What is a 1031 Tax Deferred Exchange? Simply stated, a 1031 Exchange is a rollover of equity of like properties. Under section 1031 of the Internal Revenue Code, a taxpayer may completely defer payment of taxes by trading, rather than selling his or her real estate. A 1031 exchange is an opportunity for the seller and buyer of investment property, or property used in a trade or business, to save in taxes and leverage income growth. Free 1031 Q and A Booklet Selling a business or investment property typically requires payment of capital gains taxes. The tax bill can be heavy depending on the property's appreciation in value and length of time depreciated. However, under the 1031 Exchange, capital gains can be deferred or avoided if you "exchange" the property through a "Qualified Intermediary", i.e. a Title Company or a Realty Exchange Company. How to go about a 1031 Exchange:
The properties do not have to close at the same time. The taxpayer has 45 days after the settlement to find replacement property(s) and 180 days (or before taxes are due that year) to settle on the new property(s). The Intermediary should be financially strong with knowledge to make the transaction hassle and worry-free. You may want to search for a Realty Exchange Corporation. The taxpayer's agent, broker, attorney, accountant, or family member is excluded as an intermediary. What is the benefit of not paying taxes now?
Frequently Asked Questions about 1031 Tax Deferred Exchanges Q. Is the 1031 exchange a tested concept ?
2. Develop an investment profile of alternative "Replacement" property. 3. Balancing of equities. 4. Calculation of realized and recognized gain. 5. Calculation of carry over basis in replacement property
2. Trade up or even in value. 3. Trade up or even in equity. 4. The taxpayers motivation must be to exchange. 5. The taxpayer can not have access to or have constructively received transaction funds. 6. The transaction must be structured as an exchange. 7. Identification and closing time requirements must be strictly adhered to.
If you hold title to your 1031 property with one or more persons as co-tenant owners, each of you having an individual interest, but you have filed a partnership return, then you must determine whether the partnership or the individual title owners should enter into the exchange agreement. Before proceeding with the exchange, this matter should be resolved with tax counsel. More "I was involved in a good many 1031 Exchanges when I was practicing real estate and also had a number of my tax clients involved in exchanges. Below is a primer I wrote a number of years ago. It needs a little work but the fundamentals are there. Feel free to use it." "Saul Klein" Methods of Exchanging Real Property In order to properly understand the procedures and methods of tax deferred exchanging, it is important to understand the basic structure of the tax law and in some cases, the history behind its development. Tax law is evolutionary in nature. It can be broken down into 4 basic areas. 1. Internal Revenue Code as amended 2. Treasury Regulations, constantly changing to keep up with the amended Code 3. Rulings, developed around specific situations 4. Case Law, the courts interpretation of the Code, Regulations, and Rulings It is easy to see why the tax law is evolutionary. As congress continues to amend the Code to accomplish social and economic agendas, the entire body of tax law grows. The current Code leaves us with few tax shelter vehicles. The primary ones are: 1. Interest deductions on up to two personal residences 2. Retirement accounts 3. Schedule C for self employed individuals with proper record keeping 4. Investment real estate Keep in mind that rules differ from personal use real estate to investment real estate as we discuss some of the basic concepts necessary for the understanding of exchanging. Types of income 1. Active - salaries, wages, business profits 2. Portfolio - interest, dividends, royalties 3. Passive - limited partnerships, rental real estate Passive loss limitations If you earn under $100,000 modified adjusted gross income and you "actively participate" in the management of the property, you can deduct up to $25,000 in losses, the balance are "suspended", to be used the following years or upon disposition of the property. The deduction is phased out between $100,000 and $150,000, $1,000 in deduction for every $2,000 of income. Basis This is an important concept. You can't calculate the capital gain unless you know the basis. Original Cost + Capital Improvements - Allowable Depreciation Gift - donors basis or fair market value, which ever is less Inheritance - fair market basis at death Property received in exchange - fair market value less deferred gain Capital Gain Difference between the adjusted selling price and the adjusted basis. Capital gain is divided into three categories. Realized Gain - actual gain, reported in year of sale Recognized Gain - taxable gain, taxed now Deferred Gain - tax is deferred, taxed later reduces basis of property received in exchange Depreciation Theoretical drop in the value of an asset for tax purposes only. A non-cash expenditure. Treated as a deduction but reduces basis, which will result in a larger capital gain. This taxed depreciation is said to be "recaptured". The period over which the property is depreciated is called the recovery period and has changed many times over the years. Residential income property - 27.5 years All other income property - 