Exchanges

A 1031 tax-deferred exchange enables investors to reinvest the proceeds from the sale of investment property in one or more replacement properties without incurring immediate federal (and most state) capital gains taxes on the appreciated value.  In a typical non-primary residence transaction, the property owner is taxed on any gain realized from the sale. However, through a Section 1031 Exchange, the tax on the gain is deferred until some future date.  Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment.  This deferral strategy can be repeated until the tax liability passes into the individual’s estate upon death. 

Benefits 

  •  A Section 1031 exchange is one of the few techniques available to postpone or potentially eliminate taxes due on the sale of qualifying properties. 
  • By deferring the tax, you have more money available to invest in another property. In effect, you receive an interest free loan from the federal government, in the amount you would have paid in taxes. 
  • Any gain from depreciation recapture is postponed. 
  • You can acquire and dispose of properties to reallocate your investment portfolio without paying tax on any gain.

Requirements

Qualifying Property: Certain types of property are specifically excluded from Section 1031 treatment like property held primarily for sale, inventories, stocks, bonds or notes, other securities or evidences of indebtedness, interests in a partnership, or certificates of trusts or beneficial interest. In general, if property is not specifically excluded, it can qualify for tax-deferred treatment. 

Proper Purpose: Both the relinquished property and replacement property must be held for productive use in a trade or business or for investment. Property acquired for immediate resale will not qualify. The taxpayer’s personal residence will not qualify.

Like Kind: Replacement property acquired in an exchange must be “like-kind” to the property being relinquished. All qualifying real property located in the United States is like-kind. Personal property that is relinquished must be either like-kind or like-class to the personal property which is acquired. Property located outside the United States is not like-kind to property located in the United States.

Exchange Requirement: The relinquished property must be exchanged for other property, rather than sold for cash and using the proceeds to buy the replacement property. Most deferred exchanges are facilitated by Qualified Intermediaries, who assist the taxpayer in meeting the requirements of Section 1031.

Guidelines

  • The value of the replacement property must be equal to or greater than the value of the relinquished property
  • The equity in the replacement property must be equal to or greater than the equity in the relinquished property
  • The debt on the replacement property must be equal to or greater than the debt on the relinquished property
  • All of the net proceeds from the sale of the relinquished property must be used to acquire the replacement property

  THE QUALIFIED INTERMEDIARY

A Qualified Intermediary is an independent party who facilitates tax-deferred exchanges pursuant to Section 1031 of the Internal Revenue Code. The QI cannot be the taxpayer or a disqualified person. Acting under a written agreement with the taxpayer, the QI acquires the relinquished property and transfers it to the buyer. The QI holds the sales proceeds, to prevent the taxpayer from having actual or constructive receipt of the funds. Finally, the QI acquires the replacement property and transfers it to the taxpayer to complete the exchange within the appropriate time limits.

 Time Limitations

There are strict timeline and identification rules that must be followed for a 1031 exchange. First, the investor must identify replacement property within 45 calendar days of the close on the relinquished property. This identification must be in writing, and can follow one of three possible identification rules.  Second, the investor must close on the identified replacement properties within 180 days from the close date of the relinquished property. 

Identification Rules

There are three rules that limit the number of properties that can be identified. The taxpayer must meet the requirements of at least one of these rules:

  • 3-property rule: Up to three properties are identified no matter what their value
  • 200 percent rule: Any number of properties is identified as long as their combined fair market value (FMV) does not exceed 200% of the FMV of the relinquished properties
  • 95 percent rule: Any number of properties are identified no matter what the aggregate FMV, provided 95% of the value of the identified properties is acquired

  REVERSE EXCHANGES

A reverse exchange, sometimes called a “parking arrangement,” occurs when a taxpayer acquires a replacement property before disposing of their relinquished property. A “pure” reverse exchange, where the taxpayer owns both the relinquished and replacement properties at the same time, is not allowed. The actual acquisition of the “parked” property is done by an Exchange Accommodation Titleholder or parking entity. In a typical reverse exchange, the “Exchange Accommodation Titleholder” takes title to the replacement property and holds it until the taxpayer is able to sell the relinquished property. The taxpayer then exchanges with the Exchange Accommodation Titleholder, who now owns the replacement property. An exchange structure cannot have a parking period that goes beyond 180 days. If the reverse exchange period exceeds 180 days, then the exchange is outside the safe harbor of Rev. Proc. 2000-37. With careful planning, it is possible to structure a reverse exchange that will go beyond 180 days.

 CONVERTING REPLACEMENT PROPERTY TO VACATION HOME

This is possible, but the holding requirements must be met prior to changing the primary use of the property. The IRS has no specific regulations on holding periods. However, many experts feel that to be on the safe side, the taxpayer should hold the replacement property for a proper use for a period of at least one year. If the owner later on wants to take advantage of the home owner’s exemption (up to $250,000 or $500,000 for a couple), there is now a five year holding period requirement.

  CONCLUSION

A 1031 exchange can be an effective tool for building wealth. However, investors must work with their professional tax advisor to meet the requirements of IRC Section 1031, as failure to comply with IRC Section 1031 or an unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities, including tax penalties.