Understanding and following 1031 exchange rules is critical when initiating an Internal Revenue Code Section 1031 tax deferred exchange. Seek the services of a Certified Exchange Specialist© whose designation provides the assurance the taxpayer is benefiting from a 1031 expert who is subject to a strict Code of Ethics and Conduct Preamble.
1031 Exchange
A 1031 exchange is a tax deferral of federal and state capital gains and recaptured depreciation taxes when selling and replacing real, tangible and intangible personal property held in a business or for investment. The Treasury Regulation and Internal Revenue Service (IRS) statute states “no gain or loss shall be recognized on the exchange of property held in the productive use of a trade, business or for investment if such property is exchanged solely for property of like kind which is to be held in the productive use of a trade, business or for investment.”
Same Taxpayer Requirement
“The taxpayer who sells must be the taxpayer who buys” is recognized as the same taxpayer requirement. This appears fairly straight forward. But what about the wife who owns a rental property, can the husband be on title to the replacement property? The wife should take title to the replacement property, then quit claim her husband to the title following the exchange. What about the two member limited liability companies when one member wants to cash out while the other wants to defer their gain at closing in a 1031 exchange? The members can drop their ownership from the company to the individual’s name on title, known as tenants in common. In the 1031 vertical, this is known as drop and swap. The earlier this is done the better; careful planning is required.
Like Kind
Another 1031 exchange rule is the like kind exchange requirement. Real property within the US is considered like kind or like class to all real property in the US, while real property held abroad is considered like kind to real property held internationally. Land can be exchanged for a parking lot, single family rental or an oil and gas royalty. Personal property both tangible and intangible, is far more restrictive, where the relinquished and the replacement property must be in the same asset class or group as defined by the North American Industry Classification System. Furniture must be exchanged for furniture, aircraft for aircraft, vintage car for vintage car, oil painting for oil painting and franchise fee for franchise fee.
Timelines
There are two important timelines in every exchange. The first is that the replacement property must be identified, preferably to the Qualified Intermediary (QI) no later than 11:59 PM on the 45th calendar day post-closing on the old property. The taxpayer uses a form provided by the QI to list the addresses of the potential replacement properties. Following the 45th calendar day, the replacement property must be acquired no later than the 135th calendar day or 180th calendar day post old property closing. The only time these timeframes change is when the IRS posts on their website tax relief in disaster situations or should the taxpayer be in a combat zone during the exchange timeline.
Qualified Intermediary
A fourth 1031 exchange rule is the requirement to engage a QI to accommodate the exchange. The QI cannot be a disqualified person who in the prior two years acted as the taxpayer’s agent. The role of the QI is to prepare exchange agreements in accordance with the 1031 code for the taxpayer to sign and hold the exchange funds to satisfy investment goals of liquidity and preservation of principal such that the taxpayer does not have “constructive receipt” or access to the exchange proceeds. In a pure exchange, when the taxpayer and the buyer exchange each other’s property, a QI is not required, but highly recommended to be sure the 1031 exchange rules are followed.
Learn more about 1031 exchanges and rules by downloading a three page eGuide on “Ten Reasons Why a 1031 Exchange Makes Sense.”
