In the summer of 1990, the Internal Revenue Service announced the long awaited rules on Tax Deferred Exchanges. Section 1.1031 of the IRS Code laid out in detail the procedure for turning a sale and purchase type transaction into an Exchange. The revised rules allow owners of certain types of “like kind” real estate to sell their investment or income producing property and buy other “like kind” property while deferring the Capital Gains Tax.
The “like kind” provision for Real property is quite broad and includes land, rental and commercial property; any of which can be exchanged for the other. The “like kind” provision for personal property is more restrictive.
Although Section 1.1031 of the Internal Revenue Service Code is a complicated statute (the intricacies of which should be left to a competent tax advisor), a basic understanding of its general principles is very important to most property owners and real estate professionals.
What qualifies for a 1031 Exchange?
The “classification” of properties exchanged determines if the property qualifies for Section 1.1031 treatment.
A. The IRS’s 4 classifications of Real Estate:
- Property held for personal use (Personal/Real Property)
- Property held primarily for sale (Dealer Property)
- Property held for productive use in a trade or business (Business or Commercial Property)
- Property held for investment (Investment Property)
The last two qualify for Section 1.1031 tax deferral; the first two do not. Both the property received and the property sold must be of “Like Kind”. It is the use of the property that determines its classification. What the other party does with the exchanged property does not affect your tax status.
B. Like-Kind Property
- “Like kind” refers to the use of the property and not to its grade or quality.
- “1031” property may be mixed as to type and still be like-kind. As an example, you may exchange land for a duplex, or a commercial building for a retail store, etc.
- Property held outside the USA and its territories does not qualify for exchange with property held within the USA.
C. Partnership Interests
Your interest in a partnership cannot be traded for an interest in another partnership. Exception: The partnership “as an entity” can exchange real estate it owns for other like-kind real estate.
D. Transfer between Spouses
There are no income tax consequences in entering into financial transactions between spouses. In addition, most transfers incident to a divorce are tax free. However, transactions with a former spouse are normally subject to tax unless they qualify for “non-recognition” under the provisions of Section 1.1031.
Elements of an Exchange
For an exchange to be totally tax deferred the reinvestment in the replacement property or properties must meet all of the following rules.
Rule 1: Replacement property must have an equal or greater “Acquisition Cost” than the adjusted selling price of the relinquished property.
Rule 2: All of the “Cash” received from the transfer of the relinquished property must be reinvested.
Rule 3: Replacement property should have a new or assumed “Mortgage Total” that is equal to or greater than the debt paid off on the relinquished property – or new cash may be added to offset the difference.
Rule 4: Exchanger shouldnot receive non-like property – including owner held notes, cash or personal property.
“Five Critical Elements” It is critical that the exchanger comply with the strict requirements for an exchange. The requirements for the control of the funds and the time limits for identification and receipt of the replacement property are the primary emphasis in a properly executed exchange. The five critical elements are:
A. Intent : It should be the intent (documented in writing) of the investor from the start through the completion of the entire transaction that the disposal of one property and the acquisition of another are meant to be a 1031 Exchange.
B. Form and Documentation : To properly reflect the transaction as “an Exchange” and not as a “Sale”, close compliance to the documentation requirements of the regulations is necessary at each step.
C. Control of funds : At no time in the exchange process can the Exchanger or their Agent, have any control or otherwise obtain any benefits from the cash held in the exchange escrow account.
D . Like kind Properties: The properties exchanged must be investment or commercial properties that meet the “like kind” criteria.
E. Time Limits: The replacement exchange property must be identified within 45 days of Settlement of the relinquished property, and then settled within 180 days. There are no extensions.
“Establishing Intent” Whenit is established from the start that he owner intends to dispose of the property as an Exchange, it is desirable to list the property as a 1031 Exchange. If later the owner decides not to complete the Exchange, then there are no tax or legal consequences.
Balancing the Exchange
When property is sold, it is important to make the distinction between “realized” gain and “recognized” gain. Realized gain is defined as the net sales price minus the adjusted tax basis. Recognized Gain is the taxable portion of the realized gain. The common objective in a tax deferred exchange is disposing of a property containing significant realized gain and acquiring a “like kind” replacement property so there is no “recognized gain”. In order to defer all capital gains taxes, an Exchanger must “balance the exchange” by acquiring replacement property that is the same or greater value as the relinquished property, reinvest all net equity and replace any debt on the relinquished property. A reduction in debt on the replacement property can be offset with additional cash. The Exchanger can calculate recognized gain based on the following principles:
• Taxable “Boot” is defined as “non-like kind” property the Exchanger may receive as part of an exchange. “Cash boot” is the receipt of cash and “mortgage boot” (also referred to as debt relief) is a reduction in the Exchanger’s mortgage liabilities on a replacement property. Generally, capital gain income is recognized (and therefore taxable to the extent there is a “Boot”.
• For an exchange to be fully tax deferred, the Exchanger must reinvest all equity and acquire property with the same or greater debt.
Example 1: The Exchanger is acquiring property of greater value, reinvesting the entire net equity and increasing the mortgage on the replacement property. There is no boot and no recognized gain.
Example 2: The Exchanger keeps $50,000 of the exchange proceeds, reinvesting only $150,000 as the down payment on the replacement property leaving $50,000 of “cash boot” which results in recognized (taxable) gain on only the $50,000. The remainder is tax deferred.
Example 3: The Exchanger acquires property at a lower value and while reinvesting all of the equity in the replacement property acquires less debt in the process. The $100,000 reduced debt (mortgage boot) results in recognized (taxable) gain.
Properly executing the parameters of an exchange can be a challenging proposition. The rules are intolerant and must be followed to the letter. Many accounting firms, title companies and realtors can recommend an expert in executing these transactions.
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