“What is a 1031 Exchange?” is a question I asked in June, 2003. Nearly twelve years later and having accommodated over 680 simple and complex, real and personal property, US and foreign based 1031 exchanges, listening and responding to thousands of 1031 related questions, the answer is “It depends upon the transaction.” Every 1031 exchange is different; however, each share the same goal to defer federal and state capital gain and depreciation recapture taxes that can represent upwards of 40 percent of the sale price. Each 1031 exchange must follow strict rules as defined in Internal Revenue Code Section 1031. A 1031 exchange is either a forward or reverse, meaning either the old or relinquished property is closed before the replacement property closing or the replacement property is closed before the relinquished property closing.
IRS Code 1031
The 1031 code states “No gain or loss shall be recognized on the exchange of property held for productive use in trade or business, or for investment, if such property is exchanged solely for property of like kind which is to be held for productive use in trade or business or for investment.” Eligible 1031 property includes:
- real, tangible or intangible personal property held in the productive use of a business or for investment, not including property held primarily for personal use
Inventory held primarily for resale, such as inventory held by a dealer/developer/realtor or property held for flipping is not eligible. Time is one fact of many that supports a 1031 exchange. If the intent prior to closing is to hold for resale or quick profit, rather than for investment as seasoned over time, then the IRS may take a closer look at the 1031 exchange as reported on IRS Form 8824, which is submitted along with the taxpayer’s federal return. The 1031 code excludes the following property from consideration:
- primary residence
- inventory
- corporation common stock
- partnership interests
- indebtedness or notes
1031 Exchange Rules
Each 1031 exchange must be completed within 180 calendar days unless a non-safe harbor exchange is initiated. The IRS recognizes non-safe harbor exchanges; however, they are far more aggressive and subject to IRS scrutiny to verify the exchange accommodator titleholder has the burden of ownership while on title to the parked property.
The taxpayer who owns the relinquished property must be the same taxpayer who acquires the replacement. There are exceptions, most notably, the individual who may acquire as a single member limited liability company. Should a multi-member limited liability company who is on title drop to the individual members as far in advance to entering the purchase and sale agreement and closing, each member can either initiate their own 1031 exchange or cash out and pay their tax.
When selling and acquiring from a related party, there are additional rules to consider. The replacement property cannot be acquired from a related party if the related party is cashing out. A good example is the related party who wants to sell their primary residence to the exchanging taxpayer. The related party is cashing out, making the replacement property ineligible for 1031 consideration.
Replacement property must be formally identified preferably to the Qualified Intermediary (QI), no later than 11:59 PM on the 45th calendar day post-closing. Failure to complete terminates the exchange with no exceptions.
A QI must be engaged to accommodate the 1031 exchange except in the case of a two party exchange. The QI cannot be a disqualified person or someone who has acted as the taxpayer’s agent, employee, trustee of a qualified trust or in general, a person who is a related party to the taxpayer.
Property must be exchanged for like-kind property. Real must be exchanged for real property, while personal property must be exchanged for personal property in the same class as defined in thirteen general asset codes or North American Industry Classification System.
To defer the capital gain and depreciation recapture, the net sale price of the replacement property must be equal to or greater than the old property.
Download a ten point checklist for those who are seriously considering a 1031 exchange by clicking on the button below.
