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


This material is not intended as an offer or solicitation for the purchase or sale of any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. Any opinions expressed herein are given in good faith, are subject to change without notice, and are meant for informational use only. The information contained on this site does not constitute advice on tax or legal issues. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice.

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