In a typical 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. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of "like-kind", while deferring the payment of federal income taxes and some state taxes on the transaction.
The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer's investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a "paper" gain.
The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.
Q - What are the benefits of exchanging v. selling?
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.
Q - What are the different types of exchanges?
Simultaneous Exchange: The exchange of the relinquished property for the replacement property occurs at the same time.
Delayed Exchange: This is the most common type of exchange. A Delayed Exchange occurs when there is a time gap between the transfer of the Relinquished Property and the acquisition of the Replacement Property. A Delayed Exchange is subject to strict time limits, which are set forth in the Treasury Regulations.
Build-to-Suit (Improvement or Construction) Exchange: This technique allows the taxpayer to build on, or make improvements to, the replacement property, using the exchange proceeds.
Personal Property Exchange: Exchanges are not limited to real property. Personal property can also be exchanged for other personal property of like-kind or like-class.
Q - What are the requirements for a valid exchange?
Qualifying Property - In general, if property is not specifically excluded, it can qualify for tax-deferred treatment. These types of property are specifically excluded from Section 1031
treatment: property held primarily for sale; inventories; stocks, bonds or notes; other securities or evidences of indebtedness; interests in a partnership; certificates of trusts or beneficial interest.
Proper Purpose - Both the relinquished property and replacement property must be held for productive use in a trade or business or for investment.
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.
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.
Q - What are the general guidelines to follow in order for a taxpayer to defer all the taxable gain?
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 rep
Q - Can the replacement property eventually be converted to the taxpayer's primary residence or a vacation home?
Yes, but the holding requirements of Section 1031 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.
Q - What is a Qualified Intermediary (QI)?
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.
Q - Why is a Qualified Intermediary needed?
The exchange ends the moment the taxpayer has actual or constructive receipt of the proceeds from the sale of the relinquished property. The use of a QI is a safe harbor
established by the Treasury Regulations. If the taxpayer meets the requirements of this safe harbor, the IRS will not consider the taxpayer to be in receipt of the funds. The sale proceeds go directly to the QI, who holds them until they are needed to acquire the replacement property.
Q - Can the taxpayer just sell the relinquished property and put the money in a separate bank account, only to be used for the purchase of the replacement property?
The IRS regulations are very clear. The taxpayer may not receive the proceeds or take constructive receipt of the funds in any way, without disqualifying the exchange.
Q - Are Section 1031 Exchanges limited only to real estate?
No. Any property that is held for productive use in a trade or business, or for investment, may qualify for tax-deferred treatment under Section 1031. In fact, many exchanges are
"multi-asset" exchanges, involving both real property and personal property.
www.IRS.gov
NOTE: The above information is NOT advise! It should NOT be used to make a decision of whether to use the Section 1031 Exchange program. You should seek the advise of your Tax Attorney or your CPA before making any decision. We have presented this for informational purposes ONLY!! Thank you.
