Are you considering doing a Section 1031 exchange in New Jersey? New Jersey allows 1031 exchanges. If you are looking to elevate your investment portfolio, or secure tax savings for your heirs, a 1031 exchange may be a beneficial tax strategy.
This blog begins by defining a 1031 exchange and discussing the benefits, reviews the rules for 1031 exchanges in New Jersey, and the steps in the 1031 exchange process.
Read on if you want to learn more about how the a 1031 exchange works in New Jersey. For purposes of this blog, please consider the below preliminary definitions before moving on:
- Relinquished Property: Property you sell as part of the 1031 exchange.
- Qualified Intermediary: Entity that holds the sale proceeds after the sale of the Relinquished Property and transfers sales proceeds to the seller of the Replacement Property.
- Replacement Property: Property you buy as part of the 1031 exchange.
- Identification Period: The time period to locate the Replacement Property after you sell the Relinquished Property.
- Exchange Period: The time period to buy the Replacement Property after you sell the Relinquished Property.
- Boot: Gains on the sale of the Relinquished Property that are taxed.
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What is a 1031 Exchange?
A 1031 exchange is a tax strategy used to defer capital gains from the sale of a real estate investment when those sale proceeds are used to buy new investment real estate. A 1031 exchange is often referred to as a deferred exchange, like-kind exchange, tax free exchange, or swap. You swap one investment property for another and defer capital gains taxes in the process.
The U.S. Tax Court explained in Blangiardo v. Commissioner, No. 11978-13 (T.C. June 9, 2014):
Section 1031(a) provides an exception from the general rule that gain or loss is recognized from the sale or exchange of property. Under section 1031(a)(1) no gain or loss is recognized if property held for productive use in a trade or business or for investment (the relinquished property) is exchanged solely for property of a like kind (the replacement property) that is to be held either for productive use in a trade or business or for investment purposes. In order to be treated as like-kind property, the replacement property must be identified within 45 days from the date on which the taxpayer transfers the relinquished property, and the replacement property must be received before the earlier of: (1) 180 days after the date on which the taxpayer transfers the relinquished property, or (2) the due date for the transferor’s tax return for the taxable year in which the transfer of the relinquished property occurs. Such a nonsimultaneous exchange is referred to as a “deferred exchange”.
IRS Regulation 1.1031(k)-1(a) defines a deferred exchange as follows: “a deferred exchange is defined as an exchange in which pursuant to an agreement, the taxpayer transfers property held for productive use in a trade or business or for investment (the ‘relinquished property’) and subsequently receives property to be held either for productive use in a trade or business or for investment (the ‘replacement property’)”.
Why did the U.S. government pass Section 1031(a)?
The rationale for deferring capital gains in a 1031 exchange of like-kind property is that the taxpayer’s economic situation after the exchange is fundamentally the same as it was before the transaction occurred. As was noted in the legislative history: “If the taxpayer’s money is still tied up in the same kind of property as that in which it was originally invested, he is not allowed to compute and deduct his theoretical loss on the exchange, nor is he charged with a tax upon his theoretical profit.” VIP’s Indus. v. Commissioner, No. 18584-11 (T.C. June 24, 2013)
Reasons to Do a 1031 Exchange
Is it worth it to do a 1031 exchange in New Jersey? The tax advantages (specifically deferring capital gains on the sale investment property) make 1031 exchanges a beneficial strategy for real estate investors aiming to improve their investment portfolio.
Improve Rental Real Estate Portfolio. The 1031exchange makes more money available by deferring capital gains on a sale so you can purchase a more productive real estate investment. Ways to improve your investment profile include: (1) better geographic location for appreciation, (2) increased cash flow, (3) reduce property management by consolidating investment properties, and (4) diversify one investment property into multiple investment properties.
Leverage Investment Loans. Real estate investors often obtain a loan to acquire the property. Lenders normally will allow the investor to borrow up to a certain percentage of purchase price. Investors can buyer higher value property, not only by having more money available from deferred capital gains, but by leveraging that money with a loan.
Let’s walk through an example.
For example, a lender will give an investor a loan for 75% of the purchase price. If the buyer has only $75,000 to invest, he can only buy a property in value up to $100,000. If the buyer had an extra $25,000 due to a like-kind exchange (so a total capital $100,000.00), he can now buy a property up to $133,333.00.
