What is a 1031 exchange?
What is a 1031 exchange? To put it very simply, a 1031 exchange is a legal loophole.
- A 1031 exchange is allowed by IRS regulations.
- The 1031 name came from the IRS Code Section 1031.
- In 1991 the IRS issued "safe harbor" regulations which clarified and established approved procedures for exchanges under the section.
- The IRS issued additional 1031 safe harbor guidance in 2000.
The 1031 exchange allows an investor that wants out of one or more investment properties, and wants to remain invested, to exchange the property or properties they don't want for one or more similar properties, which he or she would like to hold - without paying federal income taxes (if properly structured). Or in some cases, the investor only has to pay a small amount of taxes - to the extent cash is received or debt reduced.
A 1031 exchange is tax saving strategy not a tax avoidance strategy but a tax deferred strategy. In other words, since the investor does not "cash out," he is not required to pay federal taxes (capital gains taxes) while he remains invested. The amount of any taxes to be paid is a function of how much an investor's equity is reduced. Of course, what starts out as a very simple concept can and often does become a very complicated transaction or series of transactions.
Disadvantages of a section 1031 exchange include a reduced basis of depreciation in the replacement property. To put it simply the tax depreciation basis of the new property will be the purchase price of the new property (normal situation) reduced by the profit deferred as a result of the transaction.
For example, assume that the property being sold had original tax basis of $200,000, which has been depreciated down to $125,000. If the property is sold for its current market value resulting in a profit of $275,000 after selling expenses. The "profit" on a non-exchange sale would be the difference between the depreciated basis ($125,000) and the sale price less selling expenses ($275,000) or $150,000. Now if a new $305,000 property were purchased following the guidelines to qualify as a 1031 exchange the tax depreciation basis of the new property would not be $305,000 (the purchase price) but rather $155,000. This is less of a problem as long as one is trading even or trading up but results in less depreciation if one is trading down. The Rule of thumb: trade across or up, never trade down.
Please contact me. Let me represent you. I can help you with your property sale, purchase, and 1031 exchange.
The first and most important thing to remember is that in order to qualify for the tax savings afforded by a 1031 exchange one must follow the rules. The deal must be structured and handled in accordance with IRS regulations.
Second, the properties being exchanged must be "like kind" "qualified property." Unfortunately, a personal residence does not qualify. Incidentally, there are different sets of IRS regulations, which offer tax advantages on the sales of personal residences - see tax savings on personal residences. Other non-qualifying types of property are corporate common stock, bonds, notes, partnership interest, property purchased for resale, and land underdevelopment. Qualifying property is property (or equipment) held for use in ones business or for investment purposes. Investment property would include real estate held for investment or income production.
The original concepts of the 1031 exchange revolved around the concept that two parties (two party exchanges) could perform a simultaneous exchange of "like kind" properties of equal value and defer federal income taxes. One can see the difficulty of finding two individuals with "like kind" properties of nearly the same value, each of which wants to simultaneously exchange (simultaneous exchange), their respective property for that of the other individual. Such a transaction is a rarity.
The exchange concept developed even further to include transactions in which multiple individuals or groups of individuals would perform exchanges.
What is like kind property? With regard to real estate the interpretation is rather broad - improved or unimproved real estate held for income, investment, or business use. But, one can not exchange income, investment, or business use real estate property with personal property or with a taxpayer's personal residence.
A third important point is that the ownership form utilized before and after the exchange must remain the same - for example if property is held by a partnership, LLC, or an individual before the exchange, it must be held by the same legal entity immediately after the exchange.
Currently, the exchange process and the laws have developed to the point that the seller or sellers and buyer or buyers typically are not directly exchanging with each other and the transactions are not occurring at the same time (simultaneously). These changes have vastly expanded the usability of the 1031 exchange process. For example, party A may sell his rental property to B with the intent of deferring the tax on the profit from the sale (incidentally B may or may not himself be doing a 1031 exchange). A proceeds to buy "replacement" property from C to reinvest his funds and complete the 1031 exchange. The "replacement" (purchase) may occur either before or after the sale (exchange). In order to accomplish a delayed exchange (exchange sold first) or reverse exchange (exchange property sold after replacement purchase), A must use the services of an intermediary.
