FEATURE ARTICLE, MARCH 2006

1031 EXCHANGE — IS IT WORTH THE EFFORT?
Timely steps must be taken to assure a successful transaction.
William D. Michael, CCIM

Michael

The successful completion of a 1031 exchange is complicated and each situation, like real property, will be different. The successful completion of a like-kind exchange is extremely time sensitive. Do not expect the IRS to allow any exceptions if you do not follow the exact steps required within the exact timeframe required. This means you must identify potential properties you want to acquire with the proceeds of your sale within 45 calendar days from the date of the sale of your property. It also means once said property or properties are identified (within certain limitations imposed by the IRS as to the number of properties you can identify and the value of those properties in the aggregate), you must complete the acquisition of said properties not later than 180 calendar days from the date of your original sale.

If you are contemplating a 1031 exchange, the following observations may be helpful to you.

• Do not attempt to complete an exchange without professional advice and guidance from an income tax advisor, financial intermediary and attorney. Unless you are a trained accountant, you will need assistance in determining the projected capital gain you will achieve and are seeking to defer into the future for purpose of paying the capital gains tax. An unrelated, third-party financial intermediary is absolutely required as it must be the recipient of the proceeds from your sale and will use these same proceeds in the purchase of your replacement property. Provisions of the IRS Code call for separate handling of these funds. An attorney experienced in exchange matters is essential to properly document each step in the transaction in order to strictly adhere to IRS provisions.

• A “like-kind exchange” means a “like-kind exchange.” You can sell your commercial property and purchase another commercial property within the IRS definition of “commercial property.” You cannot sell your commercial property and buy securities with the proceeds and still expect it to qualify as a 1031 exchange. The purchase of member interests in an entity that owns commercial real estate is generally viewed by the IRS as the purchase of a “security” and therefore does not qualify a “commercial property” under IRS guidelines. There may be alternatives available to make this a qualifying transaction but careful evaluation by experienced counsel is strongly advised in this situation.

• Do not expect this to be an easy process. (But it need not be particularly painful either.) Even though you have hired the best CPA, the best financial intermediary and the best attorney, you still must identify a replacement property in which to reinvest your sales proceeds and adhere to the strict timeframes required.

Five simple steps to help you get started:

1. Identify the property you want to sell and determine the likely trading price you can expect to achieve. You may want to engage a qualified real estate broker or appraiser to assist you in this evaluation.

2. Start looking now for that replacement property or properties. Do not procrastinate. You may want to engage an experienced real estate broker to assist you in your search. Remember exchanges are extremely time sensitive. Once you complete the sale of your property, the IRS clock starts.

3. Identify a tax advisor, financial intermediary and attorney to work with and develop a step-by-step game plan.

4. In negotiating the sale of your property, try to obtain acceptable terms and conditions, which will allow you to extend (within reason) the date of settlement to allow adequate time to find a replacement property.

5. Try to enter into a purchase contract prior to or concurrently with the contract to sell your property. You may find yourself at a negotiating disadvantage if you contractually agree to sell your property and then must scramble to find a replacement property.

Over the years, I have witnessed numerous situations where a seller trying to complete a 1031 exchange could not find an acceptable replacement property, or, under even more stressful conditions, found he had to pay a premium price to acquire an acceptable replacement property. Depending on your view of market conditions at the time of your sale, it might turn out to be acceptable to pay the capital gains tax (given its current level) versus scrambling to complete an exchange.

William D. Michael, CCIM, is vice president with Lutherville, Maryland-based MacKenzie Commercial Real Estate Services, a member of the Cushman & Wakefield Alliance.


©2006 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.