1031 Exchanges

A 1031 exchange (tax-deferred exchange) is one of the most powerful tax deferral strategies remaining available for taxpayers. Anyone involved with advising or counseling real estate investors should know about tax-deferred exchanges, including realtors, lawyers, accountants, financial planners, tax advisors, and lenders. Taxpayers should never have to pay income taxes on the sale of property if they intend to reinvest the proceeds in similar or like-kind property.

The AdvantageThe Advantage of a 1031 Exchange is the ability of a taxpayer to sell income, investment or business property and replace with like-kind replacement property without having to pay federal income taxes on the transaction.

Section 1031 of the Internal Revenue Code is the basis for tax-deferred exchanges. The IRS issued "safe-harbor" Regulations in 1991 which established approved procedures for exchanges under Code Section 1031. Prior to the issuance of these Regulations, exchanges were subject to challenge under examination on a variety of issues. With the issuance of the 1991 Regulations, tax deferred exchanges became easier, affordable and safer than ever before.

The DisadvantageThe Disadvantages of a Section 1031 Exchange include a reduced basis for depreciation in the replacement property. The tax basis of replacement property is essentially the purchase price of the replacement property minus the gain which was deferred on the sale of the relinquished property as a result of the exchange. The replacement property thus includes a deferred gain that will be taxed in the future if the taxpayer cashes out of his investment. THE TAXPAYER MUST UNDERSTAND THAT A 1031 EXCHANGE IS A TAX DEFFERAL, NOT TAX AVOIDANCE.

The Basic Rules for a 1031 Exchange

1. The Relinquished Property Must Be Qualifying Property. Qualifying property is property (or equipment) held for investment purposes or used in a taxpayer’s trade or business. Investment property includes real estate, improved or unimproved, held for investment or income producing purposes. Property used in a taxpayer’s trade or business includes his office facilities or place of doing business, as well as equipment used in his trade or business. Real estate must be replaced with like-kind real estate. Equipment must be replaced with like-kind equipment.

2. Property Which Does Not Qualify For A 1031 Exchange includes –

·A personal residence

·Land under development

·Corporation common stock

·Property purchased or held for resale

·Construction or fix/flips for resale

·Inventory property

·Partnership interests

·Notes

·Bonds

3. Replacement Property Title Must Be Taken In The Same Names As The Relinquished Property Was Titled. If a husband and wife own property in joint tenancy or as tenants in common, the replacement property must be deeded to both spouses, either as joint tenants or as tenants in common. Corporations, partnerships, limited liability companies and trusts must be in title on the replacement property the same as they were on the relinquished property.

4. The Replacement Property Must Be Like-Kind. For real estate exchanges, like-kind replacement property means any improved or unimproved real estate held for income, Investment or business use. Improved real estate can be replaced with unimproved real estate. Unimproved real estate can be replaced with improved real estate. A 100% interest can be exchanged for an undivided percentage interest with multiple owners and vice-versa. One property can be exchanged for two or more properties. Two or more properties can be exchanged for one replacement property. A duplex can be exchanged for a four-plex. Investment property can be exchanged for business property and vice versa. However, as referenced above, a taxpayer’s personal residence cannot be exchanged for income property, and income or investment property cannot be exchanged for a personal residence, which the taxpayer will reside in.

5. Any Boot Received In Addition To Like Kind Replacement Property Will Be Taxable (To the extent of gain realized on the exchange). This is okay when a seller desires some cash or debt reduction and is willing to pay some taxes. Otherwise, boot should be avoided in order for a 1031 Exchange to be completely tax-free.

6. The 45-Day Rule for Identification. The first time timing restriction for adelayed Section 1031 exchange is for the taxpayer to either close on replacement Property or to identify the potential Replacement Property within 45 days from the date of transfer of the exchanged property. The 45-Day Rule is satisfied if replacement property is received before 45 days has expired. Otherwise, the identification must be by written document (the identification notice) signed by the taxpayer and hand-delivered, mailed, faxed, or otherwise sent to the Intermediary. The identification notice must contain an unambiguous description of the replacement property. This includes, in the case of real property, the legal description, street address or a distinguishable name. After 45 days, limitations are imposed on the number of potential Replacement Properties, which can be received as Replacement Properties. After 45 days have expired, it is not possible to close on any other property, which was not identified in the 45-day letter. Failure to submit the 45-Day Letter causes the Exchange Agreement to terminate and the Intermediary will disburse all unused funds in his possession to the taxpayer.

7. The 180-Day Rule for Receipt of Replacement Property. The replacement property must be received and Exchange completed no later than the earlier of 180 days after the transfer of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the exchanged property was transferred. The replacement property received must be substantially the same as the property, which was identified under the 45-day rule described above. There is no provision for extension of the 180 days for any circumstance or hardship. As noted above, the 180-Day Rule is shortened to the due date of a tax return if the tax return is not put on extension. For instance, if an Exchange commences late in the tax year, the 180 days can be later than the April 15 filing date of the return. If the Exchange is not complete by the time for filing the return, the return must be put on extension. Failure to put the return on extension can cause the replacement period for the Exchange to end on the due date of the return. This can be a trap for the

CONCLUSIONSInternal Revenue Code Section 1031 is a powerful tool for deferring capital gains tax on commercial/investment transactions. It allows taxpayers to exchange real or personal property for new "like-kind" property, while deferring recognition of any capital gains. Before engage in 1031 exchange seek the advice of appropriate legal counsel as 1031 exchange are very complicated creatures.

DisclaimerThis publication and the information included in it are not intended to serve as a substitute for consultation with an attorney. Specific legal issues, concerns and conditions always require the advice of appropriate legal professionals.