A 1031 exchange defers the federal and capital gain when selling real or personal property held in the productive use of a business or for investment. There are many rules that must be followed; otherwise, the exchange may fail. Having listened and accommodated over 680 simple and complex, forward and reverse exchanges, I have an idea of what confuses the first time exchangor and seasoned CPA when providing input on the exchange.
The 1031 Goal
A 1031 exchange defers federal and state capital gain taxes and recaptured depreciation that can total upwards of 40 percent of the sales price. The deferral is indefinite and interest free, to be viewed as additional working capital. Using the tax versus paying to the IRS allows the taxpayer to acquire more replacement property that would be unavailable if the tax was paid. Yes, the tax is due when the replacement property is sold, unless another 1031 exchange is initiated. Heirs receive a stepped up basis on the property.
Warm Up Review
In a 1031 exchange, property is sold and property is acquired no later than 180 calendar days from the first closing. The only exception to this rule is if the IRS website provides in writing a notice of a federally declared disaster, including tornadoes, hurricanes, flooding or other weather related disaster. Another exception is if the taxpayer or exchangor is in a combat zone.
Equal or Greater Value
The reason why the IRS provides a deferral is because the taxpayer’s economic position does not change from when the relinquished or old property was sold to after the replacement property is acquired. If cash is received in the exchange or the amount of debt is not equal to or greater in the replacement property, then the taxpayer has equity or mortgage boot. Net equity or the relinquished sales price less the selling expenses of sale commissions, inspection fees and title insurance, along with the debt retired at closing, must be equal to or greater in the replacement property or trigger a tax on difference. This is known also as a partial exchange.
Often times the new exchangor believes that only the net equity or profit must be reinvested in the replacement property to defer the capital gain. On the sale of land without any debt, that would be the case. But when there is a mortgage on the relinquished property, the debt must be replaced. Additional cash can be added to offset the mortgage requirement on the replacement property. Additional debt does not offset the net equity requirement. If cash is wanted, post-exchange, secure a line of credit on the replacement property tax free.
Like-Kind Property
Many think that the “like-kind” requirement means that land must be exchanged for land when in reality any real property can be exchanged for any real property as long as both are located in the US or outside the US. That means that land can be exchanged for commercial property or a vacation condominium. The intent of the property must be for productive use in a business or for investment. For personal property, the location is dependent upon looking back over the past two years to determine where it has been predominantly located. Yes, personal property such as livestock, gold and silver bullion, aircraft, vessels, collectibles, artwork, franchise rights and equipment can be exchanged and taxes deferred.
What is not eligible for consideration is a primary residence, partnership interests, debt, inventory, stocks and securities. An investment property can be acquired in a 1031 exchange, later to be converted to a primary residence. This combines Section 1031 and Section 121, allowing the $250,000/$500,000 exclusion to absorb a portion of the capital gain. What is not absorbed is that portion of the gain attributable to the years the primary was held as a rental, depreciation recapture in the relinquished and time held replacement property is held as a rental.
Determining Capital Gain
This is really a question for your CPA to answer. They may see other factors that should be considered. Facts including original purchase price, depreciation taken to date (as found on Schedule E of your federal tax return), capital improvements, selling price and selling expenses, along with the taxpayer’s adjusted gross income are utilized to determine the realized gain. Depreciation whether taken or not is recaptured to the tune of 25 percent.
This article should be mandatory reading for all taxpayers contemplating a 1031 exchange; doing so will avoid much angst. There are many more 1031 exchange rules to be followed but this brief warm up will get you thinking, then contact Atlas 1031 Exchange or your qualified intermediary.
Download “Taxpayer’s 1031 Exchange Checklist” to understand a checklist of issues to consider when considering whether a 1031 exchange makes sense.