31.5 years Optional recovery period - 40 years Under the Tax Reform Act of 1986, real property depreciation is straight line taken over the life of the asset. Under the Economic Recovery Tax Act of 1981 (1981), depreciation could be accelerated to the early years. This was known as "accelerated cost recovery system" or ACRS. Each new owner establishes a new depreciable basis based on cost of acquisition minus any deferred gain. Land is considered indestructible and is not depreciable. The value of the land must be determined and subtracted from the basis of the property to arrive at the depreciable basis. Exchanging Why exchange real property? To save taxes, yes, but said more succinctly, to build your estate with pre-tax dollars. Using proper exchange techniques results effectively in interest free loans from the government. Other reasons to exchange include: Increasing depreciable basis by acquiring property encumbered with a larger debt. Acquiring sheltered income by exchanging for unimproved land for improved property. Acquiring property without cash, when sales may be impossible. Consolidating assets by exchanging many properties for one larger property. Receiving nontaxable cash by exchanging and refinancing after and independent of the exchange. Diversifying holdings without tax consequence. Sell $150,000 Buy $ 50,000 Gain $100,000 Tax Brkt 30% Tax $ 30,000 Balance to invest: $70,000 Leveraged 4 to 1 results in a purchase of $280,000 10% annual appreciation results in $28,000 If you structured the sale in accordance with section 1031, and did not have to pay the taxes at that time, you could invest the entire $100,000 leveraged 4 to 1 and purchase a $400,000 property. At 10% appreciation, your increase in equity is $40,000. Multiply this $12,000 equity buildup over a 20 year investment horizon and the result is substantial. Internal Revenue Code Section 1031 No gain or loss shall be recognized if property held for investment is exchanged solely for a property of like kind to be held either for : 1. Production of income 2. Investment 3. Productive use in trade or business Property must be of "like kind." This means real property for real property, personal property for personal property. "Like kind" is broadly defined, that is, all real estate qualifies regardless of the "grade or quality." It is the "nature or character" of the property (realty or personalty) and not the name of the improvements (office building, apartment, hotel, etc) that determines "like kind". This was emphasized in Commissioner of Internal Revenue v. Chrichton. This case involved the exchange of mineral interests and improved real property. The mineral interests were held to be like kind property because under state law they were considered real property. In a subsequent revenue ruling, the IRS indicated that water rights also met the like kind test. Property not qualifying 1. Stock in trade 2. Partnership interests 3. Stocks, bonds, notes 4. Dealer property Multiple Properties Nothing in Section 1031 prevents a taxpayer from exchanging out of or into multiple properties. Tax Consequences Exchanges can be fully deferred or partially deferred. Any unlike kind property received in the exchange is considered boot and is recognized (taxable) in the year of the exchange. Boot is: 1. Cash or the equivalent of cash 2. Any unlike kind property 3. Mortgage relief 4. Any combination of the above Cash paid offsets mortgage relief boot. The lower of the gain or the boot is taxable in the year of the exchange. For a completely tax deferred exchange you must trade up in equity, value, and loan. Basis of Property Received This is referred to as substitute basis and is the Fair Market Value of the property received minus the deferred gain (or plus any deferred loss). The Process As it is in any real estate transaction, you must first identify the objectives of the property owner. What do they want to accomplish? Management problems, lack of control, cash flow, tax concerns; sometimes the owner is not sure of all the circumstances and it may take some time and counseling to make the determination. A basic requirement is that all participants receive the same value that they give. The end result should be that there are as many winners as there are participants. Determination of value to the participants in a real estate exchange is not complete without considering the improvement the transaction will make in the owner's life. The analysis must take into consideration the personal circumstances of the participants lives. Two Party Exchange As mentioned before, to structure a completely tax deferred exchange, the investor must acquire property (properties) with equal or greater equity and a larger fair market value than the property transferred (up in equity and value). This assumes that there is gain realized and that the taxpayer pays boot and assumes a larger loan. Example: Mr. Smith owns an industrial property valued at $372,000 with a loan of $351,000. His basis is $355,000. He exchanges with Ms. Jones apartment complex which is valued at $420,000 and has a $381,000 loan against the property. His basis is $392,000. Step 1: Balance the Equities Basic Structures of a Multiparty Exchange The very common three party exchange is comprised of a sale and an exchange, or an exchange and a sale. The information contained here are in no manner intended to be interpreted as tax or legal advice or counsel. |
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