Purpose Of 1031 Exchanges
The purpose of Section 1031 of the Internal Revenue Code is to allow the investor to defer the taxes on the appreciation of capital normally recognized on the sale of real property. These taxes may be deferred if the property was held for investment or productive use in a business or trade and is exchanged for like-kind properties under certain conditions including: That the exchanger not have constructive use of the funds until the exchange is completed and that the transaction is completed within specific time frames.
Frequently people ask what services the facilitator provides. As every transaction is different the services vary. The listed services are included in every exchange and included in the fee which is charged only after the initial closing.
The same steps and services are provided for each property transaction involving a RELINQUISHED property and repeated for each REPLACEMENT property.
Basics Of 1031 Exchange
The first key is to note the difference between investment and personal property. Both types can be exchanged, but only for like-kind property. The IRS has chapters of confusing categories for personal property. Real property is land and those things permanently attached to it. Real property may be either personal or investment. Real property that you, a relative, or an agent have recently occupied may be considered personal property. Personal residential property is not investment property.
Any property that you have occupied as your primary residence will not qualify for tax deferral under Section 1031 until you have held it for investment or productive use in a business or trade. There are separate tax shelters for residential housing which are, in many ways, better than the breaks you get under Section 1031 for investment property. A comparison of these is provided in a later chapter.
These two types of property, personal residence and investment, may not be exchanged for each other in a tax-deferred exchange. Any land that you have held for investment or for productive use in a business or trade, and have not used recently for personal use, is considered held for investment and may be exchanged for any other land to be held for investment. Raw land is the same as a factory is the same as an apartment is the same as a rental house.
The IRS gets pretty particular when you are trading forms of ownership, and prohibits the trading of stocks, bonds, and interests in ownership of a company. Most of the things you can touch can be exchanged. A car for a car, a tractor for a tractor, a building for a building, a milkshake machine for a milkshake machine are all OK; but, you cannot trade a car for an airplane, nor a rental house for a business.
Section 1031 of the Internal Revenue Code allows for the exchange of non-owner occupied real property. Second homes, vacation condos, and recreational lots are a special group that is in a gray area. They are considered personal property and not eligible for tax-deferred exchanges unless your personal use of them amounts to less than ten per cent of the time they were rented or less than fourteen days in a year. They will cause scrutiny by the tax auditor, so be careful. The burden of proof is on you.
The second key concerns holding the property for investment or for productive use in a business or trade. The key here is how long you have held the property and how long you need to hold the replacement property. Again, there is no definitive answer from the IRS, but some guidelines have been developed through IRS requests of Congress and through court cases, which, if followed, will provide considerable degree of safety. Most people have held their investment property for several years in a fee simple form.
Property should generally be held for more than 12 months and preferably 18 months before it is actively marketed or any action is taken to convert the property to personal use. You can use this guideline on both ends, the relinquished property and the replacement property. In certain circumstances property can be held for less than a year, but that is the exception to the rule.
If relatives are involved, the timing is clear: two years. If either property transferred in an exchange involving relatives is disposed of within two years, the entire exchange is disqualified.
Related parties include not only brothers, sisters, parents, and lineal descendants, but C and S Corporation holders of more than 50%, corporate controlled members, 50% partner-to-partner attribution, and grantor of a fiduciary trust. Related parties must file form 8824 for two years following an exchange. Prohibited action by one related person will invalidate the tax deferral of the other party in a related party transaction. With relatives, specific language should be included to prevent the unilateral action of one from disqualifying the exchange benefits for the other.
The fourth issue is that an exchange take place. Exchanges differ from sale and purchase in several ways. The most important is the way the value is transferred. If the value is converted to cash which is available to the taxpayer, the IRS says the transaction cannot be distinguished from a sale and, thus, does not qualify as an exchange. For this reason, as much as any, facilitators came into existence.
