A 1031 exchange is an Internal Revenue Code tax rule that allows taxpayers to defer indefinitely capital gain and recaptured depreciation taxes when selling and replacing with like-kind real or personal property held for productive use in a trade, business or for investment. The tax deferral requires strict adherence to the 1031 tax exchange rules to effectively postpone the tax payment until the replacement property is sold or possibly eliminated if heirs sell, when received or minimized when selling a primary residence that was previously a replacement rental property in a 1031 exchange.
Basic 1031 Tax Exchange Rules
When real or personal property held in a business or for investment is sold, a capital gains tax is imposed on the sales price less the adjusted basis less the selling expenses. Currently, if the taxpayer, either a US resident or foreign resident, is in the lower two of six income brackets, the capital gains tax may be zero percent. In the upper four brackets, the tax is currently 15 percent for real property and 28 percent for personal property such as artwork, precious metals and collectibles. To defer, the replacement property net purchase price must be equal to or greater than the relinquished or old property selling price. Partial exchanges are possible; however, a closer evaluation is required to confirm if it makes sense.
- The taxpayer who sells must be the taxpayer who buys. If the wife is selling, then the wife must purchase, not the wife and husband. The husband can be added to the real property deed once acquired by the wife. If a limited liability company with multiple members sells, then the same limited liability company must buy, not the individual member/managers.
- Real property can be exchanged for any real property within the US while personal property must be exchanged for like-kind personal property. Furniture must be exchanged for furniture, aircraft must be exchanged for aircraft and silver bullion for silver bullion. An oil painting must be exchanged for an oil painting not a watercolor or acrylic. Property located held predominantly in the US is not eligible to be exchanged with property held overseas.
- 1031 tax exchange rules require that replacement property must be identified by the 45th calendar day post-closing to the Qualified Intermediary (QI) and acquired within another 135 calendar days.
- A QI must be used to accommodate the exchange unless in a pure 1031 exchange where the seller and buyer want each other’s properties. A QI may not be a disqualified person.
- Taxpayer cannot have access to exchange proceeds otherwise the 1031 exchange is over and tax due. The (g)(6) limitations represent one of the critical issues that the IRS created four safe harbors including the QI, whose use safeguards the taxpayer.
- Selling or buying from a related party requires additional planning.
- Forward exchanges are different from reverse exchanges where in a forward, the relinquished property is sold before the replacement property is acquired. In a reverse, the replacement property is acquired before the old property is sold.
- In a reverse 1031 exchange, both the new and the old properties cannot be owned by the taxpayer at the same time. An Exchange Accommodator Titleholder is created by the QI to take title to receive the temporary ownership of either the old or new property.
- Cash offsets debt, but debt does not offset cash when determining boot. Boot is a term that describes a taxable benefit received by the taxpayer. For example, if property sold for $100,000 with $70,000 of cash and $30,000 of debt and the replacement property is acquired for $30,000 of cash and $70,000 of debt, there would be a tax due on the $40,000 cash not reinvested.
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