1031 exchange
From Wikipedia, the free encyclopedia
- For a variation of the 1031 Exchange, see Tenants in common 1031 exchange
A 1031 Exchange, also known as a Like Kind Exchange or Starker Tax Deferred Exchange (named for an investor who challenged and won a case against the IRS) is a transaction under United States law which specifies under section 1031 of the Internal Revenue Code, 26 U.S.C. § 1031the following:
- "No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment."
This allows taxpayers to defer all of the capital gains taxes resulting from the sale of investment property, when they use a Qualified Intermediary, follow the IRS guidelines, and use the proceeds of the sale to buy more investment property within 180 days of their sale. In order to obtain full benefit, the replacement property must be of equal or greater value, with equal or greater debt, unless the taxpayer adds cash to the deal to replace debt instead, and all of the proceeds from the relinquished property must be used to acquire the replacement property. The taxpayer must have assigned his interest in the relinquished property to a Qualified Intermediary prior to the close of the sale, so that the taxpayer has lost control of the funds before he has any opportunity to obtain them.
At the close of the relinquished property sale, the proceeds are sent by the closing agent to the Qualified Intermediary, who holds the funds until such time as the transaction pertaining to the replacement property is ready to close. Then the proceeds from the sale of the relinquished property are deposited by the Qualified Intermediary to purchase the replacement property, which is then delivered to the taxpayer, all without the taxpayer ever having "constructive receipt" of the funds.
The prevailing idea behind 1031 Exchange is that since the taxpayer is merely exchanging one property for another property(ies) of “like-kind” there is nothing received by the taxpayer that can be used to pay taxes with. All the gain is still locked up in real estate and so no gain or loss can be claimed.
Contents |
[edit] Boot
Although it is not used in the Internal Revenue Code, the term “Boot” is commonly used in discussing the tax implications of a 1031 Exchange. Boot is an old English term meaning “Something given in addition to.” “Boot received” is the money or fair market value of “Other Property” received by the taxpayer in an exchange. Money includes all cash equivalents, debts, liabilities or mortgages of the taxpayer assumed by the other party, or liabilities to which the property exchanged by the taxpayer is subject. “Other Property” is property that is non-like-kind, such as personal property, a promissory note from the buyer, a promise to perform work on the property, a business, etc.
There are many ways for a taxpayer to receive “Boot”, even inadvertently. It is important for a taxpayer to understand what can result in boot if taxable income is to be avoided.
The most common sources of boot include the following:
- Cash boot taken from the exchange. This will usually be in the form of "Net cash received", or the difference between cash received from the sale of the relinquished property and cash paid to acquire the replacement property(ies). Net cash received can result when a taxpayer is "Trading down" in the exchange (i.e. the sale price of replacement property(ies) is less than that of the relinquished.)
- Debt reduction boot which occurs when a taxpayer’s debt on replacement property is less than the debt which was on the exchange property. As is the case with cash boot, debt reduction boot can occur when a taxpayer is "Trading down" in the exchange.
- Sale proceeds being used to pay non-qualified expenses. For example, service costs at closing which are not closing expenses. If proceeds from the sale are used to service non-transaction costs at closing, the result is the same as if the taxpayer had received cash from the exchange, and then used the cash to pay these costs. Taxpayers are encouraged to bring cash to the closing of the sale of their property to pay for the following: Non-transaction costs: i.e. Rent perorations, Utility escrow charges, Tenant damage deposits transferred to the buyer, and any other charges unrelated to the closing.
- Excess borrowing to acquire replacement property. Borrowing more money than is necessary to close on replacement property will not result in the taxpayer receiving tax-free money from the closing. The funds from the loan will be the first to be applied toward the purchase. If the addition of exchange funds creates a surplus at the closing, all unused exchange funds will be returned to the Qualified Intermediary, presumably to be used to acquire more replacement property. Loan acquisition costs (origination fees and other fees related to acquiring the loan) with respect to the replacement property should be brought to the closing from the taxpayer’s personal funds. Taxpayers usually take the position that loan acquisition costs are being paid out of the proceeds of the loan. However, the IRS may take the position that these costs are being paid with Exchange Funds. This position is usually the position of the financing institution also. Unfortunately, at the present time there is no guidance from the IRS on this issue which is helpful.