The fifth key is that the property acquired must be of equal or greater value. For the tax on the gain to be totally deferred, the entire equity and at least as much mortgage liability must transferred from the relinquished property to the replacement property. If either equity or mortgage liability is less, you will be taxed on that amount or the amount of the gain, whichever is less.
Both the equity and mortgage liability must be equal or greater in the replacement property than they were in the relinquished property. Cash or other property received when the replacement property is of lesser value than the relinquished property is called boot. Remember "For your property I'll give you these five acres and a horse to boot." If either equity or mortgage is less than the item it replaces, a tax is levied on the lesser of the gain or the boot received.
Lower mortgage liability is called mortgage relief. This is considered a benefit to the taxpayer and thus is taxed. You may contribute cash to the transaction and offset mortgage differences. You may not take cash and increase the mortgage. After the transaction is completed you may refinance the newly acquired property and take cash out. No time frame has been set for this series of transactions. It would be advisable to wait a year before refinancing. Remember that your new cost basis has been established, and the IRS will get its due in the long run.
Boot is unlike property. In the terms of IRC 1031 boot is property not used for productive use in a trade or business or for an investment or unlike the property given up. Boot is taxed. Boot may be given or received. Boot is any property given or received in a tax-deferred exchange which does NOT qualify for non-recognition. This typically includes: cash, the assumption of liabilities, interest, and property taxes.
Gain to the EXCHANGER who receives boot is recognized (taxed) in an amount not to exceed the amount of boot received or the total gain, whichever is lesser. Loss is not recognized in an exchange.
The sixth key is that very specific time frames exist. This is the one area to which the IRS has given very good directions in the Regulations.
The Internal Revenue Service requires that qualified replacement property be unambiguously identified by the forty fifth day after closing of the relinquished property. This designation shall be in the hands of the facilitator, and the receipt date of the designation must be duly noted.
Closing on one, several, or all of the designated properties shall be completed by the 180th day after closing. This means when it is recorded. These dates are not negotiable.
There are three ways to designate. They are separate categories, and you may choose the category most applicable to your situation.
Most exchangers use the three property rule. Property acquired within the forty five day designation period is deemed to be properly designated.
Unambiguous designation means a specific street address, plat and lot, or metes and bounds. The designation "A lot on the north end of Bainbridge Island" would not qualify.
The seventh key is that both form and intent count when you are trying to prove that you deserve to defer the taxes on a transaction. Facts and circumstances are critical to demonstrating an exchange, but you must also demonstrate that you were attempting to live within the intent of the Code and Regulations.
As with any investment, including real estate transactions, investors should always consult with a qualified tax advisor to obtain the best advice for their own particular situation.
Definitions of Terms
IRC 1031: The Section of the Internal Revenue Code which specifies the terms and conditions under which the taxpayer may exchange certain types of property without recognition of capital gains taxes.
Exchanger: The taxpayer who has property which has appreciated in value which he wishes to exchange for other like-kind property and defer any capital gains taxes.
Like-Kind Property: Almost any real property (land and/or land with buildings) which is non-owner occupied.
Boot: Any un-like property received in an exchange, such as cash or mortgage relief in excess of the new mortgage.
Identification: The exchanger must transmit within 45 day of the closing of the relinquished property up to three potential replacement properties. Identification must be specific addresses or legal descriptions with any improvements detailed as clearly as possible.
Exchange Period: The exchanger has 180 calendar days in which to complete the entire exchange.
Facilitator: The company or individual who acts as a straw man in relinquishing the old property and acquiring the new properties, holds the funds, and ties the two transactions together.
Relinquished: The property held by the exchanger which he wishes to give up in the exchange for new property.
Replacement: The property to be acquired in the exchange. Any number of properties may be exchanged for any number of properties.
Mortgage Relief: Mortgage given-up or paid off on the property relinquished.
Mortgage Acquired: Mortgage assumed or taken to acquire the replacement property.
Delayed Exchange: When the old property is sold before the new property is acquired.
Simultaneous Exchange: When both relinquished and acquired properties close the same day.
