Sec. 1031 - Exchange of property held for productive use or investment.
A) Non-recognition of gain or loss from exchanges solely in kind.
(1) In general: No gain or loss shall be recognized on the exchange of property held for productive use in trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.
(a) Stock in trade or other property held primarily for sale,
(b) Stocks, bonds, or notes,
(c) Other securities or evidences or indebtedness or interest,
(d) Interests in a partnership,
(e) Certificates of trust or beneficial interests, or
(f) Chose in action
(3) Requirement that the property be identified and that exchange be completed not more than 180 days after the transfer of exchanged property.
For purposes of this subsection, any property received by the taxpayer shall be treated as property which is not like-kind if:
(a) Such property is not identified as property to be received in the exchange on or before the day which is 45 days after the date on which the taxpayer transfers the property relinquished in the exchange, or
(b) Such property is received after the earlier of
(i) The day which is 180 days after the date on which the taxpayer transfers the property
relinquished in the exchange, or
(ii) The due date (determined with regard to extension) for the transferor’s return of the tax
imposed by this chapter for the taxable year in which transfer of the relinquished property occurs.
Realtors are often the first to recognize the potential benefits of a Section 1031 exchange. When a seller is going to replace qualifying real estate with other replacement real estate, a Section 1031 tax deferred exchange should be suggested. Taxpayers should never have to pay taxes on the sale of real property if they intend to reinvest the proceeds in like-kind property.
Advantages: The 1031 exchange gives the taxpayer the ability to sell income, investment or business property and replace it with like-kind property without having to pay income taxes on the transaction at that point in time. This in essence equates to an interest-free loan from the government in the amount of the tax owed. It also enables the investor to reinvest more of the proceeds into the property subsequently purchases (replacement property) from the disposition of the property sold (relinquished property).
Setting the Stage for the Exchange
Once you determine that the property for sale does qualify, and the seller believes it to be in his/her best interest to participate in a 1031 Exchange, then certain language should be inserted in the contract to document this intention. (It should be noted that this language is not mandatory, but advisable.)
For a Seller: “A material part of the consideration to the seller is the option to qualify this transaction as a tax deferred exchange under Section 1031 of the IRC. Purchaser agrees to cooperate in the exchange provided purchaser incurs no additional liability, cost or expense.”
For a Buyer: “This offer is conditioned upon the seller’s cooperation to allow the purchaser to participate in an exchange under Section 1031 of the I.R.C. at no additional liability, cost or expense to Seller. Seller hereby grants buyer permission to assign this contract to an Intermediary not withstanding any other language to the contrary in this contract.”
If a realtor knows that a buyer intends to assign the contract to an intermediary in connection with an exchange, it is best to reference the buyer as “John Doe or Assigns” on the contract. If there is a paragraph which limits the buyer’s ability to assign the contract, it should be eliminated as part thereof or use the language above to allow for such assignment.
In order to effect a totally tax deferred exchange, the taxpayer must purchase replacement property equal or greater in purchase price (value) and debt than the property sold. To extent that the taxpayer is “short” in either of these, they will be deemed to have received “boot” and will be liable for taxes owed. Never “trade down.” Trading down will always result in boot received, either by cash, debt reduction, or both.
The Qualified Intermediary: The role of the qualified intermediary is essential in effecting a tax deferred exchange. During the exchange period the taxpayer must avoid actual or constructive receipt of monies from the sale of the relinquished property. If either of these is present, the exchange will be disqualified. The qualified intermediary fulfills the role of handling the funds and affecting the transfer of the properties in a manner acceptable to the I.R.S., so as to not disqualify the exchange. The qualified intermediary enters into an exchange agreement with the taxpayer to acquire the relinquished property from the taxpayer, transfer the relinquished property to its buyer, acquire the replacement property and transfer the replacement property to the taxpayer. The qualified intermediary holds the proceeds from the sale of the relinquished property and applies the proceeds to the acquisition of the replacement property.
The qualified intermediary must not be a disqualified person. Accountants, attorneys, and realtors who served the taxpayer in their professional capacities within the prior two years are disqualified from serving as a qualified intermediary for a taxpayer in an exchange.
Basic Rules for a 1031 Tax Deferred Exchange
1. The Exchange Property must be qualifying property.
Both the relinquished property and the replacement property must have been held/be held for a business or investment purpose.
Property bought with the intention of being “flipped” or put on the market for resale does not qualify. Property which is held for inventory also does not qualify.
How long does property have to be held in order to not be deemed to be bought for resale?
In general, the consensus is that a year is a safe period of time to hold the property. But, the IRS will look at the “facts and circumstances” of each individual transaction.
2. Replacement property title must be taken in the same name(s) as the relinquished property was titled.
If title was held as joint tenants with rights of survivorship then all title holders must purchase the replacement property and in the same manner. If they held the relinquished property as tenants in common, then the titleholders (taxpayers) can “split off” their interest having to reinvest their portion of the sales price of the relinquished property into a new replacement property to accomplish a totally tax deferred exchange.
3. The replacement property must be of like-kind.
For real estate exchanges, this merely means real property for real property. Unimproved real estate can be exchanged for improved real estate. Also, a 100% interest can be exchanged for an individual percentage with multiple owners. One property can be exchanged for multiple properties and vice versa. (Caution: Taxpayer still has to make sure that they are reinvesting at least the total ‘sales price” of their relinquished property in their percentage ownership.
4. The replacement property must be identified within 45 days of the transfer of the relinquished property.
If the replacement property is closed on within the 45 days, this serves as identification and no formal identification is needed. If not, the property must be identified in a letter written to the qualified intermediary and delivered, mailed, faxed, or otherwise sent within the 45 day period. The letter must contain unambiguous description of the replacement property (ie: street address, legal description).
Three Property Rule: Any three properties may be identified by taxpayer without regard to the market value of the properties. It is advisable that the taxpayer identify up to three units in their identification letter. If one of the properties was to no longer be available the taxpayer has other options. Once the 45 day period runs, there is no possibility of designating additional properties or substituting a new property for one already on the list.
200% Rule: If the taxpayer wishes to identify more than 3 properties, the value of all properties identified are limited to 200% of the value of the property sold. This rule is very limiting so the three property identification is preferred.
5. The replacement property must be received and the exchange completed to later than the earlier of 180 days after the transfer of the relinquished property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was transferred. There are no extensions granted!