Like-kind exchange: A tax-deferring strategy for investors

Section 1031 of the Internal Revenue Code provides gain is not recognized when property held in a trade or business or for investment is exchanged for like-kind property held in a trade or business or for investment. Under regulations, taxpayers can utilize this provision when they sell their property and purchase replacement property from a third party. As long as certain safe harbor provisions are followed, the gain on the old property will be deferred until the replacement property is sold. Many savvy real estate investors utilize like-kind exchanges as a vehicle for deferring taxes, thereby freeing up tax money to use for further investment. In the current real estate environment it can be difficult to find replacement property, but this strategy can still be viable and result in substantial tax savings. Often there can be an issue of the quality of the replacement property. Due to the tight timetable imposed by the Treasury, many taxpayers overpay for the replacement property. Regulations under Section 1031 require the replacement property to be identified within 45 days of closing of the old property. In addition, taxpayers must take title to the replacement property within 180 days of closing on the old property (or by the due date of the tax return, if earlier). As these dates bear down on taxpayers, many are forced to accept replacement property they would not have otherwise accepted. However, there are a number of vehicles available to facilitate finding a replacement property. There is a market of single commercial tenant, net lease properties that are offered to people who need to find replacement properties. These properties are subject to long-term leases which, if the tenant has a high credit rating, can be very secure. However, at the end of the lease or if the tenant leaves earlier, it can be very difficult to find a new tenant. Another way to expedite the replacement is to buy a tenancy in common interest. A market has developed for sponsors who convert large properties to tenancy in common ownership. Revenue Ruling 2000-22 treats a partial interest in real estate as qualifying as like-kind. The difficulty with this structure is that exit strategies depend on others buying your interest in a very limited market. In addition, the lack of regulations over the sponsors has allowed questionable transactions. The number of Section 1031 exchanges has declined substantially since the economic downturn. However, anytime a disposition of real property is contemplated, a like-kind exchange should be considered. While it is clearly harder to find replacement property in this environment, the effort can be well worth it when considering the tax savings. Robert Demmett is a CPA and partner with EisnerLubin llp, a division of WithumSmith+Brown, PC, New York, N.Y.