1031 exchanges are among the most effective tax-deferral tools for real estate investors if completed strictly in accordance with the governing rules and regulations. It is important for investors to consult with their legal counsel and accountants to devise a plan in order to properly complete the 1031 process and to avoid “boot”.
While not defined in the Internal Revenue Code, the term “boot” has become the common term in the industry to describe any portion of investors’ (i) sale proceeds, or (ii) mortgage debt satisfied in connection with the sale of the relinquished property, which is not reinvested in the replacement properties. Any boot received is taxable to the investor-taxpayers.
The most common ways that investors end up with significant boot are (A) missed deadlines, (B) improper replacement property identification, or (C) miscalculation.
(A) Deadlines. 1031 exchanges are subject to two hard deadlines. The period during which investors must identify all replacement properties (the “ID Period”) expires on the 45th day following the closing of the relinquished property. Thereafter, all replacement properties must be closed on or prior to the 180th day after the relinquished property was closed. Even if those deadlines fall on a weekend or holiday, the period does not extend to the next business day, and literally, a single minute after the identification or closing periods expire, investors are out of luck and can only avoid boot to the extent of the replacement properties actually identified and closed prior to the prescribed deadlines. Calculating and calendaring reminder alerts for two or three business days before the deadlines is a helpful way to ensure investors will be prepared to timely meet these requirements.
(B) Identification Rules. There are three options for identifying potential properties in order to qualify them as “replacement properties” for 1031 purposes:
The Three Property Rule: Up to three properties may be identified to replace the relinquished property or properties, without regard to the aggregate purchase prices or market values.
The 200% Rule: Any number of replacement properties may be identified, provided the aggregate fair market value thereof does not exceed 200% of the value of the relinquished property or properties. For example, if the relinquished property was sold for $1,000,000, then the investors can identify any number of like-kind properties so long as their values don’t collectively exceed $2,000,000.
The 95% Rule: Any number of properties (even if the total combined value exceeds 200%) can be identified so long as the investors actually consummate the purchase of at least 95% of the value of the properties identified prior to the expiration of the Closing Period. For example, if the relinquished property was sold for $1,000,000, and five properties are identified with a total market value of $3,500,000, the investor would have to close properties with at least a combined value of $3,325,000 in order to avoid boot.
Investors must submit detailed descriptions of each potential replacement property, in writing and signed, prior to the identification deadline. It is always wise to request that the qualified intermediary countersign, or acknowledge receipt of the identification form in writing, and to keep copies of fax confirmations or other delivery receipts.
(C) Calculations. Maintaining and updating a detailed “roadmap” or spreadsheet throughout the 1031 exchange process can prove invaluable in effectively navigating the transactions. The following is some of the important information to include:
As reflected in the roadmap above, some of the cash replacement requirement can be satisfied with qualified closing costs.
While the IRS has not provided a comprehensive list of qualifying costs, the following have been deemed acceptable: (i) real estate commissions; (ii) title searches and owner’s title policy premiums; (iii) deed recording fees, realty transfer fees and transfer taxes; (iv) costs of due diligence performed in connection with the purchase of a replacement property; and (v) legal fees. Costs incurred in connection with financing are not qualified to reduce 1031 cash requirements, including (i) lender’s title policies; (ii) mortgage insurance; and (ii) points or fees paid to a lender. The other category of costs which do not qualify are adjustments between a buyer and seller such as (i) real property taxes; (ii) insurance; (iii) utilities; and (iv) rent adjustments. In fact, because payment of non-qualified expenses by the qualified intermediary out of exchange proceeds will result in taxable boot, investors should be prepared to bring cash to the closing table to cover those costs.
The objective of undertaking a 1031 exchange is defeated if an investor ends up with substantial boot. In addition to having to pay taxes on the recognized gain, the investor will also be left with less money to reinvest in replacement properties. To maximize the benefits of a 1031 exchange, investors should structure the transactions to result in as little boot as possible.
This article is intended for informational purposes only, should not be considered legal advice, and is not intended to create an attorney-client relationship. Please consult with your attorney and accountant prior to relying on any information contained herein.
Jessica Zolotorofe is an attorney with the law firm of Ansell Grimm & Aaron. Her practice is focused on commercial real estate transactions, including financing, acquisitions, development, sales, leasing, and structuring tax-deferred exchanges. Jessica can be reached at 973-247-9000 or by email at JTZ@AnsellGrimm.com.