Under Internal Revenue Code (IRC) Section 1031, a real property owner can sell certain property and then reinvest the proceeds in ownership of like-kind property and defer recognition of any capital gains.
In order to qualify as a like-kind exchange, property exchanges must be performed by a “qualified intermediary” and in accordance with the strict rules set forth in the tax code and in the treasury regulations.
Contact us today and let us assist you in locating a qualified intermediary to take advantage of this asset preservation opportunity.
Under Section 1031 of the United States Internal Revenue Code (26 U.S.C. § 1031), the exchange of certain types of property may defer the recognition of capital gains or losses due upon sale, and hence defer any capital gains taxes otherwise due.
Real properties generally are of like-kind, regardless of whether the properties are improved or unimproved. However, real property in the United States and real property outside the United States are not like-kind properties.
Taxpayers may wonder whether items such as equipment used on a property are included in the lump-sum sale of the property, and if they are able to be deferred. Under Treasury regulation §1.1031(k)-1(c)(5)(i), property that is transferred together with the larger item of value will not exceed 15% of the fair market value of the larger property. So for equipment with a fair market value of $15,000, as long as the qualified like-kind property sells for >$100,000, the equipment can be included in the exchange of property and any gain realized can be deferred.
Cash to equalize a transaction cannot be deferred under Code Section 1031 because it is not like-kind. This cash is called “boot” and is taxed at a normal capital gains rate.
If liabilities assumed by the buyer exceed those of the seller (taxpayer), the realized gain of the seller will be not only realized, but recognized as well. If however, the seller assumes a greater liability than the buyer, the realized loss cannot offset any realized and recognized gain of receiving boot such as cash or other personal property considered boot.
Originally, 1031 cases needed to be simultaneous transfers of ownership. But since Starker vs. U.S. (602 F.2d 1341), a contract to exchange properties in the future is practically the same as a simultaneous transfer. It is under this case, decided in 1979, that the rules for election of a delayed 1031 originated. 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 (see next paragraph) must also be used to facilitate the transaction.
The Qualified Intermediary (also known as an Accommodator) should be a corporation that is in the full-time business of facilitating 1031 exchanges. The role of a QI is similar to, but not identical to, the role of an escrow company.
Anyone who is related to the taxpayer, or who has had a financial relationship with the taxpayer within the two years prior to the close of escrow of the exchange cannot be used as the QI. This means that the taxpayer cannot use its current attorney, certified public accountant or real estate agent.
A QI should be bonded and insured against errors and omissions. Relevant educational background such as tax, law or finance is desired. Nevada is the only state that requires a QI to be licensed.
The QI enters into a written agreement with the taxpayer where QI transfers the relinquished property to the buyer, and transfers the replacement property to the taxpayer pursuant to the exchange agreement. The QI holds the proceeds from the sale of the relinquished property beyond the actual or constructive control of the Exchangor. The QI also prepares the necessary documents to accomplish a tax deferred exchange
Section 1031 Like-Kind Exchanges
It also states that the property to be exchanged must be identified within 45 days, and received within 180 days.
1031(b) states when like-kind property and boot can be received. The gain is recognized to the extent of boot received.
1031(c) covers cases similar to those in 1031(b), except when the transaction results in a loss. The loss is not recognized at the time of the transaction, but must be carried forward in the form of a higher basis on the property received.
1031(d) defines the basis calculation for property acquired during a like-kind exchange. It states that the basis of the new property is the same as the basis of the property given up, minus any money received by the taxpayer, plus any gain (or minus any loss) recognized on the transaction. If the transaction falls under 1031(b) or (c), the basis shall be allocated between the properties received (other than money) and for purposes of allocation, there shall be assigned to such other property, an amount equivalent to its Fair Market Value at the date of the exchange.
1031(h)(1) stipulates that real property outside the United States and real property located in the United States are not of like kind.
