For taxpayers owning investment property or business owners with personal property considering a 1031 exchange, the first step is to visit your CPA to determine the tax consequences. Without knowing the tax before initiating the exchange, the taxpayer is assuming it makes sense to initiate the 1031 exchange. All too often taxpayers want to initiate an exchange without knowing the value or the reason to exchange other than to exchange for another property. That in itself is a good reason to exchange but for those taxpayers who want to justify the exchange expense, a 1031 exchange should start with a review of the realized gain on the sale.
Code Section 1.1031
A 1031 exchange is part of the Internal Revenue Code Section 1.1031 that allows taxpayers subject to federal capital gains tax, both resident and nonresident, to defer the federal and state capital gains and recaptured depreciation tax when selling real or personal property and exchanging for like-kind property held solely in the productive use of a trade, business or for investment. What is not eligible for a 1031 exchange are partnership interests, primary residence, indebtedness, stocks and securities and inventory.
Revenue Procedure 2008-16
A 1031 exchange is not intended for a second home or vacation property that is never rented. Revenue Procedure 2008-16 provides a bright line test defining how long the property should be owned and rented. In return, the Internal Revenue Service provides a safe harbor test that should the taxpayer qualify, will not challenge whether the vacation home qualifies for the proper intent of being held for productive use in a trade, business or for investment.
The taxpayer’s CPA is the gatekeeper to whether the taxpayer should initiate a 1031 exchange. As a Circular 230 tax advisor, the CPA, attorney and enrolled agents practice before the Internal Revenue Service (IRS) and are held to high standards. A practitioner may not willfully or recklessly, advise a client to take a position on a tax return regarding I.R.C. § 1031 that the practitioner knows or reasonably should know contains a position that: (a) lacks a reasonable basis; (b) is an unreasonable position as described in I.R.C. § 6694(a)(2); or (c) is a willful attempt by the practitioner to understate the liability for tax or a reckless or intentional disregard of rules or regulations by the practitioner. In addition, the advising practitioner must conduct a reasonable analysis of the taxpayer’s circumstance to determine proper facts and intent.
Qualified Intermediary Role
The Qualified Intermediary (QI) provides exchange advice versus tax advice. The QI is responsible for documenting the exchange in accordance with IRS requirements and holding the exchange funds or net equity from the relinquished property sale in accordance with the g(6) limitations of the 1031 code. Exchange counsel is provided to ensure the transaction satisfies the 1031 requirements. The QI is indemnified and held harmless from and against all loss, cost or damage resulting from participation in the exchange except to the extent that such loss, cost or damage is due to QI’s negligence or misconduct. Whether or not the taxpayer follows the exchange guidance is not up to the QI. Determining the recognized gain or tax due for the exchange is worthwhile and is the responsibility of the taxpayer or their tax practitioner. All too often the taxpayer asks questions that are best responded to by someone other than the QI. In interaction with the QI, should the accommodator hear or sense the taxpayer is heading around a curve at 70 mph without knowing the bridge is out, a proactive QI will raise the red flag to warn the taxpayer.
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