Internal Revenue Code 1031 tax deferred exchanges can be challenging to understand, leaving the taxpayer with more questions than answers. What follows is a suggested series of steps from a qualified intermediary of fifteen years, including the basic rules of a forward 1031 exchange.
What is a 1031 Exchange?
It is the recognized Internal Revenue Service strategy to defer the federal and state capital gain and recaptured depreciation tax when selling real property held as an investment or in a business and replacing with real property held as an investment or in a business. In California, the federal, state and depreciation taxes can represent forty percent of the sale. In a 1031 exchange, taxes are deferred indefinitely or until the replacement property is sold. If another 1031 exchange is initiated, the tax is again deferred. Consider the 1031 exchange as an interest free loan versus paying the tax to the US government. Eighty-eight percent of all 1031 exchanges result in the tax being paid at some point.
Hold Time and Revenue Procedure 2008-16
The first step is to determine whether your sale qualifies for a 1031 exchange. What is your hold time? If you are selling land, the suggested hold time is at least a year and a day but in the 1031 code, a hold time is not specified. The year and a day timeframe at least qualifies for long term capital gain tax, which is lower than your ordinary income tax or short-term capital gain tax. Some states, like Florida, do not have a state capital gain tax. If there is a dwelling unit on the property consisting of a bedroom, kitchen and bathroom, Revenue Procedure 2008-16requires a two year hold on the old and replacement property plus no more than fourteen personal overnights or ten percent of the annual rental and at least fourteen rental overnights (recognizing that renting to family members and family is problematic) in each of the four years. The property must be held for investment and not as a primary residence or second home, though after two years the property character can be converted to a primary or second home.
CPA
Contact your CPA to ask about the potential tax consequence of the sale. Without that number, you are assuming a 1031 makes sense. If you don’t have a CPA, ask a friend who they work with to secure the right data. With the input of your CPA, place the property up for sale and secure a Buyer.
Qualified Intermediary
Once in a Purchase and Sale Agreement, engage a Qualified Intermediary (QI) to walk through the steps of the exchange. Atlas 1031 Exchange creates an engagement letter summarizing the steps to each 1031 exchange based upon your transaction and the intermediary fee and the bank to hold your funds. The Federation of Exchange Accommodators(FEA) provides a database by state of qualified intermediarieswhose members must follow a Code of Ethics and receive a criminal background checks as part of their annual membership renewal. The FEA also administers the coveted Certified Exchange Specialist® designationto members who have been in the accommodation business at least three years, providing direct consultative services, having passed the board level exam and maintaining twenty hours of continuing education every two years.
The QI will ask for a brief description of what is being sold, ask for the hold time, who is on title to the property being sold, the sales price, is there debt to be retired at closing, who is the closing contact and has a closing date been determined. It is important to talk with the QI to allow questions and answers to flow spontaneously. The conversation also allows you to gauge the QI’s breadth and depth of 1031 knowledge. That is important to ultimately trust the QI who is holding your funds. How are the funds held and with whom? Click here for a free download of QI vetting questionsto ask.
1031 Exchange Rules
To defer the capital gain and recaptured depreciation taxes, the replacement property must be equal to or greater than the net relinquished sales price. That is the gross sales price less the sales commission, title and attorney fees, recording and QI fees. If not, tax is triggered on the difference. Partial exchanges are doable. Be sure to ask your CPA the tax consequence of the partial exchange.
The replacement property holder must be the same as the relinquished or old property titleholder. There are exceptions to this rule, including a sole member limited liability company and revocable trusts.
Real property within the US is considered like-kind to real property held within the US. Real property held outside the US, like India or Israel, can be exchanged for real property located internationally.
Replacement property candidates must be formally identified to the QI by the 45thcalendar day post relinquished property closing. The replacement property must be acquired no later than the 180thcalendar day post-closing.
Is the Buyer of the relinquished property or Seller of the replacement property related to the exchangor? If so, a series of questions need to be asked to determine how best to navigate the related party rules.
As questions surface, write them down to ask your QI. Get comfortable with the process and your QI.