Improvement Exchange: When the replacement property includes buildings to be built, or other improvements to be completed as part of the exchange. Usually done to balance the values of the acquired property with the relinquished property.
Equal or Greater Value: The replacement property must be of equal or greater net fair market value for the exchange to be fully tax-deferred.
Net Fair Market Value: The selling price of the property less all closing costs.
Adjusted Cost Basis: The cost of the property plus capital improvements, less depreciation and capital losses.
Capital Gain: The difference in value between the adjusted cost basis and the net selling price, not the amount of cash received.
Reverse Exchanges: When the exchanger acquires replacement property prior to closing on the relinquished property. This has never been approved by the IRS or adjudicated in court.
Capital Gains Taxes: Taxes due on the gain resulting from the sale of any capital asset. Calculated at the taxpayers ordinary tax rate, up to a maximum of 28%.
Example of a 1031
Because exchanges usually involve slightly greater costs than sales, and you are carrying forward a lower depreciation schedule, not every transaction should be an exchange.
To calculate your taxable gain add the original purchase price with capitalized closing costs to any improvements you have made. Subtract accumulated depreciation to determine the adjusted cost basis of your property. Subtract this adjusted cost basis and your one-time closing costs from the selling price to determine your capital gain.
|Capitalized Closing Costs
|Less Accumulated Depreciation
|Adjusted Cost Basis
|Less Selling Costs
|Net Selling Price
|Less Adjusted Cost Basis
Taxes due on Sale
|Depreciation Recapture @ 25%
|Capital Gain @ 15%
|Equity Before Tax
|Equity After Tax
If your goal includes investing in real estate, the paying of taxes when they could be deferred constitutes an Opportunity Cost. Tax deferral amounts to an interest-free loan from the government.
IRS Code-Section 1031
Federal Code Of the United States of America Section 19 IRC 1031. Exchange of property held for productive use or investment.
(a) Nonrecognition of gain or loss from exchanges solely in kind.
(1) In general. No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.
(2) Exception. This subsection shall not apply to any exchange of —
For purposes of this section, an interest in a partnership which has in effect a valid election under section 761(a) to be excluded from the application of all of subchapter K shall be treated as an interest in each of the assets of such partnership and not as an interest in a partnership.
(3) Requirement that property be identified and that exchange be completed not more than 180 days after transfer of exchanged property. For purposes of this subsection, any property received by the taxpayer shall be treated as property which is not like-kind property if —
(b) Gain from exchanges not solely in kind.
If an exchange would be within the provisions of subsection (a). of section 1035(a), of section 1036(a), or of section 1037(a), if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain, but also of other property or money, then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property.
(c) Loss from exchanges not solely in kind.
If an exchange would be within the provisions of subsection (a), of section 1035(a), of section 1036(a), or of section 1037(a), if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain or loss, but also of other property or money, then no loss from the exchange shall be recognized.
If property was acquired on an exchange described in this section, section 1035(a), section 1036(a), or section 1037(a), then the basis shall be the same as that of the property exchanged, decreased in the amount of any money received by the taxpayer and increased in the amount of gain or decreased in the amount of loss to the taxpayer that was recognized on such exchange. If the property so acquired consisted in part of the type of property permitted by this section, section 1035(a), section 1036(a), or section 1037(a), to be received without the recognition of gain or loss, and in part of other property, the basis provided in this subsection shall be allocated between the properties (other than money) received, and for the purpose of the allocation there shall be assigned to such other property an amount equivalent to its fair market value at the date of the exchange. For purposes of this section, section 1035(a), and section 1036(a), where as part of the consideration to the taxpayer another party to the exchange assumed a liability of the taxpayer or acquired from the taxpayer property subject to a liability, such assumption or acquisition (in the amount of the liability) shall be considered as money received by the taxpayer on the exchange.
(e) Exchanges of livestock of different sexes.
For purposes of this section, livestock of different sexes are not property of a like kind.
(f) Special rules for exchanges between related persons.
(g) Special rule where substantial diminution of risk.