A 1031 exchange enables taxpayers to defer federal and state capital gain and depreciation recapture taxes when selling and replacing property held in a business or for investment. The tax deferral represents an indefinite, interest free loan or additional working capital for use towards the replacement property acquisition. The tax does not go away but is due once the replacement property is sold unless another 1031 exchange is initiated.
Why Use a 1031 Exchange?
Individuals, trusts and corporations use 1031 exchanges to defer recognized gain for property located predominantly in the United States or internationally. Property is considered like-kind if both are located within the US or both located overseas. Federal and state capital gains and depreciation recapture taxes can represent as high as 40 percent of the sales price. On a $300,000 sale, taxes could consume up to $120,000 of the sale. Given the intent is to acquire like-kind replacement property, why not use the $120,000 towards acquiring replacement property rather than paying the tax?
Timberland Real Estate Investment Trusts (REITs), such as Rayonier, Plum Creek , Potlatch and Westinghouse utilize 1031 exchanges to replace acres of forests with timberland that meets their long term financial requirements or to improve economies of scale. Commercial REITs replace poor performing property with property located in the path of progress or with higher capitalization rates. Equipment and car rental companies utilize 1031 exchanges to upgrade and replace worn and heavily depreciated equipment. Individuals owning a vacation rental property exchange into like-kind property for a better location or cash flow. Farms and ranches are exchanged into like-kind real property when the owners want to retire and relocate to perhaps a warmer climate or diversify into other cash flowing properties.
Like-Kind Property
Property held in the productive use of a business or for investment are 1031 eligible. What is not eligible includes a primary residence, inventory, stocks and securities, partnership interests and indebtedness. Property is either real, tangible or intangible personal property. The property must be held or utilized for a period of time for investment rather than a flip for profit. Though the hold time is not defined in the Internal Revenue Service (IRS) Code Section 1031, two years is sufficient. Revenue Procedure 2008-16 provides a “safe harbor” for vacation properties such that the IRS will not challenge whether the vacation home qualifies as property held for productive use in a trade, business or for investment given the taxpayer follows the stated guidelines of holding both the old and the replacement property for two years. In each of those years, the property is rented at least 14 overnights at fair market rent. Personal use is limited to fourteen overnights per year.
Eligible real property ranges from land, single family residential and commercial to oil and gas royalties. Personal property includes personal property such as furniture, computers, aircraft, ships and barges, artwork, vintage cars, gold and silver bullion, numismatic coins, livestock, equipment and franchise rights.
1031 Exchange Mechanics
Each exchange is either a forward or a reverse and must be completed within 180 calendar days post-closing. The taxpayer enters into a Purchase and Sale Agreement or Bill of Sale for the property to be sold. The net equity is held by the Qualified Intermediary (QI) (under the taxpayer’s tax identification number) who facilitates the 1031 exchange by providing 1031 exchange agreements that support the taxpayer’s intent to fulfill the 1031 exchange requirements. The QI works with escrow, title company or closing attorney to prepare the settlement statements for the property being sold and the property being acquired. Given the net purchase price is equal to or greater than the net sales price, the gain is deferred; otherwise, a tax is paid on the difference in what is known as a partial exchange.
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