The Basics of the
1031 Exchange and Tenancy In Common
I get lots of questions from
the “Ask Paula” question box on my website,
http://www.Paula_Straub_Capital_Gains_Tax_Site.com,
and it seems that lately I’ve been getting a lot of
questions about the 1031-TIC exchange structure.
Basically, most people are
familiar with the 1031 exchange. Almost everyone
seems to realize that you can exchange one type of
property for a similar type of property and, in
doing so, defer capital gains tax on the sale of
your property. Fewer people are familiar with
tenancy in common because it’s not a common way to
hold real estate, but most realize that it is a form
of joint ownership. Beyond these basics, though,
there are a lot of questions about the “mechanics”
of each, so I thought I’d take some time to go over
the very basics of the 1031 and tenancy in common,
separately.
1031 Exchange
When someone sells business or
investment property, the federal government imposes
a long term capital gains tax of 15% of the
appreciated value of the property plus 25% of any
depreciation taken on the property minus sales
costs. As a really simple example, let’s say you buy
a rental home for $100,000.00 and sell it for
$200,000.00 two years later, after having taken
depreciation of $10,000.00. You owe the I.R.S.
$15,000.00 in capital gains tax, plus $2,500.00 for
what is known as depreciation recapture. So far, of
the $100,000.00 you stand to realize, you have to
pay $17,500.00 to the federal government. Thank
goodness for the generosity of the I.R.S., though,
which is kind enough to let you subtract the cost of
selling the property – let’s say $2,000.00 – from
the amount owed. So, when all is said and done,
you’ll give the federal government $15,500.00 and
take for yourself $84,500.00. That’s not even
counting state taxes. Yikes!
As I said, though, thank
goodness for the generosity of the I.R.S. (you
thought I was kidding) because according to the
Internal Revenue Code’s Section 1031, you can defer
capital gains tax on investment or business property
so long as the sale is structured as an exchange of
like kind property. Technically, you are not
deferring payment of taxes, rather, the I.R.S. is
choosing not to recognize your gain on the sale of
property, but it has basically the same tax
consequence for you. Anyhow, most states also have
in their revenue codes some piggyback version of
Section 1031, so that state taxes are deferred as
long as federal taxes are deferred under Section
1031.
Now for the details. First,
Section 1031 only applies to business or investment
property. If you own your own office building, fine.
If you’re renting a house to college kids, that will
work, too. You cannot use your own home or a second
home (usually). Second, you must “exchange” your
investment property for “like kind” property via a
“qualified intermediary”; and you have 45 days to
find another property to do so. Third, the new
property must be of equal or greater value than the
property you exchanged it for if you want to defer
all of your taxes.
OK, so how does all this work?
You put your property up for sale, and go looking
for other properties and a qualified intermediary
before your sale closes. A qualified intermediary is
a person who is qualified to facilitate the
exchange; most real estate attorneys and
professionals can find one for you. You must
identify the qualified intermediary before the sale
of your property closes. If you have not identified
any property to replace your sold property, the
proceeds of the sale will be held by the qualified
intermediary until you do. You have 45 days from the
close of the sale of your property to identify up to
three replacement properties (actually, you could
identify more than three under what’s known as the
200% Rule), and you have a total of 180 days to
purchase any or all of those properties. Once you
decide to purchase, the qualified intermediary
transfers the proceeds of the sale of your property
to the sellers of the replacement property and the
title of the property to you.
One thing to keep in mind here
is that all real estate is considered of like kind
to all other real estate. For example, you can
exchange raw (undeveloped) land for a duplex or a
single family home for an office park. It doesn’t
matter where the property is, how it’s been improved
or how its title is held. What does matter is the
value of the property. The replacement property must
be equal to or greater in value than the property
you sold. If it is less valuable than your
relinquished property, the difference in value is
taxed as “boot.”
Also, notice that you do not
have to exchange your property with the owner of the
property you end up owning. You can sell your
property to one person and buy replacement property
from another. Implied in the above examples, you can
buy or sell multiple or fractional interests. You
can put cash into the deal, but you cannot take it
out. You cannot receive cash, actually or
constructively (a legal or real estate professional
can explain what constitutes constructive receipt);
and you will be taxed on any receipt of cash. The
exchanges I’ve been describing (and probably the
most common type) are deferred exchanges wherein one
person sells their own property and then looks for
another. Reverse exchanges are also possible. In
this situation, you can purchase replacement
property before you sell your own property. The
rules here are more complex, and you may be required
to bring outside funds to the transaction in order
to make it work.
Tenancy In Common
Though perhaps less familiar,
tenancy in common is a lot less complex than the
1031 exchange. Basically, real property can have
co-owners. Those co-owners can be joint tenants or
tenants in common. There are other forms of
co-ownership, but they basically apply in a handful
of states and are only for marital property.
The hallmark of tenancy in
common is that tenants own individual, fractional
interests in a piece of property. To highlight what
this means, consider community property. Community
property is a form of co-ownership between married
couples in states that have community property laws
(like California). When real estate is held as
community property each spouse owns an undivided
one-half interest in the property. If those spouses
were to choose to hold the property as tenants in
common (which they could), then each would own one
half of the property. When the co-ownership
interests are undivided, one owner may not sell his
or her interest without the other owner’s
permission. As well, when one owner dies, the other
owner automatically receives title to the whole
property. None of this true for individual, tenancy
in common ownership interests. Let’s say you own 25%
of a parcel of raw land. You can sell your interest
without getting permission from anyone. When you
die, your interest transfers to your heirs.
So, another way to defer all
taxes is to exchange your individual property for a
fractional interest in a larger, commercial property
sold as a Tenant in Common property. The advantages
here are usually a positive cash flow and a
management company arrangement that takes care of
the landlord duties that are often expensive and
frustrating. It can remove your headaches, give you
the advantages of still owning real estate, and
often generate a higher income than you were
receiving from your original property.
Hopefully, I’ve helped you make
the connection between 1031 Exchanges and Tenants in
Common Property a bit more understandable. Or,
if it’s still a bit unclear, or if you just have
more sophisticated questions about either concept,
you should contact an attorney. Otherwise, feel free
to contact me at 760-917-0858 with more questions
about either the 1031 exchange or tenancy in common
or if you want information about how you can use a
1031 exchange and tenancy in common to defer capital
gains taxes.
Paula Straub
(760)917-0858
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