Generally, a 1031 exchange on a property you already own cannot be done, but with some creativity, there are some ways around it.
A typical 1031 exchange involves the taxpayer having the ability to defer capital gains and income tax liability by exchanging one property for a like-kind replacement property within a specific time period dictated by the Internal Revenue Service (IRS). The IRS has strict rules in place for the deferment of capital gains to prevent any possibility of tax fraud.
The requirements in an exchange for total tax deferment are some of the biggest misunderstandings when it comes to 1031 exchanges. This is why it’s necessary to be aware of the rules before attempting a tax-deferred exchange and to determine the potential for exposing taxable assets.
The Napkin Test was brainstormed by California tax attorney Marvin Starr on a napkin at a seminar as a simple exercise to compare the relinquished and replacement properties and to determine if the taxpayer is exchanging across or up in value in equity. The Napkin Test evaluates the potential for boot.
You can remove debt in two ways: going down in value, which triggers tax, or you can add cash to the transaction. The IRS allows adding cash to a transaction, but if there’s a decrease in debt due to money being taken out, there are tax consequences.
To do a 1031 exchange into a property you already own, you need to satisfy the Napkin Test and get further assistance from qualified tax or legal counsel.
A way to satisfy the test is with a leasehold improvement 1031 exchange. In a build-to-suit or improvement exchange, the taxpayer uses funds from the relinquished property to finance construction on the replacement property within the 180-day exchange period. A leasehold improvement exchange is a little more complicated.
Improvements to land already owned by the taxpayer are not viewed as suitable for tax deferment by the IRS for two reasons: materials and labor are not real property until they are affixed to the land or structure, and the taxpayer cannot purchase their own property. This means that a related party must take ownership of the property at least 180 days prior to the exchange.
This is where the leasehold improvement exchange comes into play. Six or more months before the exchange takes place, the property held by the taxpayer is given to a related party who then leases the property to an Exchange Accommodation Titleholder (EAT) for a period of time greater than 30 years to qualify as real property. Improvements are carried out by the EAT with funds from the sale of the relinquished property. Before the 180-day exchange period ends, the EAT’s interest in the ground lease and improvements are handed over to the taxpayer as the replacement property.
The related party charges the taxpayer fair market rent until terminating the ground lease after at least two years. The leasehold interest is seen as real property and allows the improvements to be eligible for a 1031 exchange.
Before attempting a 1031 exchange into a property you already own, familiarize yourself with the requirements, and understand the complexity of leasehold improvement exchanges. Your Qualified Intermediary can help guide you through this difficult and intricate process.