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. If you are interested
in more information about a 1031 Exchange, please call us and we can refer
you to our preferred 1031 partners.
1031 Exchange Basics
A taxpayer who sells and buys qualifying property, whether the taxpayer
is an individual or a corporation, partnership, trust 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.A. 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.For Example: Existing Property
Sales Price $550,000
Existing Property Tax Basis $230,000
Capital Gain + Depreciation Recapture $320,000
New Property Purchase Price $750,000A 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.
