Generally, if you exchange
business or investment property solely for business or investment property of a
like-kind, no gain or loss is recognized under Internal Revenue Code Section
1031. If, as part of the exchange, you also receive other (not like-kind)
property or money, gain is recognized to the extent of the other property and
money received, but a loss is not recognized.
In a typical exchange transaction, the property owner is taxed on any gain
realized from the sale. However, through a Section 1031 Exchange, the tax on
the gain is deferred until some future date.
The theory behind Section 1031 is that when a property owner has reinvested the
sale proceeds into another property, the economic gain has not been realized in
a way that generates funds to pay any tax. In other words, the taxpayer's
investment is still the same, only the form has changed (e.g. vacant land
exchanged for apartment building). Therefore, it would be unfair to force the
taxpayer to pay tax on a "paper" gain.
"Like-Kind Properties" are of like-kind, if they are of the same
nature or character, even if they differ in grade or quality. Personal
properties of a "like class", are like-kind properties, however,
livestock of different sexes are not like-kind properties.
The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When
the replacement property is ultimately sold, the original deferred gain, plus
any additional gain realized since the purchase of the replacement property, is
subject to tax.
Section
1031 does not apply to exchanges of inventory, stocks, bonds, notes, other
securities or evidence of indebtedness.
What are
the benefits of exchanging vs. selling?
- A Section 1031 exchange is one of the few techniques available to postpone
or potentially eliminate taxes due on the sale of qualifying properties.
- By deferring the tax, you have more money available to invest in another property.
In effect, you essentially receive an interest free loan from the federal government,
in the amount you would have paid in taxes.
- Any gain from depreciation recapture is postponed.
- You can acquire and dispose of properties to reallocate your investment portfolio
without paying tax on any gain.
What are
the requirements for a valid exchange?
- Qualifying Property - Certain
types of property are specifically excluded from Section 1031 treatment:
property held primarily for sale; inventories; stocks, bonds or notes;
other securities or evidences of indebtedness; interests in a partnership;
certificates of trusts or beneficial interest; and chooses in action. In
general, if property is not specifically excluded, it can qualify for
tax-deferred treatment.
- Proper Purpose - Both the
relinquished property and replacement property must be held for productive
use in a trade or business or for investment. Property acquired for
immediate resale will not qualify. The taxpayer's personal residence will
not qualify.
- Like Kind - Replacement
property acquired in an exchange must be "like-kind" to the
property being relinquished. All qualifying real property located in the United States is like-kind. Personal property that is relinquished must be either like-kind
or like-class to the personal property which is acquired. Property located
outside the United States is not like-kind to property located in the United States.
- Exchange Requirement - The
relinquished property must be exchanged for other property, rather than
sold for cash and using the proceeds to buy the replacement property. Most
deferred exchanges are facilitated by Qualified Intermediaries, who assist
the taxpayer in meeting the requirements of Section 1031.
What are
the guidelines for a taxpayer to defer all the taxable gain?
- The value of the replacement
property must be equal to or greater than the value of the relinquished
property.
- The equity in the replacement
property must be equal to or greater than the equity in the relinquished
property.
- The debt on the replacement
property must be equal to or greater than the debt on the relinquished
property.
- All of the net proceeds from
the sale of the relinquished property must be used to acquire the
replacement property.
A Qualified
Intermediary is the professional provider of the mandatory mechanics of an
exchange. The use of a Qualified Intermediary, as an independent party to
facilitate a tax-deferred exchange, is a safe harbor established by the
Treasury Regulations. Sometimes Qualified Intermediary's are referred to as
"accommodators" or "exchange facilitators."
When the taxpayer engages the
services of a Qualified Intermediary, pursuant to an exchange agreement, the
IRS does not consider the taxpayer to be in receipt of the funds. The sale
proceeds go directly to the Qualified Intermediary, who holds them until they
are needed to acquire the replacement property. The Qualified Intermediary then
delivers the funds directly to the closing agent who deeds the property
directly to the taxpayer.
Without a
Qualified Intermediary, and pursuant to an exchange agreement, the IRS may not
define a transaction as an exchange, thereby making it ineligible for tax
deferment status.
A taxpayer
has 45 days after the date that the relinquished property is transferred to
properly identify potential replacement properties. The exchange must be
completed by the date that is 180 days after the transfer of the relinquished
property, or the due date of the taxpayer's federal tax return for the year in
which the relinquished property was transferred, whichever is earlier. If
the taxpayer does not meet the time limits, the exchange will fail and the
taxpayer will have to pay any taxes arising from the sale of the relinquished
property.