The Treasury Department Office of Tax Analysis published a paper on the 1031 like kind exchange discussing rationale, history and thorough review of use by market vertical for fiscal years 2007 and 2010. Included in the analysis is an interesting perspective from the Joint Committee on Taxation quantifying the value while the Federal Budget does not consider the 1031 exchange a tax expenditure. Why this of particular interest is that given the drive for tax reform including the removal of the 1031 code, the analysis is deficient in quantifying the macro economic impact. 1031 exchanges provide the liquidity to sell and replace assets from real estate to equipment, especially vehicles. Eliminating 1031 exchanges as the paper recognizes, would “freeze” the replacement of real and personal property, resulting in a slower frequency of replacement, subsequent decrease in real estate sales, closings, tax revenues, potential decrease in sales of cars, aircraft and equipment with higher costs of replacement being passed on to the consumer.
1031 Exchange Rationale
1031 exchanges allow taxpayers subject to federal income tax, to defer the federal and state capital gain along with depreciation recapture taxes as long as the replacement property is equal to or greater than the net relinquished or old property sales price. The gain is deferred until the replacement property is sold at which time the tax is due unless another 1031 exchange is initiated. The tax does not go away unless the taxpayer dies and the beneficiary receives a stepped up basis. The taxpayer’s economic position does not change from the sale to the acquisition. The taxpayer has as much if not more invested in the replacement property. No economic benefit has been received other than an asset with a longer useful life with the exception of land. If cash or a reduction in debt is received between the sale and purchase, a tax is triggered referred to as equity or mortgage boot.
There are many rules to affect a 1031 exchange, one of which is the requirement to engage a qualified intermediary to hold the exchange funds and provide agreements written in accordance with the Internal Revenue Code Section 1031. A taxpayer’s attorney or CPA may be considered a disqualified person and may jeopardize should they accommodate the exchange.
1031 Exchange Rules
Applicable to the sale of real and personal property held in the productive use of a business or for investment, property must be held for the qualified intent and not primarily for personal use as a second home or a flip for profit. A fact pattern supporting proper intent for improved real estate includes reporting the asset on Schedule E and not Schedule A. Personal use cannot be more than fourteen overnights per year. Additional rules include:
Same taxpayer requirement – The taxpayer who sells is the taxpayer who buys.
Replacement Identification and Timeline – The exchange must be completed with 180 calendar days post-closing on either the relinquished sale in a forward exchange or replacement property in a reverse exchange.
Related Party – Selling or buying from a related party is subject to requirements including should the related party buyer sell the property acquired within two years of acquisition, the closing triggers the gain the exchangor intended to defer. The exchangor can only acquire replacement property from a related party if the related party is also initiating a 1031 exchange and not cashing out.
Trading up – The replacement property must be equal to or greater than the net relinquished selling price; otherwise, a tax is triggered on the difference. Partial exchanges are doable given the difference is subject to tax.
States such as California, Colorado, Idaho, Maine, Washington, Oregon, Nevada, and Virginia have legislated qualified intermediary requirements and claw back taxes to protect their residents and generate tax revenues.
Understanding the cost must be offset with an understanding of the benefits of the 1031 exchange. Like minded and impacted industries who have a vested interest in the 1031 code have organized with the help of the Federation of Exchange Accommodators (FEA) to lobby Congress. The FEA is an organization of qualified intermediaries from across the country whose members are subject to a strict Ethics Policy, continuing education and grantor of the Certified Exchange Specialist® designation. Visit www.1031taxreform.com to learn more about the repeal proposals, industry responses and 1031 tax reform developments.
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