Heirs and Inheritance. When an heirs inherit real estate, they receive a tremendous benefit called “stepped-up basis”. In short, the original sale price of the property is replaced by the fair market value at the time of death for determining capital gains on the sale.
Investopedia explained: “Step-up in basis, or stepped-up basis, is what happens when the price of an inherited asset on the date of the decedent’s death is above its original purchase price. The tax code allows for the raising of the cost basis to the higher price, minimizing the capital gains taxes owed if the asset is sold later . . . A step-up in basis resets the cost basis of an inherited asset to its market value on the decedent’s date of death.” This is valuable because real estate appreciates overtime – so the step-up is substantial.
How can you take advantage of the stepped-up basis with a 1031 exchange? The 1031 exchange allows capital gains taxes to be deferred until after your death. When the property is sold after your death, the property now can take advantage of being “stepped-up” to the fair market value for capital gains taxes.
Here’s an example.
John purchases a four-unit property for $100,000 in 1990. If John is alive and sells for the fair market value for $500,000 in 2022, there is basis of $400,000.00 in gains to factor into taxes based on the difference of actual purchase price and sale price. If John died and his heirs sold for the fair market value for $500,000.00 in 2022, there is a $0.00 in gains to factor into taxes because there is no difference between the fair market value at time of death (i.e. the stepped up basis) and sale price.
Tip: Gifts Do Not Qualify for Stepped Up Basis. Gifting the property to your heirs before death will not result in the stepped up basis – but rather keeps the tax basis of the donor. Waiting for your family to inherit real estate after your death has serious tax advantages!
Qualifying For a 1031 Exchange
Are you wondering if your sale or purchase qualifies for a 1031 exchange in New Jersey?
Here are the criteria for a 1031 tax deferred exchange:
Relinquished Property Must Have Been Held For Investment Purposes.The Relinquished Property must be currently used for “productive use in a trade or business or for investment”. Although Section 1031 does not identify a specific number of months to hold property before doing a 1031 exchange, holding for at least a year and a day is advisable. This is because Long Term Capital Gain begins to occur at one year and a day. See the article 1031 Holding Period for further analysis.
Replacement Property Will Be Used For Investment Purposes. The Replacement Property (i.e. the property you are buying” must be held by you for investment, business and/or production.
45-Day Identification Period. The replacement property must be identifed within 45-days (the “identification period”) after you sold the Relinquished Property. See 26 CFR § 1.1031(k)-1(b)(2)(i) (“The identification period begins on the date the taxpayer transfers the relinquished property and ends at midnight on the 45th day thereafter.”)
180-Day Exchange Period. The replacement property must purchased within 180-days of the sale of the Relinquished Property or the due date (including extensions) of the following year’s taxes. See 26 CFR § 1.1031(k)-1(b)(2)(ii) (“The exchange period begins on the date the taxpayer transfers the relinquished property and ends at midnight on the earlier of the 180th day thereafter or the due date (including extensions) for the taxpayer’s return of the tax imposed by chapter 1 of subtitle A of the Code for the taxable year in which the transfer of the relinquished property occurs.) If you anticipate acquiring the Replacement Property after your tax return due date, you must file an on-time tax extension for the full 180 days.
Timing on Exchange With Related Parties. The exchanger may not purchase the Replacement Property from a related party if the Replacement Property will be sold or transferred within two years after the date of the last transfer which was part of the exchange. See 26 CFR § 1.1031(k)-1(b)(2)(ii) The term “related person” means any person bearing a relationship to a taxpayer described in §267(b) or 707(b)(1).
Continuity of Title. The seller of the Relinquished property and buyer of the Replacement Property must be the “same taxpayer” with limited exceptions.
Same Country of Relinquished/Replacement Property. Both properties must be in the United States, or both must be out of the United States. According to the IRS: “Real property in the United States is not like-kind to real property outside the United States.”
Dealer Property Does Not Qualify. As discussed below, dealer property (i.e. property held primarily for re-sale) will not qualify for a 1031 exchange.
