“Does a 1031 exchange make sense?” is a common question investors and business owners ask themselves when selling property. The answer is that it depends on a number of facts including how long the asset has been held, what is the taxpayer’s adjusted gross income, is the taxpayer married or an individual, what is the recognized gain or tax due on the sale and finally, is the intent to replace the asset? If the responses are that a 1031 exchange does make sense, what are the tangible benefits?
Andy Gustafson
1031 Exchange Business Assets
A 1031 exchange is used to defer federal and state capital gain and recaptured depreciation taxes when selling real and personal property given like-kind property is replaced within 180 calendar days of the initial closing. The sale is grouped into asset or product classes including real property, tangible and intangible personal property. Good will is not eligible for a 1031 exchange. Should the business owner be the lessor of a thirty year or more lease, the lease is considered real property and can be replaced with a real property fee interest.
Earnest Money Deposits and 1031 Exchange
In a 1031 exchange, real property earnest money deposits, extension or option payments are recognized as an act of good faith of the Buyer’s intent to acquire the subject property. Following guidelines is especially important in a 1031 exchange so as not to violate the g(6) limitations of constructive receipt of the Internal Revenue Code Section 1.1031. Constructive receipt is when the taxpayer has access or possession of the funds at the time of the exchange as denoted by the closing date and the fact that property ownership has been conveyed to the Buyer. One of the primary roles of the Qualified Intermediary is to hold the earnest money deposit and exchange proceeds for the taxpayer and use them towards the replacement property purchase.
Relinquished Property Sale
When the taxpayer or exchangor sells their relinquished or old property, they will typically receive an earnest money deposit. The taxpayer has two options. The first is to hold those funds and at closing either deposit with escrow, the title company, Qualified Intermediary or keep them. Once the closing is completed and the earnest money deposit is kept, the earnest money deposit is taxable.
In a 1031 exchange, if the goal is to defer 100 percent of the realized gain, then the net equity plus the debt retired must be replaced in the new property. If this is not the intent, then the best time to receive cash is at the closing in what is referred to as a partial 1031 exchange. Whenever the replacement property is 50 to 60 percent of the relinquished property, it probably does not make sense to initiate a 1031 exchange. The tax on the 50 to 40 percent will be close to the tax that would be paid if a 1031 exchange is not initiated.
Replacement Property Purchase
In a 1031 exchange, the taxpayer will acquire replacement property and place an earnest money deposit with escrow or title company. The funds can come from the taxpayer or wired from the exchange proceeds. If adequate exchange funds are available, the earnest money deposit can also be reimbursed at closing given the taxpayer made the deposit with non-exchange proceeds. Should exchange funds be used to provide the earnest money deposit, the taxpayer must sign an Assignment of the Purchase and Sale Agreement with the Qualified Intermediary prior to the disbursement. If the sale were to fall through and the earnest money deposit was provided from exchange proceeds, then the earnest money deposit should be returned to the Qualified Intermediary to avoid constructive receipt.
Soft Costs
In addition to the earnest money deposit, the taxpayer may also ask for the Qualified Intermediary to make other payments associated with the replacement property purchase. Only capitalized expenses associated with the replacement property are to be paid either by the Qualified Intermediary or at closing by escrow or title company. It is best to confirm with your CPA whether the expenses are recognized as capitalized costs. These soft costs typically include architectural, appraisal, environmental and permits. If the CPA is not sure, then it is best to pay these with non-exchange fees to avoid the possibility of taxable boot. If the expenses are typically found on the closing statement, then they may be paid by the Qualified Intermediary without a taxable impact.
There are many rules to follow when initiating a 1031 exchange. Those taxpayers who take a cautious approach will help themselves avoid the potential of a taxable outcome. To learn more about 1031 exchanges, download a free “1031 Exchange Checklist” by clicking here.
1031 Exchange and Primary Residence
Real and personal property held for stricly personal use does not qualify for a 1031 exchange tax deferral of federal and state capital gains and depreciation recapture taxes. However, property, such as a primary residence converted to a rental and held as an investment property for two years, will qualify for a 1031 exchange. Personal property, including collectibles, vintage cars and artwork, qualifies for the tax deferral given the property is “held for productive use in a trade, business or investment” as supported by maintaining detailed ledgers recording sales and acquisitions, invoices, insurance and expense records.
1031 Like Kind Exchange Explained
The 1031 like kind exchange target persona is an individual or corporation who owns real or personal property held for productive use in a trade, business or investment and subject to US federal and state capital gain taxes. The target market will defer $3.7 billion in federal capital gain taxes in 2013 according to the Joint Committee on Taxation. Do you own land, improved property or tangible and intangible personal property, including aircraft, construction equipment, livestock, gold and silver bullion, collectibles, vintage cars or artwork? When selling, is your intention to replace with another like kind property? If selling real property, like kind means any type of real property, including a lessee’s interest in a thirty year lease. If selling personal property, the replacement personal property must be like kind or like class, as in bull for bull, gelding for a male horse or silver bullion for silver bullion.
Two Party 1031 Exchange
In a two party 1031 exchange, the taxpayer conveys the relinquished or old property to the buyer and the replacement property is conveyed from the buyer to the taxpayer. These types of exchanges are somewhat rare, given the likelihood that the taxpayer and the buyer want each other’s property. Properties are almost never the same value; consequently the taxpayer may pay tax on that portion of cash or retired debt that is not replaced. Nonetheless, these transactions do qualify as 1031 exchanges and do not require a qualified intermediary to accommodate the two party 1031 exchange.