Under section 1031 of the
Internal Revenue Code, a
real property owner can sell his property and then reinvest the
proceeds in ownership of like-kind property and defer the capital gains
taxes. To qualify as a like-kind exchange, property
exchanges must be
done in accordance with the rules set forth in the tax code and in the
treasury regulations. The 1031 exchange can offer significant tax
advantages to real estate buyers. Often overlooked, a 1031 exchange is
considered one of the best-kept secrets in the Internal Revenue
Code.
Who should consider a 1031
exchange?
If you have real property that
will net you a gain upon sale (generally
property that has been substantially depreciated for tax purposes
and/or has appreciated in fair market value), then you are exactly the
person who should consider a 1031 exchange.
There are 5 tax classes of property:
- Property used in taxpayers
trade or business.
- Property held primarily for
sale to customers.
- Property which is used as your
principal residence.
- Property held for
investment.
- Property used as a vacation home.
Section 1031 applies to the first and
fourth categories, and
potentially the fifth category. Business use is defined as, "To hold
property for productive use in trade or business." Property retired
from previous productive use in business can be qualifying property.
Investment purpose defined as real estate, even if unproductive, held
by a non-dealer for future use or increment in value is held for
investment and not primarily for sale. Investment is the passive
holding of property, for more than a temporary period, with the
expectation that it will appreciate. Property held for sale in the
immediate future is not held for
investment.
Why should you consider a 1031
exchange?
- Defer paying
capital gains taxes.
- Leverage.
- A properly structured exchange can provide real
estate investors with
the opportunity to defer all of their capital gains taxes. By
exchanging, the investor essentially receives an interest-free, no-term
loan from the government.
- Relief from property
management. The lessee takes the responsibility
to sublet and maintain the property allowing real estate buyers to
avoid most of the day-to-day management headaches.
- Upgrade or consolidate property.
- Diversify. Own multiple properties rather than
just one.
- Relocation to a new area.
- Differences in regional growth or income
potential.
- Change property types among
residential, commercial, retail, etc.
What are the 1031 exchange
rules?
The real property you sell and the
real property you buy must both be
held for productive use in a trade or business or for investment
purposes and must be like-kind.
The proceeds from
the sale must go through the hands of a qualified
intermediary and not through your hands or the hands of one of your
agents or else all the proceeds will become taxable.
All the cash proceeds from the original sale must
be reinvested in the
replacement property - any cash proceeds that you retain will be
taxable.
The replacement property must be subject
to an equal level or greater
level of debt than the relinquished property or the buyer will either
have to pay taxes on the amount of the decrease or have to put in
additional cash funds to offset the lower level of debt in the
replacement property.
1031 Timeline
Identification Period: Within 45 days of selling
the relinquished
property you must identify suitable replacement properties. This 45 day
rule is very strict and is not extended should the 45th day fall on a
Saturday, Sunday, or legal holiday.
Exchange
Period: The replacement property must be received by the
taxpayer within the "exchange period," which ends within the earlier
of... 180 days after the date on which the taxpayer transfers the
property relinquished, or... the due date for the taxpayer tax return
for the taxable year in which the transfer of the relinquished property
occurs. This 180-day rule is very strict and is not extended if the
180th day should happen to fall on a Saturday, Sunday or legal
holiday.
Replacement property
identification
3-property rule: You may
identify any three properties as possible
replacements for your relinquished property. More than 95% of exchanges
use the 3-property rule.
200% rule: You may
identify any number of properties as possible
replacements for your relinquished property as long as the aggregate
value of those properties does not exceed 200% of the value of your
relinquished property.
95% exemption: You may
identify any number of properties as possible
replacements for your relinquished property as long as you end up
purchasing at least 95% of the aggregate value of all properties
identified.
Like-Kind
Property
In a 1031 exchange you can
exchange any real property for any other
real property within the United States or its possessions if said
properties are held for productive use in trade or business or for
investment purposes. Examples of like-kind property include apartments,
commercial, condos, duplexes, raw land and rental homes*. As used in
IRC 1031(a), the words "like-kind" mean similar in nature or character,
notwithstanding differences in grade or quality. One kind of class of
property may not, under that section, be exchanged for property of a
different kind or class.
Examples of qualified like-kind
exchanges:
- apartment building
for farm/ranch
- office building for hotel
- raw land for retail space
- unimproved property for commercial property
- airplane for airplane
1031 exchange formats
Simultaneous
Two-party swap
Alderson exchange
Delayed exchange (most
common)
Safe Harbor
Multiple sales/acquisitions
Reverse exchange
Improvement
exchange
History of
1031 exchange
-
1918 - First income tax law
-
1921 - Section 202 of Internal Revenue Code states that gain or loss
not recognized on exchanges of like-kind property
-
1924 - Non like-kind exchanges excluded from Section
202
-
1928 - Code section changed to Section 112(b)(1)
-
1954 - Section 1031 enacted
-
1975 - Starker exchange; Tax court approves delayed
exchange
-
1977 - Tax court reverses prior ruling, invalidating delayed
exchanges
-
1979 - 9th Circuit reverses, reinstating initial ruling and creating
delayed exchange
-
1984 - Congress amends Section 1031; 45 day identification period and
180 day exchange period and partnerships excluded
-
1991 - Regulations 1.1031 passed
-
2002 - Revenue Procedure 2002-22 issued by IRS; 15 points to clarify
TIC interests
The role of the
Qualified Intermediary (QI)
The QI is a
person or entity that can legally hold funds to facilitate
a 1031 exchange. To be qualified, the intermediary must not be relative
or agent of the exchanging party. As an exception, a real estate agent
may serve as an intermediary if the current transaction is the only
instance in which the agent has represented the exchanging party over
the past two years.
The use of a QI is essential to
completing a successful 1031 exchange.
The QI performs several important functions in the 1031 exchange
process including creating the exchange of properties, holding the
exchange proceeds and preparing the legal documents.
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