Real Estate is “Like-Kind” With Other Real Estate. Real estate may be exchanged with any other form of real estate, and the IRS deems different types of real estate as is like-kind with all other real estate (i.e. you can exchange one type of real estate with another type as long as they were held for productive use in trade, business, or for investment and other requirements were satisfied). IRS guidance clarified that “Real properties generally are of like-kind, regardless of whether they’re improved or unimproved. For example, an apartment building would generally be like-kind to another apartment building.”
See LC W. Chester Llc v. PL Real Estate LLC, 2022 U.S. Dist. LEXIS 8292 (E.D. Pa. Jan. 18, 2022) (“Under 26 U.S.C. § 1031, a seller of investment property may defer capital gains on the taxable proceeds of the sale of the property if the seller then uses the proceeds to purchase a similar property.”)
Primary Residence / Personal Does Not Qualify. Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment. IRS Fact Sheet. The use of property solely as a personal residence is antithetical to its being held for investment or business purposes. Yates v. Commissioner, No. 3685-11(T.C. Jan. 24, 2013).
How can a vacation home quality for a 1031 exchange? Vacation and second homes can serve as either a Relinquished Property or Replacement Property by complying with the tax safe harbor IRS Revenue Procedure 2008-16. For your vacation/secondary dwelling to serve as Relinquished Property: (1) you must own it for the preceding 24 months; and (2) in each of the last two 12-month periods, the dwelling must have been rented at fair market value for at least 14-days and your time spent at the property must not exceed the greater of 14 days or 10% of the number of days rented at fair market value. To buy a vacation/second home as Replacement Property, you must: (1) own it for the next 24 months following the exchange, and (2) in each of the next two 12-month periods, the dwelling must have been rented at fair market value for at least 14-days and your time spent at the property must not exceed the greater of 14 days or 10% of the number of days rented at fair market value.
“Dealer Property” Not Allowed
Property held for resale (often called “dealer property”) cannot be included in a 1031 exchange. See Section 1031(f) (“This subsection shall not apply to any exchange of real property held primarily for sale.”) Investors building or flipping a house to an end buyer are holding the property for sale and thus cannot utilize a 1031 exchange on those transactions.
To establish whether a taxpayer has held property for sale, courts evaluate the taxpayer’s intent at the time he disposes of the property. Brauer v. Commissioner, 74 T.C. 1134 (1980) (“The taxpayer’s intent at the time of the exchange is controlling and must be determined.”)
Courts consider the following factors in assessing if the property was held for sale: (1) the nature and purpose of the acquisition of the property and the duration of the ownership; (2) the extent and nature of the taxpayer’s efforts to sell the property; (3) the number, extent, continuity and substantiality of the sales; (4) the extent of subdividing, developing, and advertising to increase sales; (5) the use of a business office for the sale of the property; (6) the character and degree of supervision or control exercised by the taxpayer over any representative selling the property; and (7) the time and effort the taxpayer habitually devoted to the sales. Cottle v. Commissioner, 89 T.C. 467, 487 (1987).
Although no single factor is determinative, the combination of several factors supporting a particular result is sufficient for a court to decide whether a taxpayer held property for sale to customers in the ordinary course of a trade or business. Raymond v. Commissioner, No. 18162-99 (T.C. Apr. 17, 2001).
See Reesink v. Commissioner, No. 2475-10 (T.C. Apr. 23, 2012) (The Tax Court approved 1031 exchange even though the taxpayer moved in eight months after the exchange. The court determined the requisite intent was proven by the taxpayers’ efforts to rent the home, including placing flyers in nearby areas and showing the property to potential renters, demonstrated their intent to hold the property for business purposes.)
See Goolsby v. Commissioner, No. 1276-07(T.C. Apr. 1, 2010) (The Tax Court rejected a 1031 exchange because the taxpayer failed to demonstrate investment intent citing, among other factors, the taxpayers’ failure to research whether certain covenants permitted the use of the real estate as rental property and their minimal efforts to actually rent the property).
Tip: Cash-Out Refinancing of Replacement Property. Investors may be disheartened to be forced to reinvest all cash from the sale of the Relinquished Property to complete a fully tax deferred 1031 exchange – who wouldn’t want to personally receive some funds from a wise investment? An option to personally cash-out while still deferring capital gains is to buy the Replacement Property for cash, complete the 1031 exchange, and then in the future do a cash-out refinance on the Replacement Property.
