1031 Exchanges are a Powerful Tax Strategy
Tax-deferred exchanges have been a part of the tax code since 1921 and are one of the last signiﬁcant tax advantages remaining for business owners and taxpayers.
One of the key advantages of a 1031 exchange is the ability to dispose of a relinquished property without incurring a capital gain tax liability in the current tax year, thereby allowing the earning power of the deferred taxes to work for the beneﬁt of the taxpayer instead of the government.
Basic Tax Exchange Requirements
The IRS allows up to a maximum of 180 calendar days between the sale of the relinquished property and the purchase of the replacement property. Within the 180-day exchange period, the taxpayer must also properly identify suitable replacement property or properties by midnight of the 45th calendar day after closing on the sale of the relinquished property. There are a number of requirements which need to be met to qualify for tax deferral under the tax code:
Both the relinquished and replacement property must be held for investment or used in a business. The IRS uses the term “like-kind” to describe the type of real property that qualify for §1031 tax deferral. Virtually any real property held for investment can be exchanged for any other like-kind real property held for investment. This deﬁnition covers a vast variety of developed and undeveloped real estate. Properties which are clearly not like-kind real property are an investor’s primary residence or property held for sale. The relinquished and replacement properties need not have identical functions (i.e. both be residential rentals or commercial strip centers). The key issue is that the taxpayer should be able to substantiate that both properties were held for investment.
The IRS requires the taxpayer to identify the replacement property(ies) within 45 days from closing on the sale of a relinquished property. The 45-day identiﬁcation period begins on the closing date and the replacement property(ies) must be properly identiﬁed in a letter signed by the taxpayer. Taxpayers have a number of ways to properly identify properties. They may identify up to three replacement properties without regard to their total fair market value (Three Property Rule). Alternatively, they can identify an unlimited number of replacement properties, if the total fair market value of all properties is not more than twice the value of the property sold (200% Rule). A taxpayer cannot meet either of these rules if they acquire 95% of the aggregate fair market value of all identiﬁed replacement properties.
The most common exchange format, the delayed exchange, requires investors to work with an IRS-approved third-party principal called a qualiﬁed intermediary. The qualiﬁed intermediary documents the exchange by preparing the necessary paperwork (Exchange Agreement and other documents), holds the exchange proceeds on behalf of the taxpayer, and structures the exchange after an assignment of the sale and purchase contracts by selling the relinquished property and purchasing the replacement property.
Captail Gain Taxes
The capital gain taxes on a 1031 exchange are deferred into the future and are only recognized when a taxpayer actually sells the property for cash instead of performing a 1031 exchange. A taxpayer will then generally recognize gain if they have some taxable boot in a partially-deferred exchange. Investors can continue to exchange properties as often and for as long as they wish
To the extent that you do not exchange even or up in value and/or exchange even or up in equity and debt, you will have received non-qualifying property (“boot”) in your exchange. If boot is received, tax is computed on the amount of gain on the sale or the amount of boot received – whichever is lower.
The term “boot” refers to any property received in an exchange that is not considered like-kind. real property. Cash boot refers to the receipt of cash. Mortgage boot, which can also be referred to as debt relief, is a term describing a taxpayer’s reduction in mortgage liabilities on the purchase of a replacement property or properties. Personal property received or non-like kind property is also considered boot in 1031 exchange transaction as only real property held for productive use in a trade or business or held for investment qualifies.
If a taxpayer receives cash or other property in addition to like-kind property, this may result in a taxable event. To determine the taxes that may be due, several steps are required. See Asset Preservation’s article, Calculating Capital Gain for more details. First, the taxpayer’s tax advisor must calculate the realized capital gain. Next, the amount of boot, money or other property received, along with any depreciation recapture, must be determined.