Introducing The 1031 Exchange
The main idea behind the 1031 Exchange is that since the taxpayer is exchanging one property for another property or properties so that the seller’s profit is not taxed. A 1031 Exchange,is sometimes known as a Like Kind Exchange, is a way of setting up a sale of certain kinds of properties of like-kind there is nothing received by the taxpayer that can be used to pay taxes.
The Relinquished Property has to be a Qualifying Property. Property that qualifies is property or equipment held for investment purposes or for the tax payers business. Investment property includes real estate, improved or not, held for investment or income purposes. Property that is used in a taxpayer’s business includes the office or place of doing business, along with equipment used in the business. Real estate has to be replaced with like kind real estate, and equipment has to be be replaced with like-kind equipment.
Properties That Do Not Qualify For A 1031 Exchange are:
– Personal residence
– Land under development for resale
– Construction or fix for resale
– Property bought for resale
– Inventory property -Corporation stock
-Bonds
-Notes
-Partnership interests
Common stock might include ditch stock that is sold with farm land.
The title has to be be in the same name as the relinquished property. If a husband and wife own property in jointly, the replacement property must be deeded to both of them, either as joint tenants or as tenants in common. Corporations, partnerships, limited liability companies and trusts have to be on the title on the replacement property, the same as they were on the relinquished property.
The 1031 Exchange is possibly the most powerful investment tool available to property owners and it has become the preferred investment vehicle for real property investors who want to defer capital gains.
The foundation of 1031 exchange rule by the IRS is that the properties involved in the transaction must be “Like Kind” and both properties have to be held for a productive purpose in business or trade, as an investment.
In the 1031 Exchange Rule, a property transaction can only qualify for a deferred tax exchange if it follows the 1031 exchange rule laid down in the US tax code and the treasury regulations.The 1031 exchange rule also lays down a guideline for the proceeds of the sale.
The second major rule is that the 1031 exchange requires that the replacement property must be subject to an equal or greater level of debt than the property sold or the buyer will be forced to pay the tax on the amount of decrease.
All 1031 exchanges must be handled through a qualified Intermediary and not through you or your agents or your proceeds will immediately become taxable
The 1031 exchange BEGINS on the date that the deed records. The 1031 Exchange Rule says: A property transaction can only qualify for a deferred tax exchange if it follows the 1031 exchange rule laid down in the US tax code and the treasury regulations.
The Exchange Period: This is the period within which a person who has sold the relinquished property must receive the replacement property. The replacement property must be “identified” within 45 days after the sale of the old property and the acquisition of the replacement property must be completed within 180 days of the sale of the old property.
The 45-Day Rule is for Identification. The first timing restriction for a delayed Section 1031 exchange is for the taxpayer to either close on replacement property or to identify the replacement property within 45 days from the date of transfer of the exchanged property.
The 45-Day Rule is satisfied if the replacement property is received before 45 days are up. Otherwise, the identification must be by written document (the identification notice) signed by the taxpayer and hand-delivered, mailed, faxed, and sent to the chosen Intermediary. The identification notice has to contain a detailed description of the replacement property. This includes the legal description, street address or a name.
After 45 days, limits are put on the number of potential Replacement Properties that can be received. More than one replacement property can be identified with one of the following three conditions:
The Three-Property Rule – Any three properties regardless of their market values.
The 200% Rule – Any number of properties; as long as the fair market value of the replacement properties does not exceed 200% of the aggregate FMV of all of the exchanged properties as of the first transfer date.
The 95% Rule – Any number of replacement properties; if the fair market value of the properties actually received by the end of the exchange period is at least 95% of the aggregate FMV of all the potential replacement properties listed.
Although the Regulations only require written notification within 45 days, it is recommended that a solid contract is in place by the end of that 45-day period. Otherwise, a taxpayer may find themselves unable to close on any of the properties that are listed under the 45-day letter.
After 45 days have expired, it is not possible to close on any property which was not identified in the 45-day letter. Failure to submit the 45-Day Letter will cause the Exchange Agreement to terminate and the Intermediary will return all of the unused funds in his possession to the taxpayer.
. The 180-Day Rule is for showing receipt of the Replacement Property according to the 1031 exchange (IRS) rule, the 180 day time line has to be adhered to under any and all circumstances and is not extend-able in any situation, even if the 180th day falls on a Saturday, Sunday or a legal holiday.
The replacement property must be received and Exchange completed no later than the earlier of 180 days after the transfer of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the exchanged property was transferred.
The logistics and process of selling a property and then buying another property are almost identical to any standard sale and buying situation, a 1031 exchange is different because the whole transaction is treated like an exchange and not just as a simple sale. So in simple terms, sales are taxable with the IRS and 1031 exchanges are not.
To make it easy to understand, when purchasing a replacement property without the benefit of a 1031 exchange your buying power is reduced, this means that it only represents 70-80% of what it did previously before the exchange and payment of taxes.
From the sale of a relinquished real estate property, we should understand this concept so that we can completely defer the capital gain taxes. The total purchase price of the replacement like kind property must be equal to, or greater than the total net sales price of the relinquished, real estate, property.
All the equity received from the sale of the relinquished real estate property, must be used to get the replacement,like kind property. The IRS tax code does NOT allow for the exchanger to exchange into a property already owned. Again,be sure to pay attention to the 45/180 day deadlines because failure to observe these time frames will invalidate your 1031 exchange
The Disadvantages of a Section 1031 Exchange includes a reduced basis for depreciation in the replacement property. The tax basis of replacement property is basically the purchase price of the replacement property minus the gain which was deferred on the sale of the relinquished property as a result of the exchange. The replacement property will include a deferred gain that will be taxed later if the taxpayer cashes out of his investment.
Basic Rules of Thumb;:
Always trade across or up. Never trade down. Trading down will always results in boot received, either cash, debt reduction or both. The boot received can be mitigated by exchange expenses paid out
Always bring cash to the closing of the relinquished property to cover the costs, which are not transaction costs
Do not accept or receive property that is not like-kind.
Do not over-finance replacement property. Financing should be limited to the amount of money needed to close on the replacement property and to exchange funds which will be brought to the replacement property closing.
It would be an understatement to say that 1031 exchange has become a driving force in commercial real estate sales transactions. For more information, consult with your tax adviser and Qualified 1031 exchange Intermediary before selling your investment property for optimal 1031 exchange benefits.