What Is a Qualified Intermediary?
A Qualified Intermediary (“QI”) is an entity that facilitates Section 1031 exchanges by creating required documentation and holding the proceeds from the sale of the Relinquished Property until those proceeds are used to close on the Replacement Property. The qualified intermediary coordinates with the attorneys, title companies, realtors, and other parties to the exchange.
Qualified Intermediary are virtually always used because the IRS created a tax safe harbor where if criteria are satisfied the IRS will accept that there is no disqualifying relationship or improper receipt of funds by the exchanger. 26 CFR § 1.1031(k)-1(g)(4)(i) (“the qualified intermediary is not considered the agent of the taxpayer. . . the taxpayer’s transfer of relinquished property and subsequent receipt of like-kind replacement property is treated as an exchange, and the determination of whether the taxpayer is in actual or constructive receipt of money or other property before the taxpayer actually receives like-kind replacement property is made as if the qualified intermediary is not the agent of the taxpayer.)
According to Malulani Grp., Ltd. & Subsidiary v. Commissioner, No. 18128-12, (T.C. Nov. 16, 2016):
A taxpayer may use a qualified intermediary to facilitate such a deferred exchange–wherein the intermediary acquires the relinquished property from the taxpayer, sells it, and uses the proceeds to acquire replacement property that it transfers to the taxpayer in exchange for the relinquished property–without the intermediary’s being treated as the taxpayer’s agent or the taxpayer’s being treated as in constructive receipt of the sales proceeds from the relinquished property. In the case of a transfer of relinquished property involving a qualified intermediary, the taxpayer’s transfer of relinquished property to a qualified intermediary and subsequent receipt of like-kind replacement property from the qualified intermediary is treated as an exchange with the qualified intermediary.
The Qualified Intermediary must be an independent third-party and may not serve as the agent of the exchanger. With few exceptions, the QI cannot be the exchanger’s employee, attorney, accountant, banker or real estate broker. The parties must be careful so as to not jeopardize the validity of the exchange or create an ethical violation.
As was explained in Blangiardo v. Commissioner, No. 11978-13 (T.C. June 9, 2014):
A qualified intermediary must satisfy a number of requirements, including the requirement that he/she not be a “disqualified person”. The term “disqualified person” includes an agent of the taxpayer at the time of the transaction, such as the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent within the two-year period ending on the date of the transfer of the first of the relinquished properties. Persons who bear a relationship described in section 267(b), e.g., family members including ancestors and lineal descendants, are also disqualified persons.
The exchanger and the Qualified Intermediary must enter into a written exchange agreement before the sale of the Relinquished Property. 26 CFR § 1.1031(k)-1(g)(4)(iii) (“A qualified intermediary is a person who . . . enters into a written agreement with the taxpayer (the “exchange agreement”) and, as required by the exchange agreement, acquires the relinquished property from the taxpayer, transfers the relinquished property, acquires the replacement property, and transfers the replacement property to the taxpayer.)
The exchange agreement with the Qualified Intermediary should indicate the exchanger has no rights to the sale proceeds from the Relinquished Property until either: (1) expiration of the 180-day exchange period, (2) if the 45-day identification period expires without identifying the Replacement Property, or (3) completion of acquiring the Replacement Property. The exchange agreements should also have provisions assigning the rights of the exchanger to the Qualifed Intermediary for both the contract to sell the Relinquished Property and the contract to buy the Replacement Property.
Qualified Intermediaries serve multiple purposes during the purchase of the Replacement Property:
- Hold and secure proceeds from the sale of the Relinquished Property until those funds are utilized to close on the Replacement Property;
- Coordinate and oversee the closings with attorney and/or accountants and provide exchange transaction documentation in compliance with 1031 exchange rules and regulations;
- Prepare exchange documentation such as the exchange agreement, assignment agreements, notice of assignment, exchange account forms, security of funds instruments (when applicable) and instructions to the closing officers;
- Facilitate the sale of the Relinquished Property to the buyer and the purchase of the Replacement Property from the seller;
- Monitor timelines and legal compliance through the 1031 exchange.
