The 1031 exchange process is fundamentally the same as when the tax deferral was legislated into law in the National Revenue Act of 1921. Historically, the intent was that as long as the taxpayer reinvested the net sales price into replacement property, the capital gains tax that would otherwise be triggered is deferred until the replacement property is sold. Farmers traded land for land, equipment for equipment and horses for horses. Over the years, investors applied the deferral strategy to the sale of real estate. The 1970s Tax Court case of Starker v. Commissioner established that the exchange did not have to be simultaneous or occur in one long closing.
1031 Exchange Code
The Internal Revenue Code Section 1031 states “no gain or loss shall be recognized on the exchange of property held for productive use in trade or business, or for investment, if such property is exchanged solely for property of like kind which is to be held for productive use in trade or business or for investment.” No gain or loss implies that the recognized gain or tax is deferred or postponed as long as replacement property of equal or greater value is acquired. Property is either real, tangible or intangible personal property. Property used predominantly in the US is considered like kind with property located in the US. Foreign held property is eligible for a 1031 exchange given the replacement property is held internationally. Hold time implies the property is held for a season of time or conservatively one to two years versus holding for profit, such as inventory, which, along with stocks and bonds, indebtedness, primary residence and partnership interests are not eligible for 1031 consideration.
Tax Consequences
The first step towards deciding whether a 1031 exchange makes sense is understanding the federal and state capital gain and depreciation recapture tax triggered upon the sale. Effective January 1, 2013, the federal capital gains rate changed from a flat fifteen percent to a high of 23.8 percent.
The federal capital gain rate for collectibles is 28 percent. Visit with your CPA to understand the tax due if a 1031 exchange is not initiated. In a 1031 exchange, the tax is now an indefinite, interest free loan or additional working capital for use towards acquiring replacement property. Given the tax can represent upwards of 40 percent of the relinquished or old property sales price, the financial incentive merits the use of a 1031 exchange.
Types of Exchanges
The two basic types of 1031 exchanges are the forward and the reverse. In a forward exchange, the old property is closed before the replacement property closing. In a reverse, the replacement property is closed before the old property closing. If the taxpayer wishes to use a portion of the proceeds to improve the replacement property, then an improvement or build to suit exchange uses an Exchange Accommodator Titleholder (EAT) to temporarily take replacement property title at the replacement property closing to make those improvements. A simultaneous exchange is when the old and new properties are closed at the same closing.
Each exchange must follow a series of exchange rules, including:
- Post-closing, the replacement property must be identified preferably to the Qualified Intermediary (QI), by 11:59 PM on the 45th calendar day. The exchange must be completed by the 180th calendar day post-closing.
- The same taxpayer who sells is the taxpayer who buys.
- To defer 100 percent of the recognized gain or tax, the replacement property must be equal to or greater than the net selling price of the old property.
- When the taxpayer sells to a related party, the related party must hold the property for at least two years; otherwise, the tax deferred is triggered.
- The taxpayer can acquire the replacement property from a related party given the related party is also initiating a 1031 exchange and not cashing out.
- A QI must be used to accommodate the 1031 exchange and cannot be a disqualified person or someone who has acted as the agent of the taxpayer in the two years prior to the 1031 exchange.
1031 Exchange Process
Once having made the decision to initiate a 1031 exchange, the next step is to engage a QI. There is a series of questions to ask that are available at the following link. The QI may send an engagement letter summarizing their fee, interest and the steps of the exchange. The QI will ask for the escrow or closing entity contact information. An escrow account will be established with the taxpayer’s tax identification number and signature on IRS Form W-9. The QI will draft exchange agreements and either send them to escrow and/or the taxpayer for review and signature. Exchange funds will be wired directly to the escrow account. When the replacement property is ready to close, the QI will work with the escrow or closing company to prepare the exchange agreements and wire the funds for the closing. The taxpayer will file IRS Form 8824 to report the exchange when filing their federal return.
The gain is deferred and due when the replacement property is later sold. If the taxpayer elects, another 1031 exchange can be initiated and the first property gain, along with the replacement property gain, can be deferred again.
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