1031 Tax Deferred Exchanges

By Rob Mann Commercial Realtor, MHE, & CREM

Reporting requirement enacted for 1031 Exchanges in Colorado

To assist the Franchise Tax Board (FTB) with tracking deferred gains and losses, the recently enacted legislation adopts new information reporting requirements for taxpayers that defer gain or loss in IRC section 1031 exchanges when Colorado property is exchanged for out-of-state property.

Taxpayers will be required to file an information return with the FTB in the tax year in which the exchange occurs and for each subsequent tax year in which the gain or loss is not recognized.

If a taxpayer fails to file the required information return, the FTB may estimate the net income due on the exchange from any information available and assess tax, penalties, and interest.

The new reporting requirement now applies to exchanges of property

The 1031 Rules

1031 Exchanges are time consuming, difficult, complicated and tedious, but they are without a doubt one of the best ways to build wealth in the US.The question really becomes about whether or not, you intend – at any point in your life – to sell for cash and pay taxes OR you want to leave that initial investment and all of it’s earned growth in a trust for your children.  Here’s why:A. If you intend to sell for cash eventually, doing a 1031 exchange may not be a good strategy for you*.  The reason for this is that 1031s DEFERtaxes, they don’t remove tax liability.  So if you intend to eventually sell, it’s a question of paying taxes now or later.* That said, one caveat is if you intend to do many exchanges before you sell – in order to leverage your money so many times that the after tax proceeds on your eventual sale would be so big that it would not matter.  This is an effective money multiplier – but very few people are comfortable with that much money in a tax bill.B. If you intend to hold the money you invest into a property, in that or other properties for the remainder of your life, then you will essentially defer taxes for your lifetime and from an investment perspective – you would remove your tax liability.  The reason for this is that the investment money and it’s growth (as equity in the real estate) could then be put into a trust for your children – and when you die, the children would receive a new basis (they would still pay estate tax but that is a separate and often cheaper tax).Thus, having a strategy about how long you will hold and investment and your eventual exit of that investment (for instance – to pay for my children’s higher education) becomes a key decision in deciding whether to 1031 exchange.

In a 1031 Exchange, a Seller sells a property (often called the “down-leg”) and purchases another property with the proceeds (often called the “up-leg”).  The rules of 1031 exchanging can be summarized quite easily.  They are as follows:Investment Properties Only (no personal residences). 

It must be a Like-kind Exchange. The term is broad: examples like an apartment building for raw land, a ranch for a strip mall would qualify.

Accommodation is a must.  You need a middleman who holds the cash after you “sell” your property. You can’t touch any of the money personally.

Identification Period. You must identify and designate up to 3 properties that you might purchase within 45 days of your closing date.

Close in 180 Days. Close the up-leg Within Six Months of the close date on the down-leg.

Cash is Taxed. This is called “boot.” You can typically take some cash from a sale but it is taxed, generally as a capital gain.

Loans make it more complicated.  The Percentage of debt on the up-leg must be greater than or equal to the down-leg.

The 1031 Process

The process for successfully completing a 1031 exchange is not always as easy as just following the rules.  Many questions must be answered before a 1031 exchange is engaged;  Why are you selling?  What do you hope to achieve in a new property?  What kind of property are you hoping to buy?  These are typical questions every Principal should answer, but some of the often missed questions can be just as important; How qualified is the agent selling your downleg at finding you an upleg?  Do you even want to use that agent? What happens if the agent does not perform in finding you something to buy?It can be helpful to know before selling, that the commercial real estate brokerage industry is very stratified.  If you are selling Multifamily and buying Triple Net Retail, it’s very important to either get a broker who is knowledgeable and experienced in both property types – or get two separate agents.  It is very common for agents to abandon Principals after the side of the exchange that they specialize in is complete.Some Principals for this reason, either request the upleg before OR choose a bigger brokerage as a fail safe.  Since the initial idea makes the exchange even more complex, and the latter usually ends up costing more, neither of these strategies are very effective.Los Angeles Commercial Real Estate is different.  First off, we are experienced in doing 1031 exchanges.  Secondly, we tie the two transactions together so that we are tied to you for both the upleg and the downleg.