USING I.R.C. SECTION 1031 EXCHANGE TO
DEFER CAPITAL GAINS TAXES
With the recent significant fluctuation in the stock market, many investors are turning to real estate, and are rediscovering the tax deferral benefits by Section 1031 of the Internal Revenue Code. Many real estate investors know that under Section 1031, a property owner can exchange one property, called the "relinquished property", for another, without paying any federal income taxes until sometime in the future, when the replacement property is sold.
Although federal capital gains tax deferral is a great incentive for a real estate investor to trade property under Section 1031, the biggest incentive for the investor is that he has additional equity to invest due to the fact that the investor who successfully completes a Section 1031 exchange has no federal capital gains tax payment. The cash that would be used to pay the capital gains taxes in a straight sale is reinvested into the new property. This tax deferral, in reality, is an interest free loan from Uncle Sam.
Although the federal capital gains tax rate is 15%, many investors still fail to take advantage of Section 1031. With the increasing visibility of like-kind exchanges, many of the myths surrounding Section 1031 exchanges have been debunked. While there are rules and limitations under Section 1031, many investors find that there is an abundance of qualified assistance to insure compliance with the rules.
Section 1031 tax deferral treatment is not available for all properties. Only investment or income producing property qualifies for Section 1031 tax deferral treatment. Property that is used for personal use, especially a personal residence, does not qualify. Property that a taxpayer purchased for resale, rather than for investment, will also not qualify. In addition, certain property like stocks and bonds are excluded under Section 1031.
Another basic requirement under Section 1031 is that a taxpayer must structure the transaction as an exchange of one property for another property of like-kind. Under Section 1031, "like-kind" means that real property must be exchanged for real property. It does not mean that a duplex must be exchanged for a duplex. A duplex can be exchanged for vacant (investment) property, for an office building, or for a tenant in common interest in real estate.
Under Section 1031, a taxpayer has specific time periods after the sale of his relinquished property, within which to identify and acquire replacement property.
The most common myth is that a Section 1031 exchange can only be accomplished where there is a true swap of properties. In today´s market, the typical Section 1031 exchange involves four (4) parties: the taxpayer (sometimes called the exchanger); the buyer of the relinquished property; the seller of the replacement property; and a qualified intermediary who provides a written agreement and structures the exchange to comply with the rules and regulations of Section 1031. The Qualified Intermediary cannot be related to the taxpayer.
Like-kind exchanges do require advance planning. There are a few drawbacks, which must be considered. First, there are additional transactional costs. Second, the basis in the replacement property is less than its costs, due to carry-over basis from the relinquished property. This lower basis limits future depreciation. A taxpayer should always consult with his tax advisors before structuring a like-kind exchange. For many real estate investors, however, the tax advantages of the interest-free loan from Uncle Same far outweigh the limitations, and structuring a successful like-kind Section 1031 exchange through an experienced Qualified Intermediary is easy.
Frequently Asked Questions
Why does the government allow tax deffered exchanges?
One common belief is that the government will ultimately receive more tax revenue. It is suggested that a taxpayer is more willing to dispose of and acquire property if there is an opportunity to participate in a tax deferred exchange. This means more business owners and investors are replacing worn or inadequate properties without incurring a large capital gain tax. As a result of these reinvestment activities, more people are employed, who, in turn, employ others through their spending. This cycle brings in additional income tax for the government.
What tax is "deferred" in a Section 1031 exchange?
Capital gains tax is comprised of two components: the tax due on the profit earned on the sale of the investment or income property (the profit earned is the appreciation in value of the property and is determined by gross sale price minus the adjusted basis and the cost of sale), AND the tax due on the recapture of depreciation previously taken by the taxpayer during the time the taxpayer owned the property.
Why do I need a Qualified Intermediary (QI)?
A QI provides many helpful functions during a 1031 exchange, including two that are absolutely necessary. First, the QI provides the taxpayer with the required documents to establish the taxpayer's intent to do an exchange. This paperwork creates the structure of an exchange and insures that the end result complies with the laws and rulings. Secondly, the QI acts as the accommodator for proceeds to protect the taxpayer from direct (actual) or indirect (constructive) receipt of the funds, either of which would invalidate the exchange. The use of a QI also satisfies one of the safe harbors set forth under IRC 1031.
What are the 45 day and 180 day rules?
Generally a taxpayer has 45 days from the transfer date of the relinquished property to properly identify the replacement property, and up to 180 days from the transfer date to acquire one or all of the identified properties. The 180 day period can be shortened. The 180 day rule is actually 180 days after the transfer of the relinquished property, or the date of taxpayer's federal tax return (including extensions), whichever event occurs first.
Do I still need a QI if I am involved in a simultaneous exchange where more than two parties are involved and all the deeds and proceeds are transferred within minutes?
Yes. Tax law provides that all exchange structures (except a two-party direct swap) need a party separate from the transaction to receive the cash proceeds. Today, the separate party is referred to as a Qualified Intermediary.
Can I do an exchange with a relative?
Yes. A taxpayer can do a direct exchange with a related party but both taxpayer and the related party must retain their respective replacement properties for at least two years after the exchange. Exchanges involving related parties present complex issues. If this issue is important to you, please contact LandAmerica Exchange or a knowledgeable tax advisor before proceeding.
When is an exchange not appropriate?
An exchange is not appropriate when the taxpayer does not want like kind property, wants a higher depreciable basis in the replacement property or desires a substantial amount of cash.
