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2014-07-22 15:46:02
1031 Tax Deferred Exchange

Broadly stated, a 1031 exchange is a swap of one business or investment asset for another. Although most swaps are taxable as sales, if you come within 1031, you will either have no tax or limited tax due at the time of the exchange. 

In effect, you can change the form of your investment without cashing out or recognizing a capital gain. That allows your investment to continue to grow tax deferred.

To qualify the properties exchanged must be held for productive use in a trade or business or for investment. Stocks, bonds, and other properties are listed as excluded by Section 1031 of the Internal Revenue Code, though securitized properties are not excluded. The properties exchanged must be of 'like kind', i.e., of the same nature or character, even if they differ in grade or quality. Personal properties of a like class are like-kind properties. Real properties generally are of like kind, regardless of whether the properties are improved or unimproved. However, a real property within the United States and a real property outside of the United States would not be like-kind properties.

Taxpayers who hold real estate as inventory, or purchase for re-sell are considered 'dealers'. These properties are not eligible for Section 1031 treatment. However, if a taxpayer is a dealer and also an investor, she/he can utilize Section 1031 on qualifying properties. Personal use property will not qualify for Section 1031.

To elect the 1031 recognition, a taxpayer must identify the property for exchange before closing, identify the replacement property within 45 days of closing, and acquire the replacement property within 180 days of closing. A Qualified Intermediary must also be used to facilitate the transaction, by holding all the profits from the sale, and then disbursing those monies at the closing, or

sometimes for fees associated with acquiring the new property.

 

In order to obtain full benefit, the replacement property must be of equal or greater value, and all of the proceeds from the relinquished property must be used to acquire the replacement property. The taxpayer cannot receive the proceeds of the sale of the old property; doing so will disqualify the exchange for the portion of the sale proceeds that the taxpayer received. For this reason, exchanges (particularly non-simultaneous changes) are typically structured so that the taxpayer's interest in the relinquished property is assigned to a Qualified Intermediary prior to the close of the sale. In this way, the taxpayer does not have access to or control over the funds when the sale of the old property closes.

At the close of the relinquished property sale, the proceeds are sent by the closing agent (typically a title company, escrow company, or closing attorney) to the Qualified Intermediary, who holds the funds until such time as the transaction for the acquisition of the replacement property is ready to close. Then the proceeds from the sale of the relinquished property are deposited by the Qualified Intermediary to purchase the replacement property. After the acquisition of the replacement property closes, the Qualifying Intermediary delivers the property to the taxpayer, all without the taxpayer ever having 'constructive receipt' of the funds.

The prevailing idea behind the 1031 Exchange is that since the taxpayer is merely exchanging one property for another property(ies) of “like-kind” there is nothing received by the taxpayer that can be used to pay taxes. In addition, the taxpayer has a continuity of investment by replacing the old property. All gain is still locked up in the exchanged property and so no gain or loss is 'recognized' or claimed for income tax purposes.

In order to qualify for this exchange, certain rules must be followed:

  • Both the relinquished property and the replacement property must be held either for investment or for productive use in a trade or business. A personal residence cannot be exchanged.
  • The asset must be of like-kind. Real property must be exchanged for real property, although a broad definition of real estate applies and includes land, commercial property and residential property. Personal property must be exchanged for personal property. 
  • The proceeds of the sale must be re-invested in a like kind asset within 180 days of the sale. Restrictions are imposed on the number of properties which can be identified as potential Replacement Properties. More than one potential replacement property can be identified as long as you satisfy one of these rules:

The Three-Property Rule - Up to three properties regardless of their market values. All identified properties are not required to be purchased to satisfy the exchange; only the amount needed to satisfy the value requirement.

The 200% Rule - Any number of properties as long as the aggregate fair market value of all replacement properties does not exceed 200% of the aggregate Fair Market Value (FMV) of all of the relinquished properties as of the initial transfer date. All identified properties are not required to be purchased to satisfy the exchange; only the amount needed to satisfy the value requirement.

The 95% Rule - Any number of replacement properties if the fair market value of the properties actually received by the end of the exchange period is at least 95% of the aggregate FMV of all the potential replacement properties identified. In other words, 95% (or all) of the properties identified must be purchased or the entire exchange is invalid.

When dealing with a 2nd Residence the following must also be considered.  For a minimum of two years prior to, and after the exchange:

  • The property must be rented for a minimum of 2 weeks to a non-relative.
  • You can rent to a relative if it is their primary residence at fair market value rent.
  • The property must only be used personally for 2 weeks or 10% of the time rented.
  • You can maintain the property for an unlimited amount of time, but documentation must be kept for these activities.
  • The property should be placed on Schedule E of your tax return and reported as income property.

Examples of a 1031 exchange

An investor buys a strip mall (a commercial property) for $200,000 (his cost basis). After six years he could sell the property for $250,000. This would result in a gain of $50,000, on which the investor would typically have to pay three types of taxes: a federal capital gains tax, a state capital gains tax and a depreciation recapture tax based on the depreciation he or she has taken on the property since the investor purchased the property. If the investor invests the proceeds from the $250,000 sale into another property or properties (without touching the proceeds and using a Qualified Intermediary), then he would not have to pay any taxes on the gain at that time.

An owner of a detached house on 3 acres is transferred by his employer to another state. Rather than selling the home, which will no longer be his personal residence, he chooses to rent it out for a period of time. After ten years, he decides that he wants to sell it but, at the same time, he has a grown son who will be going to college in yet another state. He decides that he wants to buy an apartment building in the college town for the son and other students to rent while they are in school. His house has appreciated from $200,000 to $300,000. Therefore, he arranges for an IRS Section 1031 exchange, and buys the new property, thus avoiding the capital gain at that time.

To Find out if you should do a 1031 Tax Deffered Exchange - Call Matt to discuss your options.

 
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