Taxation on Real Estate Transactions
Often, the intent of the seller in commercial real estate transactions is to sell commercial property and reinvest the proceeds of sale into the acquisition of other commercial real estate. This is a large part of what commercial developers do for a living: buy real estate, improve the real estate or hold it until market conditions improve, sell it, and make a profit. However, the Internal Revenue Code imposes a tax on the capital gains realized from the sale of real property, which reduces the amount of capital an investor or developer can re-deploy into a subsequent project. Section 1031 of the Internal Revenue Code offers options to investors and developers to defer the tax on the capital gains realized from the sale and roll them into a subsequent project.
How a Forward 1031 Works
The term “1031” refers to Section 1031 of the United States Internal Revenue Code. Under that section, the tax on the gains realized from the sale of real property can be deferred as long as the seller uses the proceeds of sale to purchase another piece of real property. Real estate investors have been using this provision for decades to defer taxes on gains and redeploy capital into new projects.
In a traditional forward 1031 transaction, the seller of property (or “Tax Payer”) contracts to sell certain real estate (the “Relinquished Property”) to a third party and identifies a second parcel (the “Replacement Property”) to acquire with the proceeds of sale of the Relinquished Property. To achieve the tax deferral, the Tax Payer must take steps to avoid receiving the proceeds of the sale of the Relinquished Property. The Tax Payer must find a way to route the proceeds of sale to the seller of the Replacement Property even though the closing of this acquisition may not take place for several months.
To carry out both transactions contemplated above, the seller may hire a third party (the “Qualified Intermediary”) to act as a straw man and hold the proceeds of sale of the Relinquished Property until it is time to pay such proceeds to the seller of the Replacement Property. This is accomplished by the Tax Payer assigning the rights under the sale contract over to the Qualified Intermediary. It is important that any real estate sales contract covering a transaction, where either party intends to utilize the benefits of Section 1031, be assignable to third parties. Under this concept, the Qualified Intermediary steps into the role as the buyer, accepts the proceeds of sale, and then holds them as an escrow agent until the acquisition of the Replacement Property closes. The Qualified Intermediary will then pay the proceeds directly to the seller of the Replacement Property which is then deeded directly to the Tax Payer.
Timing
As with most IRS matters, timing is everything in a 1031 transaction. In a forward 1031 transaction, the Tax Payer must identify the Replacement Property within forty-five (45) days of the closing of the sale of the Relinquished Property. If the Tax Payer makes such identification, the sale proceeds must be held by the Qualified Intermediary until either the closing of the acquisition of the Replacement Property or the 180th day after the closing of the sale of the Relinquished Property.
Failure to identify a Replacement Property within this 45-day window will result in loss of the tax benefits and imposition of the tax on the proceeds of sale. It is important to reiterate, however, that identification of Replacement Property within the 45-day window effectively freezes the proceeds until one of the above referenced events takes place. Failure to close on the acquisition of identified Replacement Property may result in the proceeds being held by the Qualified Intermediary for 180 days anyway with the tax also being imposed.
Keys to a Successful Forward Exchange
Most tax professionals will tell you that there is no such thing as a perfect 1031 transaction. To avoid penalties or an investigation into in a forward 1031 transaction by the IRS, one should always seek the help of three (3) types of qualified professionals.
First, anyone thinking about a 1031 transaction should locate a reputable entity that has experience serving as a Qualified Intermediary in 1031 transactions. A good Qualified Intermediary will have all the forms necessary to complete the 1031 piece of the transaction and will walk the Tax Payer through the steps of the deal while providing a roadmap and hard deadlines for action. Many entities offer Qualified Intermediary services, but not all of them know what they are doing.
Second, it is important to engage a qualified tax professional to advise on the impact of the 1031 transaction and the amount of sale proceeds that are available to roll forward. Calculation of the amount of sale proceeds that are available to be utilized in a 1031 transaction can be complicated and requires professional analysis to ensure that the maximum benefit is realized.
Third, any commercial real estate seller or purchaser should engage the services of qualified legal counsel. Commercial real estate transactions can be complex and cumbersome. Quality legal counsel will help by advising his/her client on the negotiation of deal points. Hiring legal counsel will also map a timeline with hard deadlines for action to ensure that the transactions (both sale and acquisition) go smoothly.
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