A Prof­itable Sale With­out Taxes

Sec­tion 1031 of the IRS Code may seem ar­cane, but us­ing it can be highly ben­e­fi­cial to cer­tain clients as real es­tate prices climb.

Financial Planning - - CONTENT - By Miriam Rozen

Sec­tion 1031 of the IRS Code may seem ar­cane, but us­ing it can be highly ben­e­fi­cial to cer­tain clients as real es­tate prices climb.

Sec­tion 1031 of the IRS Code may seem like an ar­cane — and per­haps even un­nec­es­sary — sub­ject for an ad­viser to be ex­pert in. But now that prop­erty prices have climbed to pre-2008 lev­els in most parts of the na­tion, it is es­sen­tial to know about 1031 ex­changes, ac­cord­ing to Steve Du­dash, pres­i­dent of Chicago-based IHT Wealth Man­age­ment.

“If you are not able to hold con­ver­sa­tions about like 1031 strate­gies with your clients, you are ob­so­lete,” Du­dash says. “You won’t have a job in five or 10 years.”

Know­ing about 1031 ex­changes is es­pe­cially valu­able for an ad­viser with clients who own rental real es­tate. Un­der this sec­tion of the tax code, clients can de­fer the fed­eral gov­ern­ment’s recog­ni­tion of cap­i­tal gains on the sale of a prop­erty if they buy a com­pa­ra­ble prop­erty — one rental home for an­other, for in­stance — within a pre­scribed time pe­riod.

Only re­cently, as real es­tate prices have risen na­tion­wide, have 1031 ex­changes re-emerged as an ex­tremely use­ful tool, Du­dash says. When clients had prop­er­ties that were un­der­wa­ter, cap­i­tal gains taxes were not even a hint on the hori­zon, he says.

The at­trac­tive­ness of 1031 ex­changes may be am­pli­fied if pro­pos­als for a flat tax be­come se­ri­ous. If such a pro­posal were to be en­acted, clients’ cap­i­tal gains might no longer be taxed at pref­er­en­tial rates but rather would fall into or­di­nary in­come brack­ets, ac­cord­ing to Chad Smith, a wealth man­age­ment strate­gist at HD Vest in­vest­ment Ser­vices in Irv­ing, Texas. “It could be chang­ing very much over the next year, and cap­i­tal gains could be taxed at or­di­nary in­come rates,” Smith says.


But even un­der cur­rent tax laws, 1031 ex­changes are an at­trac­tive tool for ad­vis­ers in an eco­nomic en­vi­ron­ment in which clients are re­al­iz­ing sig­nif­i­cant cap­i­tal gains. “It’s al­ways handy,” says Lisa De­tanna, a se­nior vice pres­i­dent and manag­ing direc­tor for Ray­mond James’ Global Wealth So­lu­tions Group in Bev­erly Hills, Cal­i­for­nia.

Ac­cord­ing to De­tanna, a client will call and say, “Oh, by the way, I’ve sold a prop­erty.”

In some cases, this can lead to a scram­ble to find a place to ex­change. For just such sit­u­a­tions, De­tanna turns to a banker whose in­sti­tu­tion has been des­ig­nated to act as a qual­i­fied in­ter­me­di­ary in 1031 ex­changes.

Un­der a typ­i­cal 1031 ex­change sce­nario, a client who owns rental real es­tate sells the prop­erty but the pro­ceeds ini­tially go to such a bank, which is pre­pared to serve as a qual­i­fied in­ter­me­di­ary or, as it is some­times called, an ac­com­moda­tor.

Un­der the IRS rules, the seller of the rental prop­erty then has 45 days to iden­tify a “like” prop­erty and 180 days to pur­chase it, us­ing the pro­ceeds that have been kept with the qual­i­fied in­ter­me­di­ary.

Although a qual­i­fied in­ter­me­di­ary adds an ex­pense, the tax sav­ings may be much greater.

The ex­change can help post­pone taxes on highly ap­pre­ci­ated prop­er­ties that clients want to sell but don’t want

to add to their tax bill.

“Some will charge a flat fee, and some charge a per­cent­age of the sale price,” De­tanna says. But, ei­ther way, “it’s nom­i­nal when you con­sider how much you are sav­ing by de­lay­ing the taxes.” In­deed, the tax sav­ing put her clients in “a whole dif­fer­ent arena” in terms of their pur­chas­ing power for a new rental prop­erty. “The de­lay of taxes lets you build wealth,” she says.


