1031 Tax Deferred Exchanges
An Exchange is a transfer of property for other like-kind property.
Summary of 1031 Exchange Law
When property is held for use in a trade, business, or investment is exchanged for property held for the same purpose (like for like), no gain or loss is recognized.
The 1031 Exchange has essentially survived tax reform. There is one noticeable change going forward. Personal property such as art work, aircraft, collectibles, etc. will no longer be exchangeable. However real property will continue to be exchanged and there have been no changes to the 1031 Exchange Rules as we know them.
A. Motivations for Exchange
Many Other Advantages to Exchange
B. Three Basic Requirements for an Exchange
Like kind property must be exchanged for like kind property
- Investment property for investment property
- Income for income
- Investment for income
Unlike Property that does not qualify in an exchange:
- Personal residence
- Stocks and bonds
- Anything in the real property exchange that is NOT like kind (e.g. personal property).
You may Exchange Real Property for Real Property
- Single family residence for a duplex (SFR must be a rental property)
- Duplex for triplex
- Triplex for Fourplex
- Fourplex for a six unit apartment complex
- Industrial building for a commercial building
- Commercial building for raw land
- One parcel of real property for five parcels of real property
- Five parcels for one parcel of real property
- Real property located in the city for real property located in the country
- Real property in one state for real property in another state
- You CANNOT exchange US real property for real property in a foreign country.
C. The Property must be held for investment
The use of the property is not the criteria, but rather the intent of the taxpayer. If the property purchased for investment, then it may be exchanged for another property purchased for investment. If the property was purchased for use in a trade or business, then it must be exchanged for another property purchased for the use in a trade or business. You may also exchange vice versa.
D. There must be an actual reciprocal exchange of a deed for a deed
If the taxpayer receives anything other than a deed to the extent the taxpayer has gain they will be taxed.
E. Mortgage Boot
This provides the taxpayer an opportunity not to close the escrows concurrently. It has strict time limits and involves a third party called an accommodator or intermediary.
- If the taxpayer elects to do a delayed exchange, then they must identify the replacement” property within 45 calendar days of the close of escrow, in writing to the accommodator or intermediary.
- Identification would be by address or legal description in writing.
- In addition, from the close of escrow, the taxpayer must close the delayed exchange within 180 calendar days. This is not in addition to the 45 day identification period. The TOTAL time allowed from the close of escrow is 180 calendar days.
- If the taxpayer has a return during the 180-day period and the exchange has not closed, the taxpayer must obtain an extension of time to file their tax return. Any property the taxpayer acquires after they file their tax return is not considered like-kind property.
- Identification Options
The taxpayer has 3 options to identify the properties chosen.
- The taxpayer may identify up to three properties, withdrawing and adding during the 45 days after the close of escrow, but no more than 3.
- The taxpayer may identify MORE than 3 properties; however, the combined value of the identified properties cannot exceed 200% of the relinquished property.
- The tax payer may identify more than 3 properties and more than 200% of the relinquished value, as long as the taxpayer closes at least 95% of the fair market value of the properties identified.
- Accommodator or Intermediary
The person or entity plays a pivotal role in the delayed exchange. For your protection the accommodator must be trustworthy, or the taxpayer should obtain a bond or letter of credit to cover the funds.
- The “qualified” accommodator or intermediary enters into a written agreement with the taxpayer.
- A “disqualified” accommodator or intermediary would be:
- Any corporation or partnership in which the taxpayer has at least 10% ownership.
- Any person who has an “agent” for the taxpayer within the last two years. This would include the taxpayers Real Estate Agent.
- Family Members
- And former related parties
Duties of the Accommodator or Intermediary
- Cause the conveyance of relinquished property from the taxpayer to purchaser.
- Hold proceeds from the sale of relinquished property beyond actual or constructive receipt of taxpayer.
- Cause the conveyance of replacement property from the seller to taxpayer.
- In all investment property sales, always reserve the right of the taxpayer to accomplish and complete a tax-deferred exchange.
F. Reverse Exchanges
The Internal Revenue Service has announced a safe harbor for reserve like-kind exchanges under which they won’t challenge either the qualification of the property as replacement property or the treatment of the exchange accommodation titleholder as the beneficial owner if the property is held in a “qualified exchange accommodation agreement”.
- For a property to be held in a qualified exchange accommodation agreement it must meet the following requirements.
- Title must be held by an exchange accommodation title holder who is not the taxpayer and is subject to Federal income tax at all times from the date of acquisition until the property is transferred.
- At the time title is transferred to the exchange accommodation titleholder, it must be the taxpayer’s bonafide intent that the property is either replacement or relinquished property in an exchange that qualifies for non-recognition.
- No later than five business days after the transfer of title, the taxpayer and the exchange accommodation titleholder enter into a written agreement the property is being held to facilitate an exchange under Section 1031.
- No later than 45 days after title is transferred, the relinquished property is property identified.
- No later than 180 days after the transfer to title to the exchange accommodation titleholder, the property is transferred as either replacement or relinquished property.
- The combined time period that the relinquished property and the replacement property are held in the qualified exchange accommodation agreement does not exceed 180 days.
- The revenue procedure is effective for the qualified exchange accommodation arrangements entered into with an accommodation title holder that acquires ownership of property after September 2000.
G. New Rule for Section 1031 and Section 121
Effective October 22, 2004, the rules regarding Section 121, Exclusion of Gain on Sale of a Principal Personal Residence have been changed.
- If a taxpayer acquired property in a Section 1031 exchange, the Section 121 exclusion will NOT apply if the property is sold during the five-year period beginning on the date of the acquisition of the property.
- This means if a taxpayer defers gain using Section 10231 and then converts the property to a personal residence, etc., taxpayer must hold the property for at least five years before they can use the Section 121 exclusion. This prevents the taxpayer from exchanging, converting, living there two years as a principal residence and sheltering up to $500,000 in gain. Now the property must be owned for at least five years, two of which was used as the taxpayer’s principal residence.