What is a 1031 Exchange?
Section 1031 of the Internal Revenue Code allows taxpayers who properly structure their transactions through a qualified intermediary to defer and potentially eliminate the income tax (i.e. Capital Gains, Depreciation Recapture) that would otherwise be due from the sale of property held for productive use in their trade or business or investment, when they purchase other "like-kind" property.
1031 Exchange Basics
1. The taxpayer who sells must be the taxpayer who buys.+
A taxpayer who sells and buys qualifying property, whether the taxpayer is an individual or a corporation, partnership, trusts or limited liability company may benefit from a 1031 Exchange. However, the sale and the purchase must involve the same taxpayer. For example, a partnership may not sell property held in its own name and then have an affiliated corporation buy the new property, since the partnership and the corporation are two separate taxpayers.
An exception exists for property held in a sole member disregarded limited liability company, which is treated as the property of the sole member for 1031 Exchange purposes. For example, an individual taxpayer may sell property held in his or her own name and buy property into a disregarded limited liability company of which the taxpayer is the sole member, since they are treated as being the same taxpayer.
2. The property sold and the property purchased must be "like-kind" and must be held for use in business or for investment. +
For the purposes of a 1031 Exchange, real property held for business or investment may include property held in fee, ground leases with remaining terms of thirty years or more and undivided interests in real property held as tenants in common. The rules for what types of real estate are "like-kind" are fairly broad. A taxpayer may sell vacant land held for business or investment and purchase a retail strip center or sell an apartment building and purchase a tenancy in common interest in an office tower. However, none of the properties may be treated as inventory for tax purposes. Examples of real property that may be treated as inventory are subdivided lots.
The rules for personal property are different than the rules for real property. First, it is important to note that only personal property that can be depreciated for tax purposes will qualify. Stocks, bonds, promissory notes, partnership interests and other non-tangible assets cannot be the subject of a 1031 Exchange. Second, "like-kind" is interpreted much more strictly with personal property exchanges than it is with real property exchanges. For example, a taxpayer who sells an airplane may only buy another airplane to complete their exchange and may not buy real estate or a piece of machinery.
Property bought or sold in a 1031 Exchange must be held by the taxpayer for business or investment purposes and not for personal use. Although there are no hard and fast rules for determining how long a taxpayer must hold and use property for business or investment so that it qualifies for a 1031 Exchange, it is generally thought that it should be for a period of no less than one to two years. Also, it is important that the taxpayer can show that he or she treats the property as business or investment property on their tax return.
3. A qualified intermediary performs a critical role in a 1031 Exchange.+
A qualified intermediary should be retained well before the taxpayer closes on the sale or purchase of any property that might be involved in a 1031 Exchange. The qualified intermediary will draft documents suited for the taxpayer's needs, which will be reviewed by the taxpayer and their personal tax advisors before being signed. The taxpayer will then assign the rights to sell their existing property, as well as the rights to purchase their new property, to the qualified intermediary, although title will pass directly and not through the qualified intermediary.
The sale of the existing property always needs to occur first, because the sale proceeds must be transferred to the qualified intermediary, which will apply the funds toward the purchase of the new property. Sometimes the purchase of the new property occurs immediately after the sale and in other cases it occurs up to 180 days after the sale of the existing property. Since the qualified intermediary will have control of the taxpayer's funds, taxpayers should make sure that the qualified intermediary that they intend to hire is insured and bonded and has excellent references.
4. Close attention must be paid to the timing rules for 1031 Exchanges.+
There are two important deadlines that must be met for a valid 1031 Exchange. First, the taxpayer must identify new like-kind property that it intends to purchase from a third party within 45 days after the sale of the existing property. Identification must be in a writing signed by the taxpayer and provided to the qualified intermediary or another third party within the 45 day period. For further information on the requirements for identification, please consult TVPX or your tax advisor. Second, the taxpayer must close on the purchase of an identified new property within the earlier to occur of (i) 180 days after the sale of its existing property and (ii) the due date for the filing of its annual federal return for the year in which the sale occurred. There are no extensions allowed for either the 45 day or the 180 day deadlines.
