A 1031 exchange is a Treasury Department Regulation and Section in the Internal Revenue Code that allows taxpayers to defer the capital gains and recaptured depreciation taxes when selling real and personal property held in the productive use of a trade, business or for investment. In addition to the exchange regulations and section 1031, Treasury and Internal Revenue Service issue rules and guidance including regulations on new legislation, revenue procedures, revenue rulings, private letter rulings, technical advice memorandums and chief counsel advice memorandums.
Form 8824
A 1031 exchange is reported along with the taxpayer’s federal 1040 tax return on Form 8824. On the four-part form, the taxpayer is asked in part one for:
- The description of the relinquished and replacement property
- The date the relinquished was originally acquired
- The date the relinquished property was transferred to the buyer
- The date the replacement property was formally identified
- Whether a related party was involved in the exchange
Part two requests information on the related party if one was involved in the 1031 exchange. A related party is defined as ascending or descending blood line but not in-laws, aunt, uncle, cousins, nieces and nephews. If the taxpayer owns greater than a 50 percent interest in an entity, the entity is considered a related party. A taxpayer who is the beneficiary or trustee of a trust is considered a related party.
Part three asks for information on the realized gain or loss and adjusted basis of the property given up and the fair market value of the property received.
Part four is for use by officers or employees of the executive branch of the Federal Government or judicial officers of the Federal Government to report nonrecognition of gain under section 1043 on the sale of property in compliance with the conflict-of-interest requirements.
1031 Exchange Theory
By allowing the taxpayer to defer the gain when exchanging property solely for like kind property of equal or greater value, the taxpayer does not receive a benefit of either cash or reduction in debt. Their economic position remains the same if not changed to the upside of owning a more expensive property. The 1031 exchange allows taxpayers to change their property without the immediate tax consequences of paying the tax. Timberland Real Estate Investment Trusts such as Plum Creek and Rayonier change vast acreage of timber for timber with better yields or closer to lumber mills to reduce expenses using 1031 exchanges. Large equipment owners of Wirtgen WR2500 or Roadtec RX-60C milling machines used in constructing highways exchange used machinery for newer equipment while rental car companies do the same to update their fleets.Taxpayers can exchange real property for triple net leases with CVS Pharmacy, Advance Auto Parts or Dollar General as the tenants in long term leases.
In 2013, the estimated tax deferred in 1031 exchanges is $3.7 billion dollars.
The 1031 exchange provides an economic incentive for taxpayers owning real and personal property to change their assets without having to pay the immediate tax outlay; rather the taxpayer is incentivized to use those otherwise paid out dollars towards the purchase of replacement property with the intent of being located in an appreciating location or in a new building with a longer depreciation potential. Without the 1031 exchange, taxpayers would not as readily change their mix of assets but would hold them longer to prolong the tax consequences. The 1031 exchange provides the lubrication or liquidity to change the asset such as land for a single family rental or to generate cash flow. The tax consequences do not go away but rather are deferred or postponed until the replacement asset is sold. There is no limit to the number of 1031 exchanges a taxpayer can initiate.
Ultimately, the tax consequence is recognized or due, whether it is offset by a stepped up basis when a beneficiary receives an heir’s asset upon their death or following the sale of a primary residence that was converted from a 1031 rental property and then sold with recognized gain partially excluded by the Section 121 $250,000/$500,000 exclusion. The exclusion is available once every two years on our primary homes.
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Review insights into the following state laws legislating exchanges in California, Colorado, Maine, Nevada, Oregon, Virginia and Washington.
