One of the greatest opportunities to build wealth
and save taxes is Section 1031 of the Internal
Revenue Code of 1986, or commonly known as a
like-kind or deferred exchange.
A deferred exchange is an exchange in which you
transfer qualified property known as the ‘relinquished
property’ and receive qualified property
as consideration known as the ‘replacement
property’.
By completing an exchange, instead of a sale,
an investor can leverage all the equity in the
relinquished property into the replacement property
and defer the capital gain tax that would normally
be paid on a sale.
Two requirements must be met for a total deferral
of tax in an exchange are: 1) the property must
be like-kind and 2) the exchanger cannot receive
cash or other benefits, typically known as ‘boot’.
The receipt of non-like kind property and/or cash
and other benefits does not disqualify the exchange,
but the exchanger will pay capital gain tax on
the ‘boot’.
There are several important considerations for
an exchange:
- The exchange must be completed within strict
time limits. The Code states the exchanger
has 45 days from the date the relinquished
property closes to ‘identify’ potential
replacement property. The total transaction,
from close of the relinquished property to
purchase of the replacement property, must
take place within 180 days.
- The replacement property purchased should
have the same or greater value as the relinquished
property. The exchanger must reinvest all
of the equity in the relinquished property
into the replacement property and if debt
is an issue, the exchanger should obtain
the same or greater debt on the replacement
property as on the relinquished property.
- The properties involved in the exchange must
be investment or income producing property,
i.e. for the productive use in your trade
or business. Personal use property, such
as your home, does not fall under Section
1031 rules.
- Also, Section 1031 does not apply to exchanges
of stock in trade, inventory, property held
for sale, stocks, bonds, notes, securities,
evidences of indebtedness, certificates of
trust or beneficial interest, or interest
in a partnership.
Examples of qualifying property include:
- Bare land
- Commercial rental
- Industrial property
- 30-year leasehold interest
- Farm land
- Residential rental
- Professional office
- % interest in investment property
As stated above, the exchanger has a 45 day window
from the close of the relinquished property in
which to identify replacement property. Exchangers
have some flexibility in identifying more than
one property as their replacement property. These
options include:
- Identifying up to three replacement properties
without regard to their fair market value.
- Identifying an unlimited number of properties
provided the aggregate fair market value
of all the identified properties does not
exceed 200% of the aggregate fair market
value of all the relinquished properties.
- If the two options above are surpassed, the
exchanger must receive the replacement property
by the end of the exchange period that has
a fair market value of at least 95% of the
aggregate fair market value of all the identified
replacement properties.
As mentioned previously, the receipt of ‘boot’ does
not disqualify an exchange, but the exchanger
who receives ‘boot’ will generally
recognize gain to the extent of the value of
the ‘boot’. Some common examples
of ‘boot’ are:
- Cash received on an exchange
- Non-qualified
property such
as
stock received
- Relief
from debt is treated as cash received
- Personal
use property received
Section 1031 allows several variations of exchanges
such as a simultaneous, delayed, build-to suit
and reverse exchanges. Exchanges require the
use of a “Qualified Intermediary (QI)” to
execute or facilitate the exchange. The IRS does
not allow the exchanger to possess or hold title
to both properties simultaneously in an exchange.
The QI become an actual principal in the transaction
and holds title to either the relinquished or
replacement property until the exchange is complete.
Other than deferment of taxes, there are several
advantageous reasons why one might want to initiate
a Section 1031 exchange.
Some of these may be,
Exchange from/to:
- A fully
depreciated property to a higher value property
that can be depreciated
- Property that cannot
obtain financing
to property that can.
- Non-income producing property
to rental property
- A higher cash flow producing
property
- For location and/or lifestyle
requirements
- Several small properties for
one larger property (management
issues)
Section 1031’s rules are strictly construed
and do not extend beyond the words or the underlying
assumptions and purposes of the exception to
capital gain treatment.
Always consult with your tax advisor before entering
into a like-kind exchange in order to ensure
that all of the requirements of Section 1031
are satisfied.
Tax Topic provided by Dottie L. Lloyd, Tax
Manager, Jones & Company, Ltd.
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