5. To get the full amount of tax deferral from a 1031 Exchange, the fair market value of the new property must be at least as much as the fair market value of the existing property and the amount of the taxpayer's equity in the new property must be at least as much as the amount of taxpayer's equity in the existing property.+
Most taxpayers want to get the full tax benefit from their 1031 Exchange. To get the maximum benefit, a taxpayer must forego the urge to use any portion of the sale proceeds from their existing property to pay anything other than the existing debt on the property, certain directly related transaction costs and the cost of purchasing the new property. If funds are paid to the taxpayer or any agent of the taxpayer or are applied to pay any costs other than those mentioned above, the amount paid will be taxable. Also, if a taxpayer buys new property worth less than the existing property, the shortfall will be taxable. Sometimes taxpayers enter into 1031 Exchanges knowing full well that a portion of the sales proceeds will be taxable, because they will still realize a valuable partial tax savings.
How does tax deferral work?
In some senses, structuring a 1031 Exchange is a trade off. If a taxpayer sells their existing property and pays the tax, he or she will have more depreciation in the new property that they subsequently purchase because the basis from the existing property did not shift over and reduce the basis in the new property as it would if a 1031 Exchange was executed. If the same taxpayer structures a 1031 Exchange from the sale of a existing property into the purchase of a new property, the tax basis from the existing property shifts over to the new property and is increased by the difference in their values.
- Existing Property Sales Price $550,000
- Existing Property Tax Basis $230,000
- Capital Gain + Depreciation Recapture $320,000
- New Property Purchase Price $750,000
- A 1031 Exchange results in the new property having an adjusted tax basis of $430,000 ($750,000 less $320,000). The taxpayer will begin depreciating the property from $430,000 over the applicable depreciation period.
If a taxpayer does not do a 1031 Exchange, the new property will have a $750,000 tax basis. The taxpayer will begin depreciating the new property from $750,000 over the applicable depreciation period. The taxpayer will have higher depreciation deductions over time, but at the significant cost of having paid all the tax up front.
In the case where a 1031 Exchange is properly structured, the taxpayer has use of money that would otherwise be paid in tax to the Government to apply toward the purchase of like-kind new property. This tax deferral will stay in effect until the property is sold, and tax will be due even then only if the taxpayer does not exchange that property for other like-kind replacement property through another 1031 Exchange. Furthermore, if an individual taxpayer retains the new property until death, his or her heirs will receive a step up in basis thus eliminating the deferred tax on the gain altogether.
What is a Reverse Exchange?
A Reverse Exchange allows many taxpayers the opportunity to get the tax benefit from a 1031 Exchange when a Straightforward Exchange is not feasible. The sale of the existing property always needs to occur before the purchase of the new property in a 1031 Exchange. Unfortunately taxpayers often find themselves in the position of needing to purchase their new property before are able to sell their existing property. Under Rev. Proc. 2000-37, the Internal Revenue Service has provided a 'safe harbor' to address this situation. In a reverse exchange under 2000-37, an exchange accommodation titleholder ('EAT') is retained to hold title to either the taxpayer's existing property or the new property for up to 180 days. In this way, the taxpayer can continue to control the existing property and the new property without holding legal title to both properties at the same time, until a third party buyer is located for the existing property. Although the EAT holds legal title, the taxpayer will always be in possession of the property pursuant to a lease. Assuming that a third party purchases the existing property within the 180 day period, the 1031 Exchange can be completed and the taxpayer's tax liability will be deferred.
Although we are providing general information about 1031 Exchanges, such information should not be relied upon as a substitute for legal or tax advice from an experienced tax advisor, who has applied the general tax rules to the specific facts and circumstances of your particular situation. 1031 Exchanges are complicated transactions, and you should ask your chosen tax accountant or legal counsel to provide you with tax advice in a form that you can rely upon under the applicable IRS regulations. Information contained herein was neither intended nor written to be used and cannot be used for the purpose of avoiding tax penalties under U.S. law or for promoting, marketing or recommending to another party any tax related matters.