What is the difference between a Section 1031 Exchange and a traditional sale? It is important to understand what a 1031 exchange is, what it does and what is required to provide the contrast with a traditional sale.
1031 Exchange
An Internal Revenue Code (IRC) Section 1031 exchange is defined in the code as “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.”
Every 1031 exchange has a first and a second leg. Property is conveyed or transferred by a warranty deed or bill of sale from the taxpayer to the buyer. In the second leg, property is transferred from the seller to the taxpayer in what is known as a forward exchange. In a reverse exchange, the sequence is simply reversed, though there are a number of additional required steps to accommodate the exchange from the perspective of the Qualified Intermediary (QI). A QI is an independent third party who provides documentation in accordance with the 1031 code and holds the exchange funds in a liquid escrow account where preservation of principle is the rule.
A 1031 exchange defers the federal and state capital gains and recaptured depreciation tax due on the transaction until the sale of the replacement property. The capital gains tax is dependent upon a number of factors including the adjusted basis which is determined by the original purchase price plus the improvements less the depreciation taken. The adjusted basis is subtracted from the sales price less the selling expenses to provide the realized gain. The realized gain is the figure that is first reduced by the amount of depreciation taken. Recaptured depreciation is multiplied by 25 percent to determine the first tax. The balance of the realized gain is subject to the federal and state (and possibly county) capital gains tax based upon the taxpayer’s modified adjusted gross income.
2013 Federal Capital Gain Tax Rates
| Individual | Married | Capital Gains | Medicare Surtax | Aggregate Tax |
| $0 – $36,250 | $0 – $72,500 | 0% | 0% | 0% |
| $36,250 – $200,000 | $72,250 – $250,000 | 15% | 0% | 15% |
| $200,000 – $400,000 | $250,000 – $450,000 | 15% | 3.8% | 18.8% |
| $400,001 + | $450,001 + | 20% | 3.8% | 23.8% |
The resulting tax is deferred or payment postponed, given the net equity and debt retired on the relinquished or old property is equal to or less than the replacement property purchase price.
There are many rules to a 1031 exchange:
- A QI must be engaged to accommodate the exchange, with the exception of a pure or two party exchange where the taxpayer and the buyer want each other’s property. It is still suggested to engage a QI to facilitate the exchange. The QI cannot be related to the taxpayer or have acted as the taxpayer’s agent in the two years prior to the exchange with few exceptions.
- Taxpayer is prevented from having access to the exchange funds during the exchange; otherwise, the g(6) limitations of the 1031 code and exchange are violated.
- Property must be held with the proper intent or productive use in a trade, business or for investment. The suggested hold time is one year with a two year hold for vacation rental properties.
- The taxpayer who sells is the taxpayer who acquires.
- Transactions between related parties are eligible given the buyer holds the property for two years; otherwise, the deferred tax is triggered. Replacement property can only be acquired from a related party if the seller is also initiating a 1031 exchange and not cashing out.
- Each exchange must be completed no later than 180 calendar days post the first leg closing with replacement property formally identified by 11:59 PM of the 45th calendar day.
- Real property may be exchanged for any real property given both are either in the US or internationally. US property is not considered like kind with real property held overseas.
- Personal property such as furniture, equipment, aircraft, precious metals, artwork and vintage cars must be exchanged for the same asset class or product code. Predominant use of both properties must be either US for US or international for international.
- Revenue Procedure 2008-16 provides a safe harbor where the Internal Revenue Service will not challenge the personal use of a vacation property given the rules defined therein are followed.
1031 Exchange v. Traditional Sale
A traditional sale occurs when a taxpayer conveys the property to a buyer and payment is made to compensate the taxpayer. Once payment is made, the taxpayer has full access to the sale proceeds. A Bill of Sale is used for personal property while a warranty deed is typically recorded for real property. The taxpayer who completes a traditional sale may have the intent to replace the property but without supporting documentation created and signed prior to the transaction has few if any facts to support the proper intent to initiate a 1031 exchange.
Finally, access to the exchange funds, whether in the form of a check or deposited into the taxpayer’s account, eliminates the possibility of a 1031 exchange. The only way to resurrect a 1031 exchange once the closing has passed is to unwind the transaction such that the taxpayer has the burden of ownership and the buyer has the proceeds.
To learn when a 1031 makes sense, download a free three page eBook by clicking here.
We Can Help
Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.
