A 1031 exchange can be explained in three ways. It is when a real or personal property held as an investment or for use in a business is sold and replaced with like-kind real or personal property held as an investment or for use in a business. It is an interest free loan or tax deferral. It is a section of the Internal Revenue Code Section 1.1031.
Proper Intent
Each 1031 exchange is based upon intent and supporting facts. Intents can change based upon health, family, employment and, unforeseen circumstances regarding the property. The intent when entering a 1031 exchange must be to hold for productive use in a trade, business or for investment. Supportive facts include the time the replacement property is held, and how it was used and reported on federal tax returns.
The sale of a property followed by the acquisition of like-kind replacement property does not qualify for a 1031 exchange. A Qualified Intermediary (QI) must be engaged to prepare 1031 exchange documents supporting the exchange and hold the exchange proceeds in a manner that does not violate the (g)(6) limitations of the 1031 code. Constructive receipt is when the taxpayer has access to the exchange proceeds. In California, Washington, Oregon, Colorado, Virginia and Maine, state legislatures have passed laws requiring the QI to follow certain procedures, with one of those being a qualified escrow account to hold the exchange funds. The account is frozen and the funds cannot be disbursed without the signatures of the taxpayer and the QI.
Tax Deferral
A 1031 exchange–properly accommodated– defers federal and state capital gains and recaptured depreciation taxes that can total upwards of 40 percent of the sales price. Given a property sells for $300,000, the taxes could be $120,000. With a 1031 exchange, the tax can be deferred, delayed until the replacement property is sold and possibly deferred again as often as it makes sense. The deferred tax represents an interest free loan used towards the purchase of qualifying replacement property. The time value of money suggests that $100 of today’s money earning 5 percent will be worth $105 in one year. Applying that to $120,000 suggests the value will be worth $126,000 after one year.
IRC Section 1031
The Internal Revenue Code Section 1.1031 states per § 1031(a)(1) 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.
Section 1031 can be used by United States taxpayers and foreigners who pay taxes to the U. S. and exchange real or personal property. 1031 exchanges apply to a variety of property, from land, multi-family rentals, and motels to gold and silver, artwork, musical instruments, livestock and aircraft. Real property can be exchanged for any real property given the state recognizes the property as real. Personal property must be exchanged for like-kind or like-class personal property. U.S. based property must be exchanged for property located in the U.S., while property held overseas is 1031 eligible for property held internationally.
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