In a two party 1031 exchange, the taxpayer conveys the relinquished or old property to the buyer and the replacement property is conveyed from the buyer to the taxpayer. These types of exchanges are somewhat rare, given the likelihood that the taxpayer and the buyer want each other’s property. Properties are almost never the same value; consequently the taxpayer may pay tax on that portion of cash or retired debt that is not replaced. Nonetheless, these transactions do qualify as 1031 exchanges and do not require a qualified intermediary to accommodate the two party 1031 exchange.
1031 Exchange Purpose
Internal Revenue Code Section 1.1031 exchange defers the federal and state capital gain and depreciation recapture taxes when selling real and personal property held productively for use in a trade, business or for investment and replacing with like-kind real and personal property. The regulations allow taxpayers subject to US federal taxes to efficiently replace assets and defer or postpone the capital gain tax consequences until the replacement property is sold. The gain can be avoided if the replacement property is held by the taxpayer at death, then the gain is stepped up in basis to their heir meaning if the heir were to immediately sell the asset, the taxpayer’s original gain is eliminated and no tax is due.
The 1031 exchange was enacted in the Revenue Act of 1921 and is estimated to defer $3.7 billion in taxes in 2013 by the Joint Committee on Taxation. Utilized by individuals and corporations, 1031 exchanges encourage the replacement of out dated capital assets with new like-kind assets such as hospital equipment, aircraft, road and construction equipment, rental cars and trucks. The tax deferral supports the exchange of real property for real property that generates cash flow or land for a single family residential rental or vacation condominium. Additional reasons to consider a 1031 exchange include consolidation, diversification, relocation, appreciation and depreciation. Properties excluded from 1031 consideration are primary residences, partnership interests, indebtedness, stocks and securities and inventory.
Multi Party Exchange
The typical 1031 exchange is a three and four party exchange. The taxpayer sells to the buyer and the replacement property is acquired from the Seller. A Qualified Intermediary, or QI, who is not considered a disqualified person or agent of the taxpayer in the two years prior to the exchange, is required to facilitate the exchange. The QI role is to prepare exchange documentation created in accordance with the Treasury Regulations and prevent the taxpayer from having access to the exchange funds, otherwise known as constructive receipt, which would invalidate the exchange. The QI industry is not regulated so care must be taken to select a QI experienced with the type of exchange contemplated and who adheres to state regulations. To receive four questions, investors should ask when vetting QIs, download this free one page guide.
1031 Exchange Misconceptions
One of the common 1031 exchange misconceptions is that only the net equity from the sale needs to be replaced or used to acquire the replacement property. This is true when there is no debt on the old property. If the debt is not replaced, a tax is triggered known as mortgage boot. Additional cash offsets debt, but additional debt does not offset cash.
Another 1031 exchange misunderstanding is when the taxpayer wants to receive reimbursement for the earnest money deposited or improvements/repairs on the old property. The IRS taxes the first dollar received as equity boot. Cash can be received at the old property closing but will be taxable.
Finally, real estate can be exchanged for any real property the state recognizes as real property. Land can be exchanged for oil and gas royalties or a multi-unit apartment and qualify for a 1031 exchange. Personal property must be exchanged for the same like-kind or like-class personal property.
To download free educational “1031 How to Guides” and “Taxpayer 1031 Checklists” for taxpayers, CPAs, Realtors and Attorneys, visit the Atlas 1031 Exchange Download web page.
