An Introduction to 1031 Tax-Free Exchanges
COURTESY OF JULE HERBERT, ATTORNEY AT LAW
THE BASICS
IRS Section 1031 provides that the exchange of certain types of property will not result in the recognition of gain or loss: “No gain or loss shall be recognized if property held for productive use in a trade or business or for investment purposes is exchanged solely for property of a like-kind.” Of course, it is usually difficult to find someone who has the property you want who is willing to accept the property you wish to relinquish. Direct barter has its inefficiencies. Fortunately, by using a “qualified intermediary,” a taxpayer can convert what would otherwise be a sale and subsequent purchase into an exchange with no recognition of gain.
The properties exchanged and received must be of “like-kind” and must be held either for investment or for productive use in a trade or business. “Delayed exchanges” allow, if properly structured, for a taxpayer to transfer property now and acquire new property at a later date and still qualify for the benefits of a tax-free exchange. A “qualified intermediary” is an entity who holds the funds from the closing on the taxpayer’s relinquished property and then provides those funds for the purchase of the replacement property at the appropriate time and place.
CAPITAL GAINS TAX RATES
Many taxpayers suppose that the so-called Taxpayer Relief Act of 1997 lowered the long-term capital gains rate from 28% to 20%. This is true only for property that the taxpayer has not depreciated (a vacant lot, for example). For property that has been depreciated, long-term capital gain in the upper bracket is taxed at 20% for the “appreciated” gain (the gain from the difference of the original basis and the net selling price). The balance of the gain will be taxed at 25% or even 28% if accelerated depreciation was used by the taxpayer. In any case, property held for less than 12 months faces a capital gains rate of 28%. You may also owe capital gains taxes at the state level.
DOES YOUR PROPERTY QUALIFY FOR 1031 TREATMENT?
There are four basic “uses” of property according to the IRS. These uses and examples of common terms or typical actual uses under these classifications are:
Property held for personal use or consumption. (Primary residence; vacation property. However, proper advanced planning can easily convert the use of vacation property to income-producing property.)
Property held primarily for re-sale. (Inventory of a developer.)
Property held for productive use in a trade or business. (Business or Rental property, “income-producing” property.)
Property held for investment. (Vacant lot; perhaps property bought and held in anticipation of market demand changes.)
Uses “3” and “4” qualify for 1031 tax deferral. And, yes, investment property can be exchanged for income-producing property. For example, a vacant lot or an office building can be exchanged for a beachfront condominium.
A taxpayer may even change the use of the property under certain rules and circumstances so that at the time of the exchange it is being held for a qualified use. Property held outside the United States and its territories does not qualify for exchange with property held within the U.S.
STEP BY STEP PROCEDURES AND TIME PERIODS
Decide prior to signing a contract or sale and purchase agreement that you wish to do a 1031 exchange. If your property is listed with a broker, be sure to advise the broker of your intent and furnish your broker with language to be inserted into any offer assuring the buyer’s willingness to cooperate with you in the exchange. (Technically, as long as your contract may be assigned to a qualified intermediary, you need no special language in your agreement. It is customary, however, to put the buyer on notice and get his agreement to cooperate in the exchange. Under current regulations his cooperation is not normally needed.)
Choose a “qualified intermediary.” This person or entity must not be a “disqualified person” or anyone acting as “agent” for the taxpayer. Check IRS Regs. Section 1.1031(k)-1(k). Enter into an Exchange Agreement with the intermediary prior to the closing date. You may wish to have your CPA or your personal attorney review this document prior to signing it.
At the closing on the relinquished property, you execute a deed and sign closing papers. Funds go to the “qualified intermediary” under terms of the Exchange Agreement between you and the intermediary.
Your 45-day deadline for identifying replacement property begins to run on the date of the closing on the relinquished property. No extension is allowed if this date happens to fall on a Saturday, Sunday or legal holiday.
Under regulations issued by Internal Revenue Service for IRC 1031 tax-deferred exchanges, there are stringent requirements regarding the identification of replacement property in a deferred exchange. You should independently confirm that the closing actually occurred on the date you signed the closing documents.
Identification of all replacement property must be made in writing, must be signed by you, and must be delivered to the intermediary on or before the 45th day. You may not identify replacement property after the 45th day.
Enter into written, assignable purchase agreement(s) to purchase the identified property or properties.
The intermediary should give you forms that will allow you to assign these contracts to the intermediary. Normally these are included with the exchange agreement.
You may identify as many as three (3) properties, regardless of their total value (the “3-property rule”), or you may identify any number of properties provided their aggregate fair market value on the 45th day does not exceed 200% of the aggregate fair market value of all your relinquished property on the date of its transfer (the “200% rule”). If you stay within these rules, it is not required that you acquire all the property you identified.
You may identify any type of real property – single-family rental, condominium, duplex, apartment building, hotel, office building, warehouse, commercial building, vacant land, etc., -- to be held for productive use in trade or business or investment. You may identify property in any state or territory of the United States or the District of Columbia. You should trade even or up in value, both as to equity and debt. Remember the IRS treats the forgiveness of a debt as income.
Once you have made timely identification of replacement property or properties for your deferred exchange, there is another important time restriction: Closing on all replacement property must be completed by the earlier of:
180 days from the transfer of your relinquished property; or
The due date for your federal tax return (including extensions) for the year in which your property was relinquished (or in event of multiple exchange properties for the year in which the first such property was relinquished).
If your relinquished property was transferred after October 17, but before the end of the year and your income tax return is due April 15, then this would be the deadline for receiving all replacement property, even though it is less than 180 days. If your exchange is in this category and you want to have the full 180 days, you may request an automatic extension of time to file your return. Consult your accountant in ample time to have a request for extension filed on your behalf.
Advise your intermediary of the closing date and agent, and confirm that the closing agent has received the funds.
Receive title to the replacement property; receive any boot; pay any additional funds needed to close.
Report the details of the transaction on your annual tax return.
** COURTESY OF JULE HERBERT, ATTORNEY AT LAW
