Month: July 2023

Real estate investment is often an excellent choice for protecting and growing your wealth over the long term. When they are well planned, such investments can grow steadily in value and produce income in a predictable manner. 

A tax-deferred exchange, often called a 1031 exchange, can be an incredibly useful tool for anyone looking to manage the tax burden on their real estate investments, though the details can get complicated. Here we’ll explain the basics.

What Is a 1031 Exchange?

Named after Revenue Code section 1031, a 1031 exchange allows for “nonrecognition of gain or loss from exchanges solely in kind.” What does that mean? If you exchange one real estate investment property for another, any capital gains tax is deferred and the basis for the old property (i.e., the original purchase price, adjusted for costs of improvements, depreciation, etc.) is rolled over to the new property. 

Here is a stripped-down example that ignores complicating factors like depreciation and transaction costs:

You currently own property A, for which the basis is $200,000. You sell Property A for $250,000 and immediately reinvest the proceeds into purchasing Property B for $300,000. Typically, you would have to pay capital gains tax on the $50,000 gain you made on the sale of Property A, and the initial basis for Property B would be $300,000. 

However, if you file for a 1031 exchange deferral, you pay no capital gains tax (at least for now), and the basis for Property B would be $250,000 (the $200K basis from Property B + the $50K additional investment required for the purchase of Property B). If you were to later sell Property B for $400,000 and keep the proceeds, you would have to pay capital gains tax on the $150,000 gain ($400K – $250K) you made from the sale.

1031 Exchange Requirements

The IRS keeps a tight rein on 1031 exchanges, and several requirements must be met in order to qualify.

1. Like-Kind Exchange
   This means the properties exchanged must be similar in nature. This is broadly defined so that any two investment properties within the United States are likely to be considered of like-kind.

1. Must Be the Same Title Holder and Taxpayer
   The benefits of a 1031 exchange can’t be transferred to someone else. The title holder and taxpayer of the new property must be the same as that of the original property.

1. No Property Held for Sale
   1031 exchanges apply to real estate held for business or investment purposes. If you are flipping houses, on the other hand, the deferral would probably not apply. 

1. The New Property Must Be Identified Within 45 Days of Selling the Old Property
   The exchange does not need to be simultaneous (more on that below), but once you sell the original property you must identify the new property you plan to purchase within 45 days. This identification must be memorialized in a signed document.

1. The Purchase Must be Completed Within 180 Days of the Sale
   The clock starts ticking once you close the sale of the original property. If you have not finalized the purchase of the new property within 180 days, you will have to pay capital gains tax on the proceeds.

1. The Proceeds Must Be Held by a Qualified Intermediary
   The owner of the properties must never come into contact with the proceeds from the sale. Instead, the funds must be held by a “qualified intermediary.” This person or organization must be someone unrelated to the owner and has not had a financial relationship with the owner for the past two years. 

Types of 1031 Exchanges

There are four basic types of 1031 exchanges.

1. Simultaneous Exchange

This means the transfer of the old property and the acquisition of the new property happen simultaneously.This can happen through a little swapping of properties, or a structured transaction involving the seller of the new property, facilitated by a qualified intermediary. While this is the simplest type of exchange, in theory, arranging  these transactions can be quite complicated.

1. Delayed Exchange

In a delayed exchange, you can sell the original property (with the funds going to a qualified intermediary) and purchase the new property later, following the 45/180-day rules outlined above. Because this allows for more flexibility, it is the most common type of 1031 exchange.

1. Reverse Exchange

In this type of exchange, you can acquire the new property before selling the original property. This has some benefits, such as taking advantage of a good purchase price and allowing you 180 days to see if the market value of your old property increases, however, these transactions typically have to be done in cash.

1. Construction or Improvement Exchange

This allows you to sell the original property, transfer the new property to a qualified intermediary, use the proceeds from the sale to make improvements to the new property within 180 days, and then have the property finally transferred to you. This can be a very beneficial arrangement but also a complicated one.

Discuss Your 1031 Exchange with an Attorney

Depending on your situation, 1031 exchanges provide significant tax benefits that you don’t want to miss out on. However, they can also be quite complex and, if done improperly, result in a tax bill you may not be ready to pay. For this reason, it is recommended to plan the transaction in advance with the help of a legal professional.

Our real estate attorneys are familiar with all the requirements of a 1031 exchange and have the experience necessary to carry them out successfully. We can help you quickly formulate a plan that meets your financial goals and minimizes your overall tax burden.

Contact our office to schedule an appointment.

Property ownership in California can be quite a lucrative investment. However, when a property has more than one owner, it is not unusual for conflict between parties or for their interests to diverge. A partition action may be the only remedy when that is the case.

What Is a Partition Action?

A partition action is a legal process in which a joint owner of real property forces the division of the property to sell it. It is based on the legal principle that someone who owns property has an absolute right to sell it. For this reason, once a partition action is begun, the other parties can’t stop the petitioner from dividing the property (unless they waived their rights in writing); they can only fight over the details of how it will be done.

They are common when multiple parties inherit a single piece of property or when multiple parties invest in real estate but cannot agree over its management.

Types of Partition Actions

There are 3 basic types of partition actions in California.

1. Partition by Sale

This is by far the most common type of partition in which the court will force the sale of the property and distribute the proceeds accordingly among co-owners who are tenants in common. 

Imagine three siblings inherit a house from their parents; most people are not interested in having a 1/3 interest in a house where they don’t live, and even fewer people are interested in buying such an interest. The most reasonable solution is typically to just sell the house.

2. Partition by Appraisal

Partition by appraisal is an alternative to partition by sale. In our inherited-house example above, imagine one of the siblings wishes to keep the house. One or both of the other siblings can seek a partition by appraisal in which the one who wants to keep the house buys out the interests of the others. This can only be done with the consent of all parties.

3. Partition in Kind

Partition in kind means the party is physically divided among the co-owners. In theory, this is the default form of partition under the law, but it often doesn’t apply. After all, you can’t physically divide a single-family house between three people. It is more appropriate when large pieces of land, such as farmland, can reasonably be divided into parcels. This tends to be a lengthy and complicated process.

Avoiding a Partition Action

Partitions can be long and expensive, so the best remedy is to prevent them from happening in the first place. 

When multiple parties choose to purchase real property together, they often assume they will always agree on important issues. That is rarely the case in practice and they should do their best to anticipate future disputes. For example, is each party free to sell their interest to whomever they wish, or must the other co-owners approve the sale? Or, more basically, what is the exact nature of each person’s interest in the property?

Regarding inherited property, the co-owners are often thrown into the situation with no advance notice. Creating a clear estate plan that guides how property should be divided can be very helpful.

Talk to an Attorney About Partitioning 

Whether you are considering filing a partition action or have been served with notice of a partition by another co-owner, you should meet with an attorney before proceeding. A clear understanding of property law is necessary to ensure the partition is done properly and your interests are fully protected.

Our legal team has plenty of experience in this area and can help you resolve your dispute out of court or represent you in the partition action itself. Contact our office to discuss your situation and create a plan for moving forward.