Taxpayers frequently enter into a Section 1031 Exchange instead of a traditional sale to avoid the often substantial capitals gains and recaptured depreciation tax obligation due as the result of gains realized upon the sale of real and personal property held for productive use in a trade, business or for investment. If the transaction meets all the requirements of a Section 1031 Exchange, any tax due on the gains realized as a result of the exchange are deferred. Understanding how a Section 1031 Exchange differs from a traditional sale, as well as a full understanding of the rules required for a transaction to qualify for a 1031 Exchange, is essential to taking advantage of the capital gains deferral offered by the exchange.
A Sale vs. 1031 Exchange
In a traditional sale, a seller sells a property and receives the income from the sale at the time of closing. The seller may then decide to purchase another property at the same time or at a later date, but the transactions are separate and distinct. In a Section 1031 Exchange, a seller must both sell and purchase a replacement property as part of one cohesive plan. The transaction will not qualify for Section 1031 treatment unless a replacement property is either identified or acquired by the 45th calendar day following the original property sale. If identified, the purchase of the replacement property is completed within 180 days of the original sale. The Tax Court summed up the concept in Bezdjian v. Commissioner, T.C. Memo 1987-140 by stating “if the Taxpayer’s transfer and receipt of property were interdependent parts of an overall plan the result of which was an exchange of like-kind properties, 1031 applies.”
The use of a Qualified Intermediary is another 1031 exchange requirement that is important to understanding how a Section 1031 Exchange works. Because the transaction is an exchange, not an outright sale, the proceeds from the original sale should never actually be available to the seller as is the case in a traditional sale. Instead, the proceeds are held by a Qualified Intermediary to be used for the purchase of the replacement property. Likewise, the deed for the replacement property must be held by the Qualified Intermediary until the exchange has been completed. Using a Qualified Intermediary is found in the safe harbor rules and “will result in a determination that the taxpayer is not in actual or constructive receipt of money or other property for purposes of section 1031,” according to Regulation 1.1031(k)-1(g)(6).
Finally, it is important to understand that Section 1031 is mandatory. As the court held in U.S. v. Vardine, 305 F.2d 60 (1962), “1031 and its predecessor are mandatory, not optional; a taxpayer cannot elect not to use them.” Although in most cases it is in the taxpayer’s best interest to invoke the benefits of a 1031 Exchange, there may be times when a taxpayer may not wish to do so. As the court pointed out, however, Section 1031 is mandatory.
Complimentary Downloads
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