What are 1031 Exchanges?
The 1031 tax deferred exchange is the most powerful tool in a real estate investor's toolbox. It is an IRS-approved method that enables you to sell your real estate property and reinvest in another property or properties, and defer federal (and most state) capital gains taxes. For individually held investments, the deferral can continue through any number of exchanges until the tax liability passes into the individual's estate. In other words, you need never pay taxes on your gains, and the gains are forgiven when you die (not passed to your heirs.) No other type of investment offers this kind of beneficial tax treatment.

The links on this page will help you explore the rules for 1031 exchanges, a dictionary of common terms, and a calculator that shows you the taxes due on your capital gains (if you were not exchanging).

Below we'll discuss a special case of 1031 exchanges that involves TICs.
 

Internal Revenue Code Section 1031 specifies that corporate shares or partnership interests cannot be “like-kind” with real estate. Thus, an individual cannot exchange real estate for shares in a real estate corporation or for interests in a real estate partnership. So long as most exchanges were made in a simultaneous swap of one property for another, this limitation was not significant. Then some years ago, the IRS approved time-deferred exchanges, making it possible for a property owner to sell property, deposit the cash with a qualified intermediary and then have 45 days to identify replacement property and a total of 180 days to acquire title to the property. This considerably expanded the possibilities of exchanges because replacement property could come from a third party. However, if the seller could not find a suitable replacement property within the permitted time, the benefits of a like-kind exchange would be lost.

The Tenancy-in-Common Solution

To provide a solution to the timing problem, some real estate firms acquired properties that were net-leased to high-credit tenants. These properties were owned as tenancies-in-common (TIC). In a TIC, two or more persons hold “undivided interests” in one or more properties, each person’s interest being a designated percentage of the whole. The real estate firms took the position that a TIC was not an “entity” such as a corporation or partnership but was merely a group of separate owners holding fractional interests in property. Thus, when an individual was unable to find replacement property within the statutory time limit, he or she could purchase a fractional interest in a TIC property managed by the real estate firm. A further advantage of the TIC structure is that the purchaser can acquire a fractional interest with a value precisely equal to the amount the individual received for the relinquished property, thus eliminating any taxable “boot.” (However, if the tenancy-in-common owns more than one structure, the purchaser must acquire the same percentage interest in all of the parcels.)

The IRS May Give Advance Rulings

Until recently, the IRS had never offered guidance as to whether an individual property owner could exchange in or out of a TIC. Now, in Revenue Procedure 2002-22, the IRS has specified the conditions under which the IRS will consider requests for private rulings. Undivided fractional interests in rental real estate will be considered an interest in real estate itself, rather than an interest in a business entity, thus permitting tax-deferred like-kind exchanges to take place. The IRS will not consider issuing a private ruling, however, unless 15 conditions are satisfied. The most important of these are as follows:

1. Co-owners must hold legal title as tenants-in-common under local law.
2. The number of co-owners cannot exceed 35 (husband and wife being treated as a single person).
3. The TIC cannot file a partnership or corporate tax return or hold itself out as a business entity.
4. Major decisions such as sale, lease, and financing must be unanimous. For other actions, a majority vote is sufficient.
5. Each co-owner must be able to transfer or mortgage his undivided interest without the approval of anyone else. However, the program sponsor may be given a right of first offer. In addition, restrictions on the right to transfer or encumber the interest by a lender in customary commercial lending practice are not prohibited.
6. All revenues and expenses of the property must be shared among co-owners in proportion to their interests.
7. Co-owner activity must be limited to those customarily performed in connection with the ownership of passive real estate. In determining “activity,” all activities of an agent as well as the co-owner are taken into account.
8. The commonly owned property must be subject to a true lease, with rent reflecting the fair rental value of the property.
9. A lender holding a mortgage on the property cannot be related to any co-owner, sponsor, property manager or tenant.
10. Payment for the fractional interest must reflect its fair market value and cannot depend on projected income or profits.

The conditions specified in the Revenue Procedure make it probable that only simple TIC structures are likely to be approved. More sophisticated structures that sometimes are utilized by promoters, such as master leases and similar arrangements that produce higher returns for the promoters, may not be eligible for advance rulings.

Comment: Real property owners considering the purchase of a fractional interest in a TIC should be careful to determine the exact amount of fees and other costs involved in the transaction. Using a like-kind exchange defers but does not eliminate the payment of taxes, so paying large fees may make the transaction undesirable.

1031 Exchange Coordinator: Asset Preservation, Inc.