- Non-like-kind property which is received from the exchange, in addition to like-kind property (real estate).
[edit] Boot tips
Always trade "Across" or up. Never trade down. Trading down always results in boot received, either as cash, debt reduction or both. The boot received can be off-set by qualified costs paid by the Exchanger.
Bring cash to the closing of the replacement property to cover loan fees or other charges which are not qualified costs. (See above)
Do not receive property which is not like-kind.
Do not over-finance replacement property. Financing should be limited to the amount of money necessary to close on the replacement property in addition to exchange funds which will be brought to the replacement property closing.
[edit] Time limits
IRS rules control the length of time that the replacement property must be held before it may either be sold or used to enter into a new tax deferred exchanged. In highly appreciating markets, people may take the opportunity of selling their personal residence (where no capital gain is due below $250,000 for a single person or $500,000 for a married couple) and moving into a former rental property for a specified time period in order to turn it into their new personal residence, and thus avoid capital gains taxes.
In order to qualify for this exchange, certain rules must be followed:
- Both the relinquished property and the replacement property must be held either for investment or for productive use in a trade or business. A personal residence cannot be exchanged.
- The asset must be of like kind. Real property must be exchanged for real property, although a broad definition of real estate applies and includes land, commercial property and residential property. Personal property must be exchanged for personal property. (There are some complicated rules surrounding this -- for example, livestock of opposite sex are not considered like kind property for the purpose of a 1031 exchange.)
- The proceeds of the sale must be invested in a like kind asset within 180 days of the sale. However, the property must be identified within 45 days, but up to three properties may be identified.
[edit] Time Limits and difficulties involved in meeting them
In a 1031 Delayed Exchange the clock begins ticking when the relinquished property closes. All properties that will be used as replacement property for the exchange must be identified in writing before the end of the identification period, which is limited to 45 days.
All replacement property purchases must be closed before the end of the exchange period, which is limited to 180 days.
Frequently, the most difficult component of a 1031 exchange is identifying a replacement property within the first 45 days following the sale of the relinquished property. The IRS is strict in not allowing extensions.
A 1031 exchange is similar to a traditional IRA or 401K retirement plan. When someone sells assets in tax-deferred retirement plans, the capital gains that would otherwise be taxable are deferred until the holder begins to cash out of the retirement plan. The same principle holds true for tax-deferred exchanges or real estate investments. As long as the money continues to be re-invested in other real estate, the capital gains taxes can be deferred. Unlike the aforementioned retirement accounts, rental income on real estate investments will continue to be taxed as net income is realized.
An alternative to a 1031 exchange for someone who wants to defer capital gains tax, but who does not want to continue to hold property is a structured sale. This method offers both buyer and seller many benefits and is regarded as ideal for those looking to retire from or exit from the real estate or business market.
[edit] Examples of a 1031 exchange
An investor buys a strip mall (a commercial property) for $200,000. After six years he could sell the property for $250,000. This would result in a gain of $50,000 on which the investor would have to pay a capital gains tax, but, if he invests the proceeds from the $250,000 sale in another property, then he would not have to pay any taxes on the gain at that time.
An owner of a detached house on 3 acres is transfered by his employer to another state. Rather than selling the home, which will no longer be his personal residence, he chooses to rent it out for a period of time. After ten years, he decides that he wants to sell it but, at the same time, he has a grown son who will be going to college in yet another state. He decides that he wants to buy an apartment building in the college town for the son and other students to rent while they are in school. His house has appreciated from $200,000 to $300,000. Therefore, he arranges for an IRC 1031 Exchange, and buys the new property, thus avoiding the capital gain at that time.
