IRS Warns Real Estate Investors Not to Push 1031 Timelines
The 1031 exchange is a tax planning strategy which is key to real estate investors' financial plans. Section 1031 of the Internal Revenue Code (IRC) allows a taxpayer to defer the capital gains taxes on the real estate they are selling when they also properly acquire new investment real estate within a 180 days.
Say in 2008 you bought a rental property for $200,000. As the economy recovered, the value of the home also appreciated to $500,000. If you sell the house, you’ll have a $300,000 capital gain profit, bringing with it a likely $45,000 tax bill.
If you are selling the investment real estate to buy another rental property, however, you have another option. By selling the old property and buying the new property through a Qualified Intermediary, you can effectively exchange the equity in your current property for equity in the new property.
Since there was no sale, you won’t owe capital gains taxes now--but you will pay the tax when you finally sell the new property in the future. (Qualified Intermediaries are professionals that specializes in 1031 exchanges).
Reverse Exchanges
Normally, a taxpayer would (using a Qualified Intermediary) sell their existing investment property and then use the funds to purchase a new investment property within 180 days. There is also, however, a reverse/deferred exchange, where the process is reversed. An exchange facilitator buys the new property and the taxpayer has 180 days to sell their existing property and complete the exchange.
Stay Inside the Window or Suffer
As you can imagine, the IRS isn’t always happy about seeing their tax money sent far into the future. This was the case with the estate of George Bartell. The estate had conducted a reverse exchange, where an exchange facilitator acquired the new property before the existing property was sold.
The IRS argued the exchanges didn't occur within the 180-day window. The exchange facilitator had acquired the new property over a year in advance of the date of the transaction with Bartell. As a result, the IRS demanded the payment of capital gains taxes on the sale of the property.
Bartell took the IRS to tax court [Estate of George H. Bartell, Jr. v. Commissioner, 147 T.C 140 (2016)]. Bartell argued although the property was acquired early by the exchange facilitator, there is court precedent which allow for an exchange under those circumstances.
You Can Beat the IRS!
But the IRS Doesn’t Care
The Tax Court agreed with Bartell and allowed the 1031 exchange to go through and the taxes to be deferred. Don’t think, however, that just because Bartell won it means you can do the same. On August 14th, 2017, the IRS issued Action on Decision 2017-06, which basically says the IRS disagrees with the Tax Court and “will not follow the Tax Court’s opinion in Bartell.”
Although the IRS is forced to allow Bartell to defer capital gains, it will not allow others with similar circumstances to defer. The IRS will continue to deny similar exchanges and is essentially daring real estate investors to take them to court.
Appeals Court Shopping
Even through the Tax Court will again rules against the IRS, the IRS is looking for an opportunity to take a new case to appeal and win. The Bartell case would have been appealed to the 9th Circuit, which has historically ruled favorably to real estate investors regarding 1031 exchanges. But the IRS can wait until it finds a test case in an appeals court more likely to rule in favor of the IRS.
You Don’t Want to Be That Test Case
As a real estate investor, being in the test case position would likely not be in your best interest If you are planning a 1031 exchange, make sure to work with an experienced Qualified Intermediary which has a track record of successfully completing exchanges.
You also want to make sure you closely follow the timelines outlined in the section 1031 of the IRC and in Revenue Procedure 2000-37, which outlines the procedure for conducting a deferred exchange.
Don’t Color Outside the Lines
Be wary if your Qualified Intermediary suggests a strategy which supposedly can allow you to acquire the new property and sell the old property more than 180 days apart. If this does happen, you may wish to get a second opinion from another Qualified Intermediary and also consider paying for advice from an experienced real estate attorney.
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Joshua Escalante Troesh is a tenured professor of Business at El Camino College and the founder of Purposeful Finance. His career provides him with a unique insight on personal financial, having owned multiple businesses, being a VP at a financial institution leading up to 2008, and a Director of Marketing for a dot-com leading up to 2000.