Taxpayers use a 1031 exchange to defer federal and state capital gain and depreciation recapture taxes when selling and replacing real and personal property held in the productive use of a business or investment. If a 1031 exchange is not initiated prior to or on the day the relinquished or old property is closed, then a tax that can represent up to 40 percent of the sales price is triggered and due in the year the taxpayer files their federal tax return. For the new investor, understanding the rules of a 1031 exchange can be a challenge. What follows is a review of four issues that may not be adequately explained by the Qualified Intermediary (QI) who facilitates the 1031 exchange.
Equal to or Greater
The taxable gain is deferred given the replacement property purchase price is equal to or greater than the net selling price of the old property. Many think that only the gain or net profit needs to be reinvested. The reason for the 1031 exchange tax deferral is that the taxpayer’s economic position does not change, implying that no benefit of cash or reduced debt is received. All the net equity from the sale and the debt retired if any, has been reinvested into the replacement property. Partial exchanges are doable given at least 60 percent of the relinquished property sale is exchanged. Otherwise, the tax on the amount not reinvested will come close to the tax due if a 1031 exchange was not initiated.
For example, if Jack sells an investment property for $150,000, $60,000 of debt or mortgage on the property is paid off and selling expenses including sales commission, are $7,500 plus title and escrow fees totaling $9,000, the net equity is $150,000 – $60,000 – $9,000 = $81,000. To defer the capital gain on the sale, a 1031 is initiated. The replacement property needs to be acquired for at least $141,000.
Return of 1031 Exchange Proceeds
Continuing with the Jack’s example, say after the relinquished property closing where the net equity of $81,000 is wired to the 1031 escrow account, he later decides due to any number of reasons not to continue with the 1031 exchange. He informs his QI he wants to terminate the 1031 exchange and requests the return of the $81,000. Regulation § 1.1031(k)-1(g)(6) places limitations on the taxpayer’s rights to the exchange account once the 1031 exchange begins, stating “in no event shall Exchangor receive, pledge, borrow or otherwise obtain the benefits of the Exchange Account, including earnings thereon, before the end of the Exchange Period.” Except that:
- If the taxpayer does not identify replacement property to the QI by the end of the identification period or the 45th calendar day post-closing, then the 1031 exchange ends and exchange funds are returned to the taxpayer on the next business day.
- If the taxpayer has received the identified replacement property before the 180th calendar day, then the balance of funds can be returned to the taxpayer.
- The 180th calendar day exchange period has expired.
Once the 1031 exchange is initiated as recognized by signed exchange agreements and escrow closing, the earliest the taxpayer can receive the exchange funds is the 45th calendar day. Should the QI acquiesce and provide the proceeds, the QI is acting as the taxpayer’s agent and not as an independent arms length QI bringing into question whether the QI did the same for other 1031 exchanges.
Replacement Property Identification
Post-closing on the old property, the 45th calendar day represents when the taxpayer must formally identify, preferably to the QI, the replacement property. The identification requirement is that the replacement property identified is unambiguous, meaning if real property, an address, county roads or tax parcel identification number is provided. If personal property, the IRS recognizes make, model and year as the identification format to use.
Three properties regardless of value can be identified or, if four or more, then the total value of the properties identified cannot exceed two hundred percent of the relinquished selling price. Once identified, the list cannot be changed. Be sure to identify at least two properties, if not three, to provide contingencies should one fall through.
Ineligible Property
Property ineligible for 1031 consideration includes:
- Primary residence
- Indebtedness
- Inventory
- Securities and bonds
- Partnership interests
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