When taxpayers ask what they should know about a 1031 exchange, I suggest reading this brief article to attempt to cover four key target areas that match up with the characteristics of their transaction. Every 1031 exchange is different though they are all either a forward or reverse exchange, meaning that the old property is sold before the new or in a reverse, the new is acquired before the old is sold with both types of exchanges completed within 180 calendar days. They also share the goal of deferring the capital gain though partial 1031 exchanges may be the desired outcome when not all the exchange proceeds or debt retired is replaced. When you think all bases are covered, there are the exceptions to the rules that are reviewed given the taxpayer’s 1031 exchange specifics.
Equal to or Greater
Often the misconception is that only the net profit needs to be reinvested in the replacement property. When selling property without debt, this is true. When selling property with debt, the debt retired must be replaced, along with the net equity. The replacement property must be equal to or greater than the net selling price of the relinquished property; otherwise, the IRS considers a benefit has been received. The benefit is that the taxpayer has received cash as in equity boot or a reduction in indebtedness or mortgage boot. Boot is taxable. Additional cash always offsets debt, but additional debt does not offset cash.
Same Taxpayer
The taxpayer who sells is the taxpayer who buys or the tax return that sells is the tax return that buys. This rule can become an issue when in a multi-member limited liability company, not all members want to initiate a 1031 exchange. A drop and swap strategy may be imposed to dissolve the limited liability company to the names of the individual members, known as tenants in common, and proceed with entering into the purchase and sale agreement and closing. By holding title as tenants in common, the members who want to initiate a 1031 exchange can while the others members may cash out and pay the tax. If a wife is on title in a non-community property state, then the wife must acquire the replacement property. If she wants to have her husband on the deed, she may execute a quit claim.
45 Day Identification
Should the 1031 exchange not be completed by the 45th calendar day post-closing, an identification of the potential replacement properties must be submitted, preferably to the qualified intermediary. Three properties regardless of value may be identified or following the two hundred percent rule, four or more with the total fair market value not exceed two hundred percent of what was sold. If by 11:59 PM of the 45th calendar day, the identification form is not submitted, then the 1031 exchange fails and the exchange proceeds are returned on the next business day. If property is identified and does not close within the 180th calendar day, the exchange fails and the funds are returned on the next business day. If at no fault of the taxpayer, none of the properties identified close, the funds still must be held until the 180th calendar day.
Property Ineligible for 1031 Replacement Property
The 1031 exchange tax deferral is intended for either real property or tangible or intangible personal property held in the productive use of a trade, business or for investment. Personal use must be minimal; consequently vacation properties may only be considered eligible for 1031 exchanges given personal use does not exceed 14 overnights per year. Revenue Procedure 2008-16 provides the IRS requirements. Primary residences, inventory, securities, partnership interests and indebtedness are not eligible for 1031 exchanges. Revenue Ruling 99-6 provides the exception regarding partnership interests.
Other rules include disqualified persons, related parties, like kind for like kind property and the requirement to use a qualified intermediary.
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