How to Do a 1031 Exchange in New Jersey
The following are the general steps for the 1031 exchange process in New Jersey.
Step 1: Contract of Sale of the Relinquished Property
Exchangor goes under contract to sell their Relinquished Property. The contract should include provisions (often called the exchange cooperation clause) requiring the Buyer to comply with the 1031 Exchange.
See the following example of an exchange cooperation clause requiring the buyer to comply with the exchange process:
Buyer acknowledges that the Seller reserves the right to utilize the transaction contemplated by this Agreement as part of a tax-free exchange under 26 USCS § 1031, as amended. As an accommodation to Seller, Buyer agrees to reasonably cooperate with Seller and any qualified intermediary selected by Seller, at Seller’s sole cost and expense, in Seller’s efforts to effectuate and coordinate the Closing as part of such a tax-free exchange. Seller may assign this Agreement and its rights hereunder to any qualified intermediary for the purpose of completing a tax-free exchange under 26 USCS § 1031, as amended. In the event of such an assignment, the documents and instruments to be delivered by Buyer at the Closing shall, at such qualified intermediary’s option, be delivered to such qualified intermediary or its designee.
The contract should be assignable to the Qualified Intermediary.
Step 2: Selection of a Qualified Intermediary
If you haven’t already found a Qualified Intermediary, now you would need to find one. As discussed above, the Qualified Intermediary will be assigned the rights to the contract for the sale of the Relinquished Property and hold the sale proceeds.
Step 3: Execution of the “Exchange Agreement”
As noted above, federal law requires an exchange agreemnt to be executed between the exchanger and Qualified Intermediary.
Step 4: Preparation for Closing on the Sale of the Relinquished Property
As in real estate closings, there are contingencies and issues to be satisifed. Inspections, governmental approvals if necessary, title search, appraisals and mortgage approvals resolving liens such as mortgages and delinquent taxes. Once the sale of the Relinquished Property is ready to close, the Qualified Intermediary can prepare and also review any pre-closing documents to ensure legal compliance.
Step 5: Closing on the Sale of the Relinquished Property
At the closing, the Relinquished Property is transferred to the Qualifed Intermediary and then to the buyer. The sale proceeds are then received by the Qualified Intermediary and held in a qualifed escrow account so the exchanger has no control over the funds. Title is conveyed directly from the owner/exchanger to the purchaser (not to the Qualified Intermediary) as allowed under Revenue Ruling 90-34.
Step 6: Identifying the Replacement Property
Identification of possible replacement properties should be in a written document stating the street address, legal description, and/or distinguishing name.
Frequently, a form identification letter is provided by the Qualified Intermediary following the sale of the Relinquished Property. The identification letter is normally sent to the Qualified Intermediary. The IRS explained:
The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary. However, notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient. Replacement properties must be clearly described in the written identification. In the case of real estate, this means a legal description, street address or distinguishable name. Follow the IRS guidelines for the maximum number and value of properties that can be identified.
Exchangers may identify more than one Replacement Property. According to 26 C.F.R. § 1.1031(k)(1)(4)(i), exchangers may identify:
(a) Three properties without regard to the fair market values of the properties (the “3-property rule”), or
(b) Any number of properties as long as their aggregate fair market value as of the end of the identification period does not exceed 200 percent of the aggregate fair market value of all the Relinquished Properties as of the date the Relinquished Properties were transferred by the taxpayer (the “200-percent rule”).
Identifying in 45-days and closing in 180-days on the Replacement Property are fast and high stakes deadlines – failure to comply negates the exchange.
Kevin Manafi, a Compass real estate agent specializing in investments, recommends the following to meet this deadline:
When looking to find an investment property quickly, first clearly define your criteria – also known as your “Buy Box”. This includes your budget, towns/geographic regions, property attributes (property style/age, minimum number of units, square footage, bed/bath count, proximity to shopping, schools, or other anchor destinations), and any particular “must-have” features (driveway/garage, a backyard, or a basement). If you’re financing the sale, speak with your loan officer to estimate financing costs, and further narrow down your search on the areas with potential for the rent roll to exceed the estimated mortgage payment for your budget range, ruling out lower-rent regions right off the bat. It’s important to not only consider cash flow potential, but to invest in a property and area where you expect strong appreciation on rents and equity. The combination of cash flow and appreciation potential is the recipe for a successful long-term investment. If sounds like a lot to handle in a short time – an experienced realtor who specializes in investments can make a world of difference!
