Yes, C Corporations many times can facilitate 1031 exchanges with third party purchases or sellers by transferring assets within the corporate structure via non – taxable asset transfers, such as property distributions, dividends, and D reorganizations.
Table of Content
- What is a 1031 Exchange?
- How to Do a 1031 Exchange in 7 Steps
What is a 1031 Exchange?
A 1031 exchange, named after section 1031 of the U.S. Internal Revenue Code, is simply a way to postpone capital gains tax on the sale of a business or investment property by using the proceeds to buy a similar (“like – kind”) property.
When an individual, partnership, limited liability Company (LLC) or S corporation sells appreciated real estate, any gain flows from the entity to the individual and tax is assessed at the individual level. Generally, there is no tax paid by the entity.
But when a C corporation sells appreciated real estate, it is a separate taxable entity and pays tax on its profits, so it will owe tax on the sale. Also note that when the after – tax sale proceeds are distributed to the shareholders as dividends, the shareholders are still expected to pay another tax on the dividend income.
This means that the income from the sale of the property is being taxed twice – once at the corporate level and once at the individual level. When combining both the federal corporate and individual taxes, and also state taxes at both the corporate and individual levels, the total combined tax rate can be more than 50 percent.
So to avoid double taxation, some C Corporations prefer to structure the sale of the property as a stock sale as opposed to an asset sale, where the individual shareholders would sell their stock in the corporation instead of the corporation selling its assets. Note that this normally eliminates the corporate level taxes, as only the individuals would be taxed – but many buyers may balk at this approach.
Another solution commonly used in the United States is converting the C Corporation to an S corporation. Normally, an S corporation can sell appreciated real estate and generally not owe tax on the sale. Howbeit, the gain is passed through to the shareholders, who will be subject to tax on their individual tax returns.
However, to effectively do this, the conversion to an S corporation is expected to occur at least 5 years before the sale of the property. If the sale occurs within 5 years of conversion, the corporation will be expected to pay a 21 percent tax on the “built – in gain”, which is the difference between the corporate assets’ fair market value and the tax basis at the date of conversion.
Note that this is one of the few instances where an S corporation may be subject to tax. The shareholders are then expected to pay tax on the gain passed through to them from the S corporation – and would more or less still incur double taxation. But, after 5 years, the built – in gains tax expires and the threat of double taxation is eliminated.
A more preferred solution for selling within 5 years of conversion would be for the selling corporation to complete a 1031 exchange, and thus pay no tax at all. For all the reasons stated above, using the 1031 exchange to defer tax is a wonderful strategy for anyone or business selling appreciated real estate held in a corporation.
Top 5 Rules and Guidelines for a 1031 Exchange
Have it in mind there are several rules that need to be followed while doing a 1031 exchange. In the United States, rules and guidelines related to tax implications and time frames can be confusing and problematic. If you’re considering a 1031 exchange, here is what you should know about all the rules.
1. You Need a Qualified Intermediary to Handle the Execution of the 1031 Exchange
All 1031 financial transactions, starting with the proceeds from the sale of the old property, are expected to go through the hands of what’s termed a “qualified intermediary.” This intermediary is charged with holding all the profits from the sale and then disburses those monies at the closing of the exchanged property (or sometimes for fees associated with acquiring the new property).
Note that to be qualified; the entire amount of the cash proceeds from the original sale has to be reinvested toward purchasing the new real estate property. Any cash retained by you from the sale of the old property is taxable income.
Additionally, at the close of the relinquished property sale, the proceeds are sent by the title company handling the closing directly to the qualified intermediary. This qualified person or entity is then tasked with holding the funds until the transaction for the replacement property acquisition is ready to close.
Then the proceeds from the sale of the relinquished property are deposited by the qualified intermediary to purchase the replacement property. After the acquisition of the replacement property closes, the qualified intermediary delivers the property to the taxpayer, all without the taxpayer ever having what the IRS calls “constructive receipt” of the funds.
2. The Properties Must Be “Like – Kind” to Qualify
In the United States, 1031 exchanges must be done with like – kind properties. The rules for like – kind properties have evolved over the rules. In 1984, Section 1031 of the tax code was changed so that the definition of like – kind was extensively expanded.
Presently, there are options to sell a rental house and buy a small apartment building. But before the change in rules and qualifications, you didn’t just have to trade a house for a house but a three – story apartment building for a three – story apartment building.
Also note that the properties don’t have to be in the same sector. For instance, you could sell an apartment building and invest the proceeds in an industrial building. International and domestic properties are not “like – kind” 1031 exchange properties, either.
Instead you can use almost any property in the United States for a 1031 exchange. Nonetheless, it is imperative that if you cannot find the right property to reinvest the proceeds, don’t do a 1031 exchange. You should avoid buying the wrong property at the wrong time in the housing cycle.
