The bidder’s position in the 1031 exchange cycle is one of the major factors affecting their bids behavior. Timing of the auction in relation to the 45th calendar day post old property closing can influence the bidder’s aggressiveness. Understanding the objective of a 1031 exchange and how it works should lessen the angst of competing bidders if the 1031 bidders are known. Ultimately, the bidding is not about the quantity of 1031 funds available but more importantly the bidder’s value point.
The 1031 Exchange Strategy
The 1031 exchange strategy allows for the deferral of the federal and state capital gains and recaptured depreciation taxes, which can represent 40% of the properties sales price. According to the Internal Revenue Code (IRC) Section 1031 “no gain is recognized when property held for use in a business or investment is exchanged for like kind property held for productive use in a business or investment.” Property refers to both real and personal property. The tax deferral serves as an interest free loan allowing for using those taxable dollars towards the purchase of a replacement property given the new property is equal to or greater than the property sold. The reward is that when the capital gains tax is ultimately paid, the risk of a higher tax rate is compensated for by either annual cash flow, a conservative appreciation or both on the replacement property.
What Affects the Exchangor’s Aggressiveness
Factors affecting the bidder with 1031 money, referred to as the Exchangor include:
- Is the land adjacent to their existing property?
- Quality of soil, history of crop production, topography, and water source
- Has the Exchangor closed or in contract on their property?
- If their property sold, is the auction before or after the 45th calendar day post old property closing?
Exchange Process
There are two types of exchanges, a forward and a reverse. In a forward exchange, which is the most common type, the old property is sold before the new property is purchased. In a reverse 1031 exchange, the new property is purchased before the old property is sold. A reverse is a bit more complex and expensive. The opportunity to defer the tax in the exchange can be lost if the old property does not sell within 180 calendar days. In addition, the farmer now owns two properties, and a Qualified Intermediary fee has been paid. The only reason the Exchangor may risk a reverse 1031 exchange is they have a buyer for their old property and a closing date scheduled. More importantly, they want to get the new property off the market now because it is undervalued or the Exchangor really wants the land.
Given today’s economy, many landowners would not favor taking a risk, and would prefer using a forward exchange. Consequently, they have two polar milestones:
- Formally identify the replacement property to the Qualified Intermediary by the 45th calendar day post closing on the sale of their old or relinquished property
- Close on the replacement property by the 180th calendar day post closing on the sale of their old property.
Knowing when the Exchangor closed on their old property and the sales price can provide valuable insights into their actions.
Sales Price of Exchangor’s Old Property
To determine the sales price, it is recommended to check with the Realtor, newspaper postings or County Clerk of Court web site. This will help to identify what the Exchangor needs to spend to defer their capital gains tax.
Closing Date of Exchangor’s Old Property
What was the date when the old property was sold? Once known, add 45 calendar days to understand where the Exchangor is in the identification milestone. If the auction date is before the 45th day, the Exchangor may be less aggressive bidding higher than their old property sales price because he may have time to locate other properties. If the auction date is after the 45th calendar day, the Exchangor has formally identified this property as one of potentially three properties (if using the three property rule) and will most likely be more aggressive.
Solution
The 1031 code defers the capital gains tax when property of equal or greater dollar value is acquired. If the Exchangor does not use all the exchange funds and debt retired on their old property, a tax is triggered on the difference. For example, a farmer sells land for $850,000. He will be looking to bid upwards of $850,000 for the new property. If the farmer spends $700,000, he will pay tax on the net difference less selling and purchase costs. If the competing bidders know the price and date the Exchangor’s old property was sold, they will be less likely to be frustrated at the price paid.
For those landowners who have 1031 funds to reinvest, there is no recourse but to hold the property for productive use in a business or investment. That implies but not limited to using the land for development, hunting, conservation and farming. If it is determined the property is used primarily for personal enjoyment, the IRS could question the 1031 exchange and potentially disallow the tax deferral resulting in an audit, penalty and taxes due.
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According to Section 1031 (a)(2) of the Internal Revenue Code “property held primarily for resale to customers in the ordinary course of the taxpayer’s business” is considered inventory or stock and ineligible for a 1031 exchange. To qualify for the tax deferral treatment, the property should be held in productive use in business or investment. Distinguishing between the dealer and investor status of the property is crucial for determining 1031 exchange eligibility for the transaction.