Can real estate be exchanged for anything other than real estate?
Generally no. All real estate can be exchanged for all other real estate EXCEPT when:
· The real estate is held as your primary residence or is held for personal use
· The real estate is held primarily for sale or as inventory
· The real estate located in the
· The real estate is not identified or acquired within the time frames provided in the Internal Revenue Code (IRC)
Do second homes qualify for exchange treatment?
Yes, as long as the primary purpose for the vacation home is not for personal use. If you are contemplating such an exchange, we strongly urge you to contact a knowledgeable tax advisor before proceeding.
Do real property leases qualify for Section 1031 exchange treatment?
Yes. With the requirement that leases must have at least 30 years (including unexercised options) remaining at the time of the exchange to qualify as like kind property to real estate. Unexercised options to renew can be included in the 30-year calculation.
Do the names on the replacement property and the relinquished property have to be the same?
Yes. Exceptions include single member limited liability companies and grantor trusts which pass through entities for federal income tax purposes.
Can I offer an exchange to my lender in lieu of foreclosure?
Theoretically, yes, however it is still likely that there is a taxable capital gain and depreciation recapture even if there is no remaining equity. Because there are several complexities to consider, it is best to consult your CPA or tax advisor.
Are partnerships allowed to do exchanges?
Yes. All tax-paying entities are entitled to the benefits of Section 1031; however, the Code is clear that individual partners may not exchange their partnership interest for another partnership interest or for real property.
Can I finance the purchase of the relinquished property?
Yes. If the taxpayer desires to use the note to purchase the replacement property, then the note should be issued by the buyer to the Qualified Intermediary (QI). The taxpayer cannot receive any installment payments during the exchange period. The note can be used to purchase the replacement property, or the QI can sell the note to a third party. If at the end of the exchange period the note has not been sold or satisfied in full, the QI will distribute the note to the taxpayer and it will be taxable boot.
When is a reverse exchange appropriate?
Your CPA or tax advisor can provide the best guidance. Some common examples of when a reverse exchange is appropriate are:
· Market conditions arise where the value of replacement properties is rapidly accelerating or desirable properties are becoming less available. A reverse exchange allows you to acquire the right property before values get out of reach or the property is removed from the market
· You are ready to close on the replacement property, but the buyer of your relinquished property is unable to close on time. If you cannot extend the closing of the replacement property, then a reverse exchange may be your only option for tax deferral
· You have several relinquished properties to dispose of in order to complete a typical deferred exchange within the statutory 180 days. Unfortunately, only some of the properties can be disposed of within that time. By using these proceeds to acquire a fractional interest in the replacement property, you can do a reverse exchange for the remaining fractionalized interest, providing an additional 180 days to dispose of the remaining relinquished properties
Can I exchange unimproved real property for improved real property?
Yes. Improved real property is like kind and can be exchanged for unimproved real property and vice versa. Real estate is like kind to real estate so long as it is held for productive use in a trade or business or for investment purposes.
Courtesy of LandAmerica Exchange Services
Principals for Using Section 1031
In order for an investor/taxpayer to avoid immediate recognition of gain there are three primary principles which must be followed when doing an exchange. These are principles only. The rules are quite specific, and failure to use them correctly can end in tax disaster. Consult your tax professional regarding the actual mechanics of a successful exchange. The National Council of Exchangors website is: http://www.nce1031.com.
1. The investor must be exchanging into a property which has a price at least as high as the value of the property the investor is leaving behind. Such properties are known as "upleg properties".
2. The upleg property must have at least as much debt against it as the property the investor is leaving behind. In the event that the debt is lower on the upleg property there is taxable "mortgage or debt relief", even if no cash is received by the investor.
3. The investor cannot receive property that is not "like kind". Any cash, tangible or intangible personal property, personal residence or dealer inventory property is considered to be unlike kind under Section 1031 and is taxable. (personal residences are given separate treatment under Section 1034).
An important note on popular "delayed exchanges" utilizing "accommodators" or "qualified intermediaries":
Investor/taxpayers are actually exchanging a "deed for a deed" with the accommodator or intermediary. The taxpayer, technically, never has possession of any of the funds realized from the sale of the property they are leaving behind. They deed their "old" property to the accommodator, who then legally closes the sale with the buyer. The accommodator then holds the funds until they are later used by the accommodator to purchase the upleg or "new" property. After the accommodator closes on the new property, they then deed it to the taxpayer. The difference between delayed exchanges and simultaneous exchanges is that in a delayed exchange the taxpayer goes out of title to their old property at a different time than they go into title on the upleg property (up to 180 days difference). This is where the services of the accommodator are necessary. Where there is a true, simultaneous, "deed for deed" exchange, no accommodator is required.
Please note two VERY IMPORTANT points from the foregoing:
· IN ORDER FOR THE TAXPAYER/INVESTOR TO DEFER GAIN HE OR SHE MUST NOT RECEIVE ANY CASH OUT OF THE TRANSACTION.
- THE INVESTOR/TAXPAYER MUST CREATE A TRANSACTION WHEREIN AN EVEN LARGER POTENTIAL TAX EVENT IS CREATED FOR THE PARTY WHOSE PROPERTY THEY ARE ACQUIRING! (The new property must cost more and have a bigger mortgage then their previous property.)
Information Provided Courtesy of The Nashville Team