3. Both Properties Must Be Held for a Productive Purpose in Business or as an Investment
To qualify for a 1031 exchange, both the new and old properties have to be held as an investment or used in a trade or business. Held for investment simply means holding the property for future appreciation. Used in a trade or business also means income – producing, such as used in a business or used as a rental property.
A fix and flip kind of property is regarded as property held for sale. You may be able to count it as a 1031 exchange if you end up renting it out for a few months before selling it to an investor.
4. Your Gain Is Tax – Deferred, but It Is Not Tax – Free
When you use a 1031 exchange, have it in mind that you are merely postponing the tax because you are exchanging one similar asset for another. While that helps your current cash flow, your gain will eventually be taxed when you sell the new property.
However, there is no time limit for holding the property. You can defer taxes as long as you still own the property. And you can do another 1031 exchange on the same property down the road and again defer the taxes, as long as you’re exchanging like – kind properties and following all the rules. You don’t even have to sell the property in your lifetime. You can pass it on to your heirs.
5. Timing Is Everything
It’s pertinent that you understand there are several important dates to complete a 1031 Exchange. A like – kind exchange does not have to be a simultaneous swap of properties. But you are expected to meet two – time limits, or the entire gain will be taxable. These limits cannot be extended for any circumstance (except in the case of presidentially declared disasters).
First and foremost, you have 45 days from the date you sell the relinquished property to identify potential replacement properties that you propose or intend to buy. This identification is expected to be in writing, signed by you, and delivered to a person involved in the exchange, such as the seller of the replacement property or your qualified intermediary.
Giving notice to your attorney, real estate agent, accountant, or similar persons acting on your behalf in any part of the transactions is always not enough. In addition, during this Identification Period, replacement properties are also expected to be clearly described in the written identification. In terms of real estate, it entails a legal description, street address, or distinguishable name.
The second time limit is more or less known as the Exchange Period. The replacement property must be received, and the exchange completed no later than 180 days after the sale of the exchanged property. Howbeit, to complete a 1031 exchange, a taxpayer is mandated by law to identify the replacement property within 45 days of closing and acquire the replacement property within 180 days of closing the sale of the original property.
How to Do a 1031 Exchange in 7 Steps
A 1031 exchange can be complex, so it is always advisable you consult with a qualified tax pro. However, here are some basics about how a 1031 exchange works and the steps involved.
1. Identify the property you want to sell
Remember that not every real estate deal is suitable for a 1031 exchange. The IRS imposes strict limits on the use of the 1031 exchange on vacation properties. A 1031 exchange cannot involve your personal property or primary residence. This means you can’t use the 1031 exchange to eliminate the capital gains you may owe if you sell your family home for a significant profit.
2. Identify the property you want to buy
The property you’re selling and the property you’re buying have to be “like – kind,” which means they’re of the same nature, character or class, but not necessarily the same quality or grade (more on that below). Note that property inside the U.S. isn’t considered like – kind to property outside the U.S.
3. Choose a qualified intermediary
Note that you need a qualified intermediary in place to receive the money from the sale of property 1 before you can buy property 2 under the 1031 exchange. It’s advisable you only work with a professional experienced with 1031 exchanges.
IRS laws explicitly state that you are not allowed to use your own attorney, employee, accountant, real estate agent, or a relative as the qualified intermediary. What is the qualified intermediary’s role? If they receive the profits from the sale and roll it over into a new property, you never received the money. And you probably can’t be charged income tax or capital gains taxes on it.
4. Decide how much of the sale proceeds will go toward the new property
Have it in mind that you don’t have to reinvest all of the sale proceeds in a like – kind property. Generally, you can defer capital gains tax only on the portion you reinvest. So if you keep some of the proceeds, you might end up paying some capital gains tax now.
5. Do not forget the calendar
For the most part, you are expected to meet two deadlines or the gain on the sale of your property may be taxable. First, you have 45 days from the date you sell your property to identify potential replacement properties. You have to do that in writing and share it with the seller or your qualified intermediary. Second, you have to buy the new property no later than 180 days after you sell your old property or after your tax return is due (whichever is earlier).
6. Be careful about where the money is
Do not forget that the whole idea behind a 1031 exchange is that if you didn’t receive any proceeds from the sale, there’s no income to tax. So, taking control of the cash or other proceeds before the exchange is done may disqualify the deal and make your gain immediately taxable.
7. Inform the IRS about your transaction
Note that you will likely have to file IRS Form 8824 with your tax return. That form is where you describe the properties, provide a timeline, explain who was involved and detail the money involved.
Generally, 1031 Exchange is a complex scenario, and it is strongly advised that anyone considering strategies to avoid the double taxation of a C corporation asset sale first seek advice and proper guidance from tax professionals. Howbeit, the use of a 1031 exchange and conversion to S corporation status can be useful strategies for those C corporations wishing to avoid double taxation on the sale of appreciated real estate properties.