Over the past 17 years, we have had the pleasure of guiding thousands of Exchangors through the 1031 Exchange process. Our Blog draws from that experience and includes content ranging from the basics of an Exchange for first time Exchangors to detailed commentary on complex exchanges for the expert investor. If you do not find the topic or specific question you are looking for, reach out to us via email at info@atlas1031.com or call our office to speak with our team at 1 800 227 1031.
Section 1031 of the Internal Revenue Code allows taxpayers to enter into an exchange of property instead of a traditional sale in order to defer the payment of capital gains taxes that would otherwise be due. Because of the various and complex rules that must be followed for a transaction to qualify as a Section 1031 Exchange, a Qualified Intermediary, or QI, is required to facilitate the transaction. In short, a QI facilitates the exchange through the use of an Exchange Agreement and Assignments of the relinquished and replacement property Purchase and Sale Agreements entered into by the QI and the taxpayer. Part of the QI’s role is to hold, and ultimately transfer between the parties, funds that are used in the transaction. Given the fiduciary role of a QI, individual states have enacted laws specifically aimed at Qualified Intermediaries in an attempt to prevent misappropriation of funds. In Virginia, § 55-525.1 et seq. addresses the duties and responsibilities of a QI, who is referred to as an Exchange Facilitator in Virginia.
1031 eligible multi-family properties are available in Warrensburg, Missouri, located 64 miles from Kansas City and 218 miles from St. Louis. Whiteman Air Force Base and University of Central Missouri are the leading employers.
When selling land, whether farmland, timberland or raw land, federal and state taxes are triggered and due in the year following the sale. The sale proceeds are reported on the taxpayer’s federal and state tax return. If the property sold for a value greater than the purchase price, then a capital gains tax is due. The capital gains tax is currently 15 percent given the property has been owned for at least a year and a day and the taxpayer is in the 25 percent tax bracket and above. If owned for a shorter period, then the short term rate or the ordinary income tax, is imposed. Recaptured depreciation is not due given land cannot be depreciated.
When a taxpayer realizes a gain on the sale of property, the taxpayer typically owes capital gains taxes on the amount realized. One method often utilized by taxpayers to avoid the payment of capital gains taxes is to enter into a Section 1031 Exchange instead of a traditional sale. When a transaction qualified for Section 1031 treatment the capital gains taxes that would otherwise be due are deferred. When a non-resident alien, or foreign, investor is involved the rules become a bit more complicated.
1031 exchange examples include any real property exchanged for like-kind real property. A 1031 exchange is a tax deferral strategy based on the Internal Revenue Service and Treasury Department Regulation Code Section 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.”
No Gain or Loss
When real property is sold, federal and state capital gain and recaptured depreciation taxes are triggered that can exceed 40 percent of the sales price. If the taxpayer’s intent is to replace the property sold with like-kind property of equal or greater value or even partial value, within 180 calendar days of the initial sale, then the 40 percent tax obligation can be deferred indefinitely or until the replacement property is sold. There is no limit to the number of 1031 exchanges a taxpayer can initiate.
In effect, the 1031 exchange is an interest free loan. The taxpayer is able to use those otherwise paid tax dollars towards acquiring replacement property.
1031 Exchange Examples
Real property can also be exchanged and taxes deferred. Commercial property such as rental properties, condominiums, buildings, shopping centers, strip malls, timberland, mineral, gas and water interests (state dependent) and land represent real property eligible for a 1031 exchange. Real property with predominant use in the US can be exchanged with real in the US. Property held overseas can be exchanged for property held internationally. A taxpayer who owns a condominium held for investment in Singapore can exchange for real property held in a trade, business or for investment in India.
Improvement or Build to Suit Exchanges
1031 exchanges also include improvements made to real property such as when a taxpayer who sells a condominium or rental property acquires a rental property that requires improvements or rehab. In a 1031 exchange, the replacement property is titled to an Exchange Accommodator Titleholder while the improvements are made to the property. The real property is conveyed to the taxpayer no later than the 180th calendar day posting closing on the old property.
Examples of 1031 exchanges are everywhere, from gas stations and convenience stores to motels, land, condominiums, apartments and equipment. To view specific 1031 exchange examples view the Atlas 1031 testimonials. To download an eBook on “Ten Reasons Why a 1031 Exchange Makes Sense,” click here.
The forward 1031 exchange is one of many types of 1031 tax deferred exchanges. Also known as a delayed exchange, in a forward 1031 exchange, the relinquished or old property is sold by assigning the rights of the Purchase and Sale Agreement (PSA) to the qualified intermediary who instructs the title company to direct deed the property to the buyer. A Notice of Assignment is signed by the buyer. An Exchange Agreement is then signed by the Exchangor. The net equity is then wired to either the replacement property closing, if scheduled to closed within a couple of days, or to an escrow account established under the Exchangor’s tax identification number. The funds are held in the escrow account until needed for the replacement property closing to occur within 180 calendar days of the relinquished property closing.
Identification Phase
In a forward 1031 exchange, replacement property is to be formally identified to the qualified intermediary by the 45th calendar day post-closing listing the addresses of up to three properties regardless of value, or four or more given the total value does not exceed two hundred percent of the relinquished property sales price. An identification form is provided by the qualified intermediary along with a letter identifying the 45th and 180th calendar day of the forward 1031 exchange.
Should no properties be identified, the forward 1031 exchange ends at 12:00 AM on the 45th calendar day post relinquished property closing. Exchange funds held in the Exchangor’s escrow account are wired the following business day, ending the exchange. If the net equity and debt retired at the relinquished property closing is not replaced with replacement of equal or greater value, then federal and state capital gains and recaptured depreciation taxes are due when the Exchangor files their federal tax return.
Replacement Phase
The replacement property can be acquired at any time in the forward 1031 exchange. In a simultaneous 1031 exchange, the old and new property can be closed on in the same closing or same day. If the replacement property is to be acquired within days of the relinquished property closing, it is suggested to separate the closings by a couple of days to allow for the exchange fund wire to clear the banks. Otherwise, the closing staff is anxiously waiting for the exchange funds to be received.
The rights of the replacement property PSA, but not the obligations, are assigned to the qualified intermediary who instructs the title company to direct deed the replacement property from the seller to the Exchangor. A Notice of Assignment is signed by the seller.
The Assignment of rights to the PSA effectively enables the qualified intermediary to become the seller of the relinquished property and to receive the exchange funds from the sale for use to acquire the replacement property as the buyer. A 1031 exchange is a series of interdependent steps requiring strict adherence to the requirements set forth in Internal Revenue Code Section 1031.
Deferred Improvement Exchange
Another form of the forward 1031 exchange is when a Deferred Improvement Exchange, improvements are to be made on the replacement property using the exchange proceeds. The steps are similar to a forward 1031 exchange, except an Exchange Accommodator Titleholder, (EAT) acquires the replacement property on behalf of the Exchangor and holds title. The Exchangor oversees the construction, approving vendor invoices that are paid by the qualified intermediary. It is critical to include a description of the improvements on the identification letter. The 45th and 180th calendar day timeframe requirements still apply. No later than the 185th calendar day post relinquished property closing, the EAT conveys title to the Exchangor. For states that impose transfer taxes, attention should be given towards understanding whether a transfer tax is due at time of recording.
