Your clients selling real estate may be facing a new challenge when using a 1031 exchange to defer capital gains.
A 1031 Exchange allows for the deferral of capital gains on highly appreciated real estate investments through the use of IRS code Section 1031. The code allows an investor to swap the real estate property being sold for another “like kind” property and defer the capital gains tax until the new property is sold. Of course, when the new property is sold, it can also take advantage of IRS code Section 1031 and defer capital gains taxes.
There are three primary rules governing a 1031 exchange that are bumping into some challenges in the current market.
- The new property being swapped must be considered “like-kind” in the eyes of the IRS for capital gains taxes to be deferred.
- You have 45 days from the sale of your property and the intermediary receiving the cash to designate the replacement property. An intermediary is the entity who holds the cash from the sale to avoid constructing a receipt for the seller. The designation of the replacement property must be done in writing to the intermediary and must specify the property being acquired for the 1031 exchange. Generally, you can designate up to three properties provided you eventually close on one of them.
- You must close on your new property within 180 days of the sale of the property you want to defer the capital gains tax on.
According to a July 6 article in National Real Estate Investors entitled, As the July 15 Deadline Nears, 1031 Exchange Investors Confront a Supply Pinch and “Rich” Pricing, it is in complying with these rules that the current challenge is created.
In the article, Drew Reynold of Realized Holdings says, “The coronavirus pandemic has thrown the economy and real estate market into turmoil, leading to serious issues for exchange buyers, which means they are not the only investors trying to find a replacement property. They are competing against others who have that same July 15 deadline,” Realized Holdings estimates current demand for 1031 properties is about three times higher than usual.
What seems to exacerbate this problem is that, according to a National Real Estate Investors article, some potential sellers have delayed putting their properties on the market, adopting a wait-and-see attitude regarding the pandemic and recession.
“Due to the limited supply and high demand, pricing may be getting too rich,” said tax attorney Ken Weissenberg, co-leader of the national real estate practice at New York City-based accounting and advisory firm EisnerAmper LLP.
This problem may continue past the July 15 deadline as specific types of real estate being sought are now in high demand and may affect prices. The article goes on to say, “Property types in high demand among 1031 buyers include drugstores, grocery stores, and logistics centers. By and large, investors are hunting for properties in “COVID-resistant” sectors that have performed well during the pandemic. Meanwhile, observers say, 1031 investors are shying away from asset classes like retail and offices that have been beaten up during the pandemic.”
There are other ways of deferring capital gains for a client who is considering the sale of their real estate. These alternatives include Opportunity Zone funds and 1031 Delaware Statutory Trusts (DSTs).
Also, consider the use of an Intermediated Installment Sale Trust, which has its foundation in IRS code Section 453 and may allow the deferral of capital gains for up to 20 years. One of the advantages of this type of trust is that it eliminates the like-kind, 45 day, and 180 day rules of a 1031 exchange.
Its disadvantages are that it eliminates the step-up in basis found in the 1031 exchange and the deferral is limited to 20 years. However, this trust adds better diversification for your client, asset protection, and monthly income - all in a trust that the financial advisor manages for their client.
It is also more versatile as it can be used for franchise licenses, aircraft, and equipment sales which were eliminated from 1031 exchanges in the Tax cuts and Jobs Act of 2017.
Plus, this type of trust can handle items the 1031 exchange was never able to touch like the sale of a business, personal residents, and collectibles.
This strategy is not appropriate for a failed 1031 exchange, but is an option that should be viewed as your client examines the future sale of their real estate.
To have us model the potential tax benefits for a client considering the sale of any asset with high capital gains, please call us at 858 964 – 0500 and ask for a Dunham Regional Sales Associate or feel free to call me directly at the same number if you have any questions.
This document is provided for informational purposes only by Dunham & Associates Investment Counsel, Inc. solely in its capacity as a Registered Investment Adviser and should not be construed as legal and/or tax advice. Dunham & Associates Investment Counsel, Inc. does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.