Joseph Aucoin posted on July 25, 2014 14:18
What is a 1031 tax-deferred exchange?
A 1031 tax-deferred exchange is a method allowed by Internal Revenue Code (IRC) §1031, whereby an owner of certain investment or business property may defer paying capital gains taxes on the sale of such property if the owner acquires "like kind" property within a certain period of time.
What property qualifies as "like kind" property?
All real estate held for investment or business purposes may be considered "like kind" to any other real estate held for investment or business purposes. For example, raw land can be exchanged for an apartment building. The Exchanger must be able to demonstrate that both the property being sold (the "relinquished property") and the property being bought (the "replacement property") is held for business or investment purposes.
Note that stocks, bonds, partnership or LLC interests, personal residences or inventory do not qualify as like kind property.
Basic Terminology of 1031 Exchanges
* Exchanger - is the taxpayer who is electing to defer the capital gains by effecting a 1031 exchange.
* Buyer - is the person who is purchasing the property the Exchanger is selling.
* Seller - is the person who owns the property the Exchanger is buying.
* Qualified Intermediary - is a neutral party (it may be an individual or an entity and it can not be the Exchanger's accountant or attorney) who facilitates the exchange by holding the proceeds from the sale of the relinquished property and then uses such proceeds for the purchase of the replacement property. The QI also provides all the proper documentation to preserve the integrity of the exchange in case of an audit.
* Relinquished property - is the property the Exchanger is selling in the exchange.
* Replacement property - is the property the Exchanger is buying in the exchange.
* Boot - is any non like kind property received in the exchange (i.e. cash, debt relief.) Boot is taxable.
Motives for Exchanging
* Defer paying capital gains taxes.
* Exchange several smaller hard to manage properties for one larger easier to manage property.
* Exchange a partial interest in one property to a full interest in another.
* Exchange to a property an investor may use in his own practice (i.e. a doctor could sell a rental property and buy an office building he may use for his practice.)
* Exchange raw land for rental property to generate cash flow.
* Exchange depreciated property to higher value property that can be depreciated.
* Exchange a rental property in Boston for a rental property in Florida, which later serves as a retirement home.
Mechanics of a 1031 Exchange:
The Exchanger assigns his interest in the P&S Agreement to the QI. The QI receives the net sale proceeds so that the Exchanger does not have actual or constructive receipt of the funds. The QI holds the net sale proceeds until they are needed for the close of the replacement property.
What must I do in order to defer paying all capital gains taxes?
In order for an Investor to defer all capital gains taxes, there are four general guidelines that must be followed:
1. The replacement property must be equal to or greater in value.
2. The debt on the replacement property must be equal to or greater in value.
3. The equity in the replacement property must be equal to or greater in value
4. All net proceeds must be used to acquire replacement property.
To the extent that the value, debt or equity on the replacement property is less than the value, debt or equity on the relinquished property, the Exchanger may have taxable boot.
Are There Time Limitations to Complete an Exchange?
An Exchanger must identify the replacement property within 45 days after the sale of the relinquished property and close on the replacement property within 180 days after the close of the relinquished property.
Can I buy a replacement property before I sell my relinquished property?
This is known as a "reverse exchange." Although IRC §1031 and its regulations do not provide guidelines and do not explicitly recognize reverse exchanges, with careful structuring and planning, reverse exchanges can be a viable option.
How are Transactional Costs Handled?
Some transactional costs paid by the Exchanger reduce realized and recognized gain and increase the tax basis of the replacement property. For instance, if the Exchanger receives $15,000 cash back in the exchange but applies $10,000 to the brokerage commission, the Exchanger will recognize only $5,000 taxable income and $10,000 will be added to the tax basis of the replacement property. Practitioners suggest that other transactional costs may also be deducted if paid in connection with the exchange. These costs typically include commissions, transfer taxes, finder's fees, title insurance premiums, legal fees, intermediary fees, and recording fees.
Where are the sale proceeds held?
The sale proceeds are held in a federally insured joint account which require both the signature of the Exchanger and the signature of Greater Boston Exchange Company, LLC.
In What Tax Year is the Exchange Reported?
The Exchanger must file Form 8824 for each tax year property was transferred to another party in an exchange. In addition, Form 4797 must be filed for depreciable property and Schedule D for non-depreciable property in the year the relinquished property is sold.