This is very important, if funds are received by A from the sale of his exchange property or title to his replacement property is received A can not go back and institute an agreement with an intermediary and give the respective funds or title to the intermediary. A would have lost his chance to use a 1031 exchange. An agreement for purchase or sale can be made before an intermediary agreement is made. But, the intermediary agreement must be in place and the (purchase or sale) contract assigned before the (any) closing occurs.
With a delayed exchange, the intermediary first receives the funds from the sale of the exchanged property. With a reverse exchange, the intermediary first takes title to the replacement property purchased. If you are considering a 1031 exchange notify your real estate agent when listing your property for sale or interring into a purchase agreement.
In difference to a simultaneous exchange where the sale (exchange) and purchase (replacement) occur simultaneously, the delayed and reverse exchange the sale and purchase transactions occur at different times. A delayed exchange is one in which the replacement (purchased) property is closed on at a later date than the closing on the exchange (sold) property. A reverse exchange is one in which the "replacement" (purchased) property in closed on before the closing on the exchange (sold) property.
Also, there is also a special form of exchange called an improvement exchange, in which, one desires to acquire a property and arrange for construction of improvements on the property before it is received as replacement property. This can be done either as a delayed or reverse structured exchange.
The reason for improvement exchanges is that the IRS regulations do not allow the purchaser of a property to expend funds on up grading the property after taking title and include the expenditures as part of the 1031 exchange. If the improvements are made prior to taking title then they become part of the basis of the acquired property. The scope of improvement exchanges have been hampered by the year 2000 IRS guidance which indicated that the improvement exchanges as well as reverse exchanges must meet the 180 day rule - the reverse exchange must be completed (take title to the replacement property) within 180 days. It is difficult to complete large construction projects with in the 180-day time period.
Regarding timing or time clocks, there are various tasks that must be accomplished within scheduled time frames (5-day rule, 45-day rule, and 180-day rule). That is if one wants to afford themselves of the benefits (reduced risk of an adverse tax ruling) of compliance with the IRS "safe harbor" guidance. Although compliance with the safe harbor guidelines is not mandatory, it would be risky at best not to comply.
When property (replacement or exchange depending on whether delayed or reverse exchange) is identified during the 45-day period, there are additional rules which must be complied with - the three-property rule, 200% rule, and 95% rule.
IRS regulations are somewhat simple as to who can be an intermediary - it can not be the taxpayer or a disqualified entity. Disqualified entities include accounts, attorneys, and real estate agents that, acting in their professional capacity, have served the taxpayer within the prior two years. I want to be your real estate agent, your Realtor®, not your intermediary. I will be glad to help you sell and purchase property. I can also advise you on some potential entities to be your intermediary.
What happens when one trades down? First a taxable profit is generated. The "excess" funds (cash) one receives on the sale (exchange) of his property over and above the funds expended to purchase (replace) the property to complete the exchange is called "boot". This "boot" will be taxable income.
For example, if A sells his rental property for $350,000 dollars and buys a smaller place for $250,000 (assuming all cash transactions), A will have realized a $100,000 cash gain or boot. The $100,000 is taxable income (assuming his cost basis on the exchanged property was below $250,000).
One should also be aware that, there are special rules for related party exchanges including a two-year holding period. In addition to the more obvious family members, there is a list of other entities, which are considered "related" such as:
- Two partnerships if the same persons either directly or indirectly own more than 50% of both entities.
- Two corporations that are more than 50% owned by the same controlled group.
There are other items, which can generate taxable income or "boot" on a 1031 exchange including receipt of non-like kind property and reduction in debt. The various types of boot producing actions and boot offsets are topics in themselves - see boot.
This discussion is meant to give one a brief overview of a powerful tax deferment technique - the 1031 exchange. Should one determine that they might want to utilize this technique, a more thorough study of the matter should be undertaken before any action is taken. One source of information is IRS publication 544.
Please contact me. Let me represent you. I can help you with your property sale, purchase, and 1031 exchange.