What is a 1031 Exchange?
A 1031 Exchange is a process authorized by the IRS in which business or investment properties that are considred “similar” are exchanged without an immediate tax liability being incurred by the property owner.
Why does the government allow this?
1031’s are alllowed because when a property owner reinvests proceeds of a sale into another property, the gains haven’t been realized in a way that allows the owner to pay any tax. In other words, the taxpayer’s investment is still considered the same, except the physical form of the property is different. It would be unfair to force the property owner to pay taxes on what is essentially a “paper” gain, therefore the taxes are deffered until the gain is realized materially.
Do the taxes ever get paid?
The exchange under Section 1031 is considered tax-deferred, NOT tax-free. When the replacement property is ultimately sold, the gain which was original deferred plus any gains realized since the purchase of the replacement property, are subject to be taxed.
Exchange vs. Sell?
By taking advantage of deferring the tax, you ultimately have more money to invest in another property. Essentially, you are getting an interest free loan from the federal government (who doesnt love that!), for the amount you would have paid in taxes. Should the property be sold and the proceeds not reinvested, profits received on the initial property sale will be taxed.
Are 1031 Exchanges only limited to real estate transactions?
Absolutely not! Any property that may be held for “productive use” in a business, trade, or for investment, could possibly qualify as a 1031 exchange and treated as tax-deferred. Many exchanges that take place are what is known as a “multi-asset” exchange, which can involve both real estate as well as personal property.
What Are The Different Types of Exchanges?
- Personal Property Exchange: Exchanges are not limited to real estate property. Personal property can also be exchanged for other personal property that is considered to be of “like-kind” or “like-class”.
- Simultaneous Exchange: The exchange of the property and the replacement property occurs at the same time.
- Delayed Exchange: There is a gap of time in between the transfer of the property and the purchase of the replacement property. There are strict time limits involved in a delayed exchange which are important to note.
- Build-to-Suit Exchange: This allows the taxpayer to make improvements to the replacement property using the proceeds received from the exchange.
- Reverse Exchange: This takes place when the replacement property is acquired before transferring the relinquished property. These transactions may also be referred to as “parking arrangements”.
In order for the taxpayer to defer the taxable gains, what guidelines need to be followed?
- The replacement property value must be greater than or equal to the value of the relinquished property.
- The amount of equity in the replacement property must be greater than or equal to the amount of equity in the relinquished property.
- The amount of debt on the replacement property must be greater than or equal to the amount of debt on the relinquished property.
- The net amount of the proceeds from the relinquished property sale must be used to purchase the replacement property.
What is a Qualified Intermediary?
A qualified intermediary is an independent third party that helps facilitate tax-deferred exchanges relating to Section 1031 of the Internal Revenue Code. The qualified intermediary must not be either the taxpayer or a disqualified person.
What is the role of the Qualified Intermediary?
Once a written agreement with the taxpayer is established, the qualified intermediary will acquire the property and then transfers it to the new buyer. The qualified intermediary will then hold the proceeds of the sale in order to prevent the taxpayer from receiving the funds materially. The qualified intermediary will then acquire the replacement property and transfer it to the taxpayer in order to complete the exchange within the appropriate time frame.
What happens with the title? Does the Qualified Intermediary take it?
In most situations, the qualified intermediary will not take control of the title. IRS regulations currently allow the properties to be deeded directly between the two parties, just as it is in a normal home sale transaction. The interests in the property purchase and sale contracts of the taxpayer are then assigned to the qualified intermediary. The qualified intermediary will then instruct the owner of the property to deed the property directly to the appropriate party.
Why is a Qualified Intermediary needed?
The exchange is finalized the moment that the taxpayer actually receives the proceeds from the sale of the relinquished property. Using a qualified intermediary is a safe harbor that was established by the US Treasury Regulations. Should the taxpayer meet the requirements of this safe harbor, the Internal Revenue Service won’t consider the taxpayer to have received the funds. The proceeds of the sale will go directly to the qualified intermediary, who will then holds them until they are necessary to purcase the replacement property. The qualified intermediary will then deliver the funds to the closing agent directly.
What time restrictions are there on completing a 1031 exchange?
The taxpayer has up to 45 days after the relinquished property is transferred to identify possible replacement properties. The 1031 exchange must be fully completed within 180 days of the transfer of the relinquished property, or the date that the federal tax return is due for the year in which the property was transferred, (whichever is earlier). The taxpayer may be able to get the full 180 days by obtaining an extension of the due date in certain circumstances.
What happens if the taxpayer can’t identify a replacement property inside of 45 days, or close on a replacement property before the expiration of the exchange period?
In this case, unfortunatly, an extension is not available. If the taxpayer doesn’t abide by the time limits, the exchange will be considered a failure and the individual will have to pay any taxes that may have arose from the initial sale of the relinquished property. The exception to this would be if the IRS has granted extensions in specified disaster areas.
Are there requirements when properly identifying “replacement property”?
Possible replacement properties must be identified in writing, which must be signed by the taxpayer, and must be delivered to a party to the exchange that is not considered to be a “disqualified person”. A “disqualified person” is any individual that may have a relationship with the taxpayer that is close enough that the person could be presumed to be “under the control of the taxpayer”. This may include immediate family relatives, the attorney of the taxpayer, the taxpayer’s accountant, or real estate agent. The identification is also not allowed to be made orally, it must be put into writing.
Is there a limit to the number of properties that may be identified?
Three rules exist that may limit the number of identifiable properties. The taxpayer has to meet the requirements of one or more of these rules:
- The 3-Property Rule: The individual is allowed to identify a maximum of 3 possible replacement properties without any regard to their actual value.
- The 200% Rule: An unlimited number of properties may be identified, however the total value of the properties can’t be larger that 2x the value of the property that was relinquished.
- The 95% Rule: The taxpayer may identify an unlimited number of properties, however, before the conclusion of the exchange period the individual must purchase replacement properties that have an aggregate fair market value that is equal to no less than 95% of the aggregate fair market value of all the properties identified.
What if the exchange can’t be completed within the 180 day time frame?
If the period that the reverse exchange takes place in is greater than 180 days, then the exchange falls outside of the safe harbor. With some detailed planning, a reverse exchange can be structured that will go beyond 180 days, however the taxpayer will lose any presumptions that may be accompanying the safe harbor compliance.
