A 1031 exchange allows the taxpayer to defer federal and state capital gain and depreciation recapture taxes when selling and replacing property held in the productive use of a business, trade or for investment. The taxpayer’s CPA should always be asked to quantify the tax consequences of the transaction, which represents one of the most important taxpayer’s criteria to evaluate when considering whether or not to initiate a 1031 exchange. Ultimately, when the 1031 exchange is reported to the Internal Revenue Service on form 8824 along with the taxpayer’s federal return, the CPA will provide the details of the 1031 exchange and affix their signature.
1031 Exchange
The taxes triggered upon the property sale can represent upwards of 40 percent of the relinquished or old property sales price. If the intent of the taxpayer is to replace with like-kind property, then a 1031 exchange begins to make sense. When the tax deferral is an added incentive, there is a high probability the taxpayer will elect to utilize those tax dollars that would otherwise have been paid to the Internal Revenue Service (IRS) towards the replacement property purchase in a 1031 exchange.
The Internal Revenue Code states “no gain or loss is 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.”
Property
Property eligible for 1031 consideration includes real, tangible and intangible personal property. Any real property can be exchanged for any real property given both are located in the United States or international for international. Real property includes land, improved property, oil and gas royalties. Personal property is one of thirteen general asset codes or personal property found in the North American Industry Classification System (NAICS). Intangible personal property includes franchises, licenses, permits, patents and copyrights. Personal property exchanges must be replaced with the same type of asset – bulls must be replaced with male cows, gold bullion for gold bullion, oil painting for oil painting and classic car for classic car.
Hold Time
There is no amount of time specified in the Internal Revenue Code Section 1.1031 that the relinquished or replacement property must be held. The IRS suggests that two years is sufficient. For vacation property that is rented and used sparingly for personal use, the IRS provided Revenue Procedure 2008-16 as a bright line test stating that, in addition to satisfying the 1031 exchange requirements, if the taxpayer follows the outlined two year hold for both the relinquished and the replacement while renting out for at least fourteen overnights per year at fair market rent, then the IRS will not challenge whether the vacation property qualifies as property held for productive use in a trade, business or for investment.
Hold time is one fact of many that supports the proper intent to hold in a business or for investment. A good fact pattern includes adequate hold time to allow an investment to season, be rented or in a rental pool, have personal use that does not exceed fourteen overnights per year and be reported on Schedule E of the taxpayer’s return. Can a property be exchanged if held for less than one year? Yes. The shorter the hold time the more substantial the fact pattern should be.
Same Taxpayer
The 1031 code requires that the taxpayer who sells is the taxpayer who buys. This implies that if the wife is on title, then the wife must acquire and once the exchange is old and cold the husband can be added. If an entity, such as a two member limited liability company, is on title, then the entity must be on the replacement property title. Unless in as far in advance as possible, the title is changed to reflect the individual member names, referred to as drop and swap. Caution, the IRS is asking on form 1065, Schedule B, questions 13 and 14 whether the entity distributed property to the members. A single member limited liability company can sell the relinquished property and the sole member can acquire the replacement property in their name.
There are many rules and exceptions that must be followed in a 1031 exchange. If you have a question about your transaction, click the button below and receive a response from a Certified Exchange Specialist®.
