Tax-Deferred Exchange
A tax-deferred exchange (otherwise known as a “1031 exchange” referring to the tax code section pertaining to exchanges of property or “tax-free exchange” and a misleading title since the tax is actually deferred and not free“) can be used as a means of avoiding immediate taxation on the gain from a rental property by deferring the gain into a replacement property.
Reasons to Exchange: Structuring a transaction so that it meets the requirements of Section 1031 can offer many benefits to a taxpayer, including:
(1) A taxpayer can acquire a property without the availability of a great deal of cash.
(2) A tax-free exchange allows greater creativity to a taxpayer in converting a business property into personal-use property. The exchange allows a taxpayer to acquire a property suitable to personal use prior to conversion.
(3) Exchanges put off the payment of tax on a transaction. The effect is like getting an interest-free loan from the government.
(4) The problem of “excess of mortgage over basis” is avoided. When a mortgage exceeds basis, the excess is ordinary income in the year of sale when the installment method is used. This is not true with an exchange.
Business or Investment Use Requirement - To qualify for a Sec 1031 exchange, the properties exchanged must both be held for business or investment use.
Like-Kind Requirement - The properties exchanged must be like-kind (similar in nature, but not necessarily of the same quality). Real estate must be exchanged for real estate (improved or unimproved qualifies).
Caution: Sometimes real estate is held in a partnership or other entity. Generally, an entity ownership does not qualify as like-kind. Although, tenant-in-common interests (sometimes referred to as TICS), if structured properly, can. Please contact this office for details.
Property Acquired with Intent to Exchange - If a taxpayer acquires (or constructs) property solely for the purpose of exchanging it for like-kind property, the IRS says that the taxpayer doesn’t hold the property for productive use in a trade or business or for investment, and as to the taxpayer, the exchange doesn’t qualify for non-recognition treatment under Code Sec. 1031.
Simultaneous or Delayed - The exchange can be simultaneous or delayed. If delayed, the property received in the exchange must be identified within 45 days after the property given is transferred. No matter how many properties are given up in an exchange, a taxpayer is allowed to designate a maximum of either:
(a) Three replacement properties regardless of FMV, or
(b) Any number of properties, as long as the total FMV isn’t more than 200% of the total FMV of all properties given up.
If a taxpayer identifies replacement properties over these limits, he/she is treated as if none were identified. A taxpayer can, however, revoke an identification at any time before the end of the 45-day time period.
The receipt of the new property must be completed before the EARLIER of:
(1) 180 days after the transfer of the property given, OR
(2) The due date (including extensions) of the return for the year in which the property given was transferred.
Qualified Intermediary – Generally, to qualify for a delayed Sec 1031 exchange, a qualified intermediary is engaged to hold the funds from the sale until the replacement purchase is made. It is important to understand that the taxpayer cannot take possession of the proceeds form the sale and then buy another property. If that happens, the event does not qualify for exchange and is immediately taxable.
Reverse Exchanges – It is possible to structure a reverse exchange that complies with the Section 1031 delayed exchange requirements. However, it requires that the replacement property be purchased first, by the intermediary, without the benefits of the proceeds from the property given up in the exchange. Thus, only taxpayers with the cash financial resources can accomplish reverse exchanges.
Tax-deferred exchanges can be very tricky and should not be entered into without first analyzing the tax aspects. Exchanges are actually equity exchanges, and if a taxpayer reduces their equity position (takes out cash or boot in the exchange), then the gain might not be deferred and the expense of structuring an exchange wasted. As a rule of thumb, if a taxpayer moves up in property value and up in equity in the property, there is a taxable event. Please call this office before initiating the transaction.
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