolutions, where the parties want to sell their property and go their separate ways. The problem here is that partnership or LLC interests are not considered property for Section 1031 purposes, so the partnership or LLC must first drop title down to the individual partners or members before the sale occurs. This arrangement is known as a “drop and swap,” and presents certain problems that must be addressed well in advance.
On occasion, a taxpayer will become obligated to acquire the replacement property before the relinquished property has sold. This situation gives rise to a “reverse” exchange scenario, which is expressly permitted under IRS rules, but is much more cumbersome and expensive to undertake, the primary reason being that the QI in a reverse exchange is required to hold legal title to property during the exchange period. This is a situation in which a lender’s familiarity with the exchange process becomes critical if the lender is to remain an efficacious participant in the taxpayer’s purchase. In a future article, the issues surrounding the reverse exchange process will be addressed in greater detail.
A speaker at a recent national conference I attended advanced these statistics: On the West Coast, out of 100 transactions that could be structured as an exchange, 93 are in fact structured as an exchange. On the east coast, out of the same 100 transactions that could be structured as an exchange, 93 are not. Clearly, taxpayers in our area are only beginning to take full advantage of section 1031, and it behooves all of us involved in commercial transactions to become more familiar with this valuable tool.
Denis R. Caron is vice president of LandAmerica Exchange Co., a subsidiary of LandAmerica Financial Group, a Fortune 500 company, and has structured more than 1,000 exchanges over the past decade. His office is located in Cromwell. He can be reached at (800) 899-5842, ext. 131.