As a Qualified Intermediary accommodating 1031 exchanges, I am often asked the question how to determine the capital gain when selling the replacement property when the property was originally acquired in a previous 1031 exchange. My first response is to gather your settlement statements before contacting your CPA who is familiar with your past federal tax returns. The goal is to determine the realized gain of the property to be sold that will ultimately be used to determine the recognized gain or tax due.
Andy Gustafson
1031 Exchange and Partnership Interests
Taxpayers who own real property in a business or for investment consider a 1031 exchange when selling and replacing with “like-kind” property. The alternative is to pay the federal and state capital gain and depreciation recapture tax that can represent up to 40 percent of the sales price. A 1031 exchange defers or postpones the recognized gain or tax due if a series of rules are followed. The tax is eventually due when the replacement property is sold and another 1031 exchange is not initiated. The 1031 exchange allows those otherwise paid tax dollars to be used as interest free working capital towards the replacement property acquisition.
Ineligible for 1031 Exchange
Any real property held in the productive use of a business or for investment is eligible for 1031 consideration. Land can be exchanged for commercial property or a multitude of other types of real property. The following is ineligible for a 1031 exchange:
- Primary residence
- Indebtedness
- Inventory
- Stocks and Securities
- Partnership Interests
Partnership Interests
The legal definition of partnership interest is “an association of two or more persons to carry on as co-owners a business for profit.” Partnerships may contain individuals or corporations. In 1984, partnership interests were excluded from non-recognition treatment under Internal Revenue Code § 1031; however, there are a couple of exceptions.
Revenue Ruling 99-6
Per the Omnibus Budget Reconciliation Act of 1990, “an interest in a partnership that has in effect a valid election under Internal Revenue Code (I.R.C.) Section 761(a) to be excluded from the application of all of subchapter K is treated for purposes of I.R.C. § 1031 as an interest in each of the assets of the partnership and not as an interest in a partnership.”
Revenue Ruling 99-6 allows a taxpayer in a 1031 exchange who is already a partner in the partnership to purchase all of the remaining interests of the other partners in the partnership. For example, if Jack and I are 50/50 partners in a partnership that owns the replacement property, Jack who has initiated a 1031 exchange, can buy my interest as replacement property. Under Revenue Ruling 99-6, the acquisition is treated as if the partnership first liquidated, then Jack, acquired a 50 percent interest in the underlying real estate.
Revenue Ruling 99-5
Per Rev Ruling 99-5, “if a taxpayer owns 100 percent of a disregarded LLC and the taxpayer sells a portion of the LLC interests to a buyer, the taxpayer is treated as if it first sold an undivided interest in the assets of the LLC and the taxpayer and the buyer then contributed their undivided interests to a new partnership. Therefore, the sale of the LLC interests by the taxpayer could be structured as an exchange by the taxpayer of an undivided interest in the underlying property.” A buyer acquiring a portion of the LLC interests is considered as a contribution to the new partnership, qualifying the LLC interests as replacement property in a 1031 exchange given the buyer acquires the interests to hold in the productive use of a business or for investment and not for flipping or for profit.
Drop and Swap
Partnerships experience challenges when, following the decision to sell the underlying property, one partner wants to cash out and the other wants to defer the gain in a 1031 exchange. The same taxpayer requirement of the 1031 code requires the taxpayer who sells to be the taxpayer who buys. With proper planning as far in advance of the purchase and sale agreement, one option is to dissolve the partnership, dropping title from the partnership to the individuals or tenants in common. Once as tenants in common, one taxpayer can cash out while the other taxpayer defers their gain in a 1031 exchange.
Dissolving the partnership should be reviewed with your CPA or tax attorney. Attention should be given to IRS Form 1065, questions 13 and 14. Dropping too close to the closing date may cause the IRS to question the 1031 exchange given the short time the new titleholders hold the property.
Download “Ten Reasons Why a 1031 Exchange Makes Sense” by clicking here.
Four Key 1031 Exchange Insights
Taxpayers use a 1031 exchange to defer federal and state capital gain and depreciation recapture taxes when selling and replacing real and personal property held in the productive use of a business or investment. If a 1031 exchange is not initiated prior to or on the day the relinquished or old property is closed, then a tax that can represent up to 40 percent of the sales price is triggered and due in the year the taxpayer files their federal tax return. For the new investor, understanding the rules of a 1031 exchange can be a challenge. What follows is a review of four issues that may not be adequately explained by the Qualified Intermediary (QI) who facilitates the 1031 exchange.
1031 Exchange and 2014 Capital Gain Tax Rates
Taxpayers selling and replacing real and personal property held in the productive use of a business or investment utilize a 1031 exchange or Internal Revenue Code Section 1031 to defer federal and state capital gains and depreciation recapture taxes. Taxes that represent upwards of forty percent of the sale can be used to acquire the replacement property. In effect, the 1031 exchange is an indefinite, interest free loan. The taxes are ultimately due when the replacement property is sold and the taxpayer cashes out.
1031 Exchange Rules in 2014
Smart investors and business owners utilize a 1031 exchange when selling and replacing real and personal property held in the productive use of a business or for investment. The alternative to a 1031 exchange is to pay the federal and state capital gains and depreciation recapture tax, which can represent upwards of 40 percent of the property sales price. A 1031 exchange allows the taxpayer to use those otherwise paid dollars towards the replacement property purchase. If the 1031 exchange rules are not strictly followed, the outcome can be a disqualification, tax payment, interest on the tax not paid, penalty and drama of an IRS audit.
QI Expectations When Initiating a 1031 Exchange
When a taxpayer engages a Qualified Intermediary (QI) or Certified Exchange Specialist® (CES) to accommodate their 1031 exchange tax deferral, they should know what to expect. This article provides an overview or roadmap for the steps of the 1031 exchange. An Internal Revenue Code (IRC) Section 1031 exchange allows the taxpayer to defer the federal and state capital gain and depreciation recapture when selling real or personal property held in the productive use of a business or investment when exchanged for property to be held in the productive use of a business or investment. Primary residences, partnership interests, indebtedness, inventory and stocks and securities are not eligible for 1031 consideration.