The ex­changes are pos­si­ble in a va­ri­ety of cir­cum­stances be­cause of how broadly the tax law de­fines a “like” prop­erty. There is tremen­dous flex­i­bil­ity in the term. “It doesn’t have to be apart­ment to apart­ment,” De­tanna says. “You can switch to a du­plex or ex­change to a strip mall. It doesn’t have to be res­i­den­tial.”

For Smith, 1031 ex­change strate­gies have en­abled him to help clients who are “tired of be­ing land­lords.” For such clients, Smith has fre­quently rec­om­mended that they con­sider lim­ited part­ner­ships that own rental real es­tate. These part­ner­ships aim at pro­vid­ing turnkey so­lu­tions for in­vestors who don’t want to look for an­other sole-own­er­ship prop­erty or haven’t been able to find one yet.

But when eval­u­at­ing lim­ited part­ner­ships — some­times struc­tured as ten­an­cies in com­mon — ad­vis­ers should ap­proach the pro­pos­als with skep­ti­cism, Smith says.

“Our firm works with only two ven­dors” of such ve­hi­cles, he says, in order to limit its busi­ness to firms in which it has con­fi­dence. Even then, his firm hires an out­side coun­sel to re­view any new in­vest­ment pack­ages the ven­dors of­fer. “We are very, very cau­tious,” Smith says.

“That turnkey op­tion is not right for every­body,” he adds. “It needs to fit into their over­all plan and their in­come needs.”

For her part, De­tanna gen­er­ally steers clients away from turnkey 1031 in­vest­ment ve­hi­cles. “There are lots of neg­a­tives as­so­ci­ated with these,” she says. “You have no con­trol; gen­eral part­ner fees are usu­ally high. You are in a part­ner­ship maybe with 35 other part­ners, and you get very lit­tle in­for­ma­tion about them or the man­age­ment of the as­sets.”


On the other hand, one-to-one 1031 ex­changes are valu­able for clients’ fi­nan­cial plan­ning and, in par­tic­u­lar, es­tate plan­ning, De­tanna says. “If the pa­tri­arch and ma­tri­arch have mul­ti­ple rental prop­er­ties and the adult kids don’t have the band­width to be in the prop­erty man­age­ment busi­ness, 1031 op­tions are some­thing we would gen­er­ally dis­cuss,” she says.

Some­times, since the heirs will get the step-up in prop­erty val­ues when they in­herit rental real es­tate, the best op­tion is to wait and al­low them to sell it and avoid more ex­pen­sive strate­gies, De­tanna and other ad­vis­ers says.

At IHT Wealth, Du­dash says, he asks clients con­sid­er­ing a 1031 ex­change, “What is your pur­pose?” By know­ing their endgame, he can help them fig­ure out if such an ex­change makes sense in their cir­cum­stances.

Some­times, a 1031 ex­change strat­egy can help with multi­gen­er­a­tional plan­ning. A rental prop­erty owner can make an ex­change to buy a home for an adult child or an el­derly par­ent who then pays rent. This can be an at­trac­tive op­tion be­cause no one has to pay cap­i­tal gains taxes.

But, Du­dash cau­tions, of­ten the fam­ily dy­nam­ics over­whelm what­ever rental pay­ment struc­ture is


Miriam Rozen, a Fi­nan­cial Plan­ning con­tribut­ing writer, is a na­tional re­porter for Law.com in Dal­las. Fol­low her on Twit­ter at @Miri­amrozen.

de­vised and re­la­tion­ships turn sour. “It doesn’t al­ways work out,” he says.

An­other sce­nario in which a 1031 strat­egy might be help­ful, as long as the clients have two years of lead time, is in fi­nanc­ing a sum­mer home or a fu­ture res­i­dence.

If the clients have a rental prop­erty, they can sell that and ex­change it for a home in a va­ca­tion spot of their choice and then rent out that va­ca­tion prop­erty for two years, so they sat­isfy the IRS’ re­quire­ments for the 1031 ex­change. Af­ter that, the place is theirs to en­joy for­ever — no cap­i­tal gains tax pay­ments re­quired.

But the devil is in the de­tails. Ac­cord­ing to Alan Solt­man, a CPA with Merlis, Solt­man, Green & As­so­ciates in Los An­ge­les, who works with De­tanna, the IRS will not chal­lenge that the dwelling qual­i­fies as a like ex­change un­der 1031 if it is leased at least 14 days at a fair rental in each of the first two years af­ter the ex­change.

But if the clients use the home dur­ing the two-year hold­ing pe­riod, lim­i­ta­tions ap­ply. For a 1031 ex­change, the prop­erty own­ers’ per­sonal use can­not ex­ceed the greater of 14 days or 10% of the to­tal num­ber of days the prop­erty was rented at a fair mar­ket price, Solt­man says.

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