Step 7: Contract of Sale of the Replacement Property
Once you have identified the Replacement Property, you must reach a formal contract with the seller of that property. The Contract and rights thereof will be assigned to the Qualified Intermediary.
Here is an example of a sale provision that can be used for the purchase of your Relinquished Property that requires the Seller to comply with various documents that are often necessary for the closing:
Seller acknowledges that the Buyer reserves the right to utilize the transaction contemplated by this Agreement as part of a tax-free exchange under 26 USCS § 1031, as amended. As an accommodation to Buyer, Seler agrees to reasonably cooperate with Buyer and any qualified intermediary selected by Buyer, at Buyer’s sole cost and expense, in Buyer’s efforts to effectuate and coordinate the Closing as part of such a tax-free exchange. Seller may assign this Agreement and its rights hereunder to any qualified intermediary for the purpose of completing a tax-free exchange under 26 USCS § 1031, as amended. In the event of such an assignment, the documents and instruments to be delivered by Seller at the Closing shall, at such qualified intermediary’s option, be delivered to such qualified intermediary or its designee.
Step 8: Preparation for Closing on the Sale of the Replacement Property
Similar to the sale of the the Relinquished Property, the standard formalities most likely will need to occur after a contract is executed. This may include inspections, appraisals, obtaining necessary government certificates, title searches and clearing title issues. Good practice is to keep the qualified intermediary aware in advance of any transfer of funds and closing dates.
Step 9: Closing on the Sale of the Replacement Property
At the closing, the Qualified Intermediary will transfer the sales proceeds to the seller of the Replacement Property. Any excess remaining cash in their possession may be transferred to the exchanger as transferrable boot.
Key Takeaway: Sellers customarily give a buyer credits as part of a real estate sale for rent, security deposit, utilities, post-closing repairs, and property taxes. This can create taxable cash boot due to unspent proceeds from the sale of the Relinquished Property. Avoid these taxable gains by having the seller pay the credits to the buyer directly outside of the closing (and not included on the settlement statement).
Step 10: Report the Exchange to the IRS
Once the exchange is completed, consult with your tax advsior as to reporting the exchange to the IRS. The IRS created Form 8824 – Like-Kind Exchanges to be used in reporting 1031 exchanges. Form 8824 requires among other information property description, relationships between the parties, property value, gain and loss, and cash received.
“Boot” in a 1031 Exchange
“Boot” is gain realized in an exchange. Boot does not invalidate the transaction – but introduces taxable gain. As such, the exchange goes from “fully tax deferred” to a “partially tax deferred” exchange.
Examples of boot and circumstances for it to occur include:
- Cash proceeds received by the exchanger at the sale of the Relinquished Property;
- Remaining cash received that was not spent after acquiring the Replacement Property and completion of the exchange;
- Property received that does not qualify for a 1031 exchange (i.e. stocks, bonds, notes, or partnership interests)
- Receipt of property which is not “like-kind”;
- Receipt of property that is intended for personal use;
- Non-transaction costs such as prorated rent, taxes, utilities, and tenant security deposits transferred to the buyer;
- Debt reduction boot (i.e. when debt taken on the Replacement Property is less then the debt which existed on the Relinquished Property);
- Excess borrowing boot (i.e. borrow more than is necessary to purchase the Replacement Property, in which case the qualified intermediary will return excess cash proceeds from the sale of the Relinquished Property).
Tip: Don’t Over Borrow to Avoid Boot! Be careful on the size of the loan on purchasing the Replacement Property. Cash on the sale of the Relinquished Property must be used as part of the down payment and closing costs when acquiring the Replacement Property. Tax on excess cash at the end of the exchange will not be deferred!
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Gluck v. Commissioner, 129 A.F.T.R.2d (RIA) (2d Cir. Mar. 17, 2022) (partnership interest, even where partnership sole asset is real estate, “cannot qualify for like-kind exchange treatment.”)