Smart investors and business owners utilize a 1031 exchange when selling and replacing real and personal property held in the productive use of a business or for investment. The alternative to a 1031 exchange is to pay the federal and state capital gains and depreciation recapture tax, which can represent upwards of 40 percent of the property sales price. A 1031 exchange allows the taxpayer to use those otherwise paid dollars towards the replacement property purchase. If the 1031 exchange rules are not strictly followed, the outcome can be a disqualification, tax payment, interest on the tax not paid, penalty and drama of an IRS audit.
Primary 1031 Exchange Rules
To defer one hundred percent of the tax triggered at sale, the replacement property must be equal to or greater than the relinquished or old property sales price. A common misconception is that only the net profit needs to be reinvested. All net equity and debt retired on the relinquished property must be reinvested into the replacement property or the taxpayer has equity, or mortgage boot.
The taxpayer who sells must be the taxpayer who buys. The same taxpayer requirement has the exception where a single member limited liability company (SMLLC) is considered a disregarded entity for federal tax purposes that allows the single member to acquire the replacement property if the SMLLC sold and vice versa. A wife who is on title and not her husband must acquire in the name of the wife and later if desired, add the husband to title using a quit claim.
Each 1031 exchange follows the two timeframes known as the 45th calendar day post-closing and the 180th calendar day post-closing. In a forward exchange, the replacement property must be formally identified in writing to the qualified intermediary (preferably) those properties that may be acquired. The property or properties acquired post the 45th calendar day must be on the property identification list. There is no back dating of the property identification. Properties identified do not need to be under contract and must be unambiguous stating their address or use of a map or roads to outline the property. Personal property is to be identified using year, make and model if applicable.
Real property must be exchanged for any real property while personal property must be exchanged for “like-kind” personal property of the same class of asset. Real property located in the US is considered “like-kind” with real property located in the US. Property held predominantly outside the US is considered “like-kind” with property held overseas.
1031 exchanges with related parties adhere to a special set of rules when the buyer and seller share lineal ascending or descending blood lines along with siblings, or when the taxpayer owns more than 51 percent of the entity. When the taxpayer initiating the 1031 exchange sells to a related party, the related party should not sell the property for two years; otherwise, the tax deferred is triggered. The taxpayer can purchase from a related party given there is not the presence of a tax avoidance scheme. The rule is that a tax avoidance scheme is not present when the basis of the replacement property is lower or near the relinquished property basis.
A qualified intermediary (QI) must be engaged to accommodate a 1031 exchange with the exception of a two party exchange. The role of the QI is to draft 1031 exchange agreements in accordance with the Internal Revenue Code Section 1031 that supports the taxpayer’s intent. The QI also holds the exchange funds, or net equity, in the relinquished sale in a manner that preserves principal and liquidity. Should the taxpayer touch or have access to the exchange funds, the 1031 exchange is terminated. Exchange funds are typically held in a qualified escrow agreement that requires dual signatures for disbursement, one from the taxpayer and one from the QI.
It is recommended that the first step in a 1031 exchange is to visit with your CPA to understand the tax consequences of selling.
To learn more about why a 1031 makes sense, click here to download a free white paper.
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.