The sale of the relinquished property and the acquisition of the replacement property do not have to be simultaneous. A non-simultaneous exchange is sometimes called a Starker Tax Deferred Exchange (named for an investor who challenged and won a case against the IRS). See Starker v. United States, 602 F.2d 1341, 79-2 U.S. Tax Cas. (CCH) paragraph. 9541, 44 A.F.T.R.2d 79-5525 (9th Cir. 1979). For a non-simultaneous exchange, the taxpayer must use a Qualified Intermediary, follow guidelines of the Internal Revenue Service, and use the proceeds of the sale to buy more qualifying, like-kind, investment or business property. The replacement property must be “identified” within 45 days after the sale of the old property and the acquisition of the replacement property must be completed within 180 days of the sale of the old property.
Section 1031 is most often used in connection with sales of real property. Some exchanges of personal property can qualify under Section 1031. Exchanges of shares of corporate stock in different companies will not qualify. Also not qualifying are exchanges of partnership interests in different partnerships and exchanges of livestock of different sexes. However, as of 2002 IRS ruling (see Tenants in common 1031 exchange), Tenants in Common (TIC) exchanges are allowed. For real property exchanges under Section 1031, any property that is considered “real property” under the law of the state where the property is located will be considered “like-kind” so long as both the old and the new property are held by the owner for investment, or for active use in a trade or business, or for the production of income.
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.
There are many ways for a taxpayer to receive “Boot”, even inadvertently. It is important for a taxpayer to understand what can result in boot if taxable income is to be avoided.
The most common sources of boot include the following:
The 1031 ends on the earlier of the following:
The identification period is the first 45 days of the exchange period. The exchange period is a maximum of 180 days. If the Exchanger has multiple relinquished properties, the deadlines begin on the transfer date of the first property. These deadlines may not be extended for any reason.
A deadline that falls on Thanksgiving, Christmas, or New Year’s Day does not permit extension.
Identified replacement property that is destroyed by fire, flood, hurricane, etc. after expiration of the 45 day Identification Period does not entitle the Exchanger to identify a new property.
Mistakenly identifying condominium A, when condominium B was intended, does not permit a change in identification after the 45 day Identification Period expires. Failure to comply with these deadlines may result in a failed exchange.
IRS rules control the length of time that the replacement property must be held before it may either be sold or used to enter into a new tax deferred exchange. In highly appreciating markets, people may take the opportunity of selling their personal residence (where no capital gain is due below $250,000 for a single person or $500,000 for a married couple) and moving into a former rental property for a specified time period in order to turn it into their new personal residence, and thus avoid capital gains taxes.
In order to qualify for this exchange, certain rules must be followed:
Difficulties involved in meeting limits
A 1031 exchange is similar to a traditional IRA or 401(k) retirement plan. When someone sells assets in tax-deferred retirement plans, the capital gains that would otherwise be taxable are deferred until the holder begins to cash out of the retirement plan. The same principle holds true for tax-deferred exchanges or real estate investments. As long as the money continues to be re-invested in other real estate, the capital gains taxes can be deferred. Unlike the aforementioned retirement accounts, rental income on real estate investments will continue to be taxed as net income is realized.
An alternative to a 1031 exchange for someone who wants to defer capital gains tax, but who does not want to continue to hold property is a structured sale. This method offers both buyer and seller many benefits and is regarded as ideal for those looking to retire from or exit from the real estate or business market.
How a 1031 exchange is accomplished
An alternative to the 1031 exchange
Examples of a 1031 exchange
An owner of a detached house on 3 acres (12,000 m2) 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 IRC Section 1031 exchange, and buys the new property, thus avoiding the capital gain at that time.
In addition to the sale of real estate, selling an interest in real property may also qualify for a 1031 Exchange. An example of this would be the sale of an easement.
Warning: Like-Kind Exchange of Loss Property
Please note that ERA is not giving legal advice. This is merely intended to help educate our valued clients and future clients. For more information, please contact us. We can help you whether a buyer or a seller interested in a 1031 Exchange. We have many reputable Accommodators that we can refer you to as well.