1031 real estate exchange rules define how to go about deferring federal and state capital gains and recaptured depreciation taxes when selling and replacing a real property investment. A 1031 exchange, or Internal Revenue Code (IRC) Section 1.1031, allows any entity, both U.S. residents and foreign non-residents, to defer or postpone the payment given certain 1031 real estate exchange rules are strictly followed. The first step is to be aware that the taxes can be deferred indefinitely or until the replacement property is sold. Taxes, both federal and state, along with a twenty-five percent recaptured depreciation tax, can amount to upwards of 40 percent of the property’s sales price. If you could be given up to 40 percent of the real estate sales price interest free to use towards acquiring replacement property, wouldn’t you ask what the 1031 real estate exchange rules and requirements are?
1031 exchange rules
1031 Exchange Insight
In 2012, Section 1031 exchange of the Internal Revenue Code will defer an estimated $3.2 billion in capital gains and recaptured depreciation taxes for individuals and corporations, according to the Joint Committee on Taxation. The tax deferral is estimated to be $3.7 billion and $4.1 billion in 2013 and 2014 respectively. What do these taxpayers have that you may not?
1031 Exchange History
Ever wonder when and how the 1031 exchange materialized? For those new to the Internal Revenue Code Section 1.1031 tax deferred exchange, the code states “no gain or loss shall be recognized on the exchange of property held for the productive use in a trade, business or for investment if such property exchanged solely for like-kind which is to be held for the productive use in a trade, business or for investment.” The 1031 exchange represents a tax deferral strategy where a property owner sells one or more relinquished properties for one or more like-kind replacement properties, deferring the payment of federal and state capital gains and recaptured depreciation taxes.
1031 Exchange Justification and History
The philosophy of the 1031 exchange is based upon the premise of a property owner who reinvests the sale proceeds and retired debt into a like-kind replacement property; their economic position has not changed. The taxpayer has not received the economic gain or cash to pay the taxes triggered by the sale. Consequently, to force the taxpayer to pay the tax would be unfair. The tax obligation does not go away, rather it is deferred until the replacement property is sold. Once the replacement property is sold and another 1031 exchange is not initiated, the original deferred gain plus any additional gain realized since the replacement property purchase is taxed.
The genesis of the 1031 surfaced hundreds of years ago when property owners bartered for property. Farmers would trade land for land or livestock for livestock. When a better horse or cow was traded, the farmer would request something in addition to equalize the value traded. That something extra may have been food, a weapon, an ax or money. These additional items of value or benefits were known as boot. Today, the idea of cash received or mortgage not replaced is viewed by the Internal Revenue Service as a benefit, taxable and commonly known as equity and mortgage boot.
The original 1031 exchange was legislated into law with the Revenue Act of 1921. The code remained without much change from 1928 to 1984, when time limits were imposed as a result of the Starker decision in 1979.
Prior to 1979, 1031 exchanges were accommodated in one day long closing where the relinquished property was closed, followed by the replacement property closing. The impact of the Starker decision was that 1031 exchanges did not have to close the same day; the closings could be delayed. What is now known as a forward exchange allows for the relinquished property to be closed followed on another day by the replacement property closing. In 1984, the 45 and 180 calendar day limits were imposed, requiring the potential replacement property to be identified by the 45th calendar day post-closing with the 1031 exchange completed no later the 180th calendar day post-closing.
In 1991, four safe harbors were created as a bright-line test to determine whether the taxpayer is in actual or constructive receipt of money or property while having initiated an exchange. One of these safe harbors is the use of a Qualified Intermediary to hold the exchange funds during the exchange period. The (g)(6) limitations of the 1031 code states that “in no event shall Exchangor receive, pledge, borrow, or otherwise obtain the benefits of the Exchange Account, including earnings, thereon, before the Exchange Period.” Once a taxpayer touches the exchange funds or receives a notes payable from the property buyer, it is considered boot and taxable. Use of safe harbors prevents the taxpayer from having access to the exchange funds.
We Can Help
Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.
1031 Exchange Rules: Equity and Mortgage Boot
1031 exchange rules apply to Internal Revenue Code Section 1031 tax deferred exchanges. A 1031 exchange allows resident or non-resident United States federal taxpayers to defer capital gains and recaptured deprecation taxes when exchanging real or personal property held for productive use in a trade, business or for investment for like-kind real or personal property held for productive use in a trade, business or for investment. The tax otherwise paid in a traditional sale is deferred indefinitely until the replacement property is sold or another 1031 exchange is initiated.
1031 Exchange Rules: Exchange Requirement
Taxpayers frequently enter into a Section 1031 Exchange instead of a traditional sale to avoid the often substantial capitals gains and recaptured depreciation tax obligation due as the result of gains realized upon the sale of real and personal property held for productive use in a trade, business or for investment. If the transaction meets all the requirements of a Section 1031 Exchange, any tax due on the gains realized as a result of the exchange are deferred. Understanding how a Section 1031 Exchange differs from a traditional sale, as well as a full understanding of the rules required for a transaction to qualify for a 1031 Exchange, is essential to taking advantage of the capital gains deferral offered by the exchange.
A Sale vs. 1031 Exchange
In a traditional sale, a seller sells a property and receives the income from the sale at the time of closing. The seller may then decide to purchase another property at the same time or at a later date, but the transactions are separate and distinct. In a Section 1031 Exchange, a seller must both sell and purchase a replacement property as part of one cohesive plan. The transaction will not qualify for Section 1031 treatment unless a replacement property is either identified or acquired by the 45th calendar day following the original property sale. If identified, the purchase of the replacement property is completed within 180 days of the original sale. The Tax Court summed up the concept in Bezdjian v. Commissioner, T.C. Memo 1987-140 by stating “if the Taxpayer’s transfer and receipt of property were interdependent parts of an overall plan the result of which was an exchange of like-kind properties, 1031 applies.”
The use of a Qualified Intermediary is another 1031 exchange requirement that is important to understanding how a Section 1031 Exchange works. Because the transaction is an exchange, not an outright sale, the proceeds from the original sale should never actually be available to the seller as is the case in a traditional sale. Instead, the proceeds are held by a Qualified Intermediary to be used for the purchase of the replacement property. Likewise, the deed for the replacement property must be held by the Qualified Intermediary until the exchange has been completed. Using a Qualified Intermediary is found in the safe harbor rules and “will result in a determination that the taxpayer is not in actual or constructive receipt of money or other property for purposes of section 1031,” according to Regulation 1.1031(k)-1(g)(6).
Finally, it is important to understand that Section 1031 is mandatory. As the court held in U.S. v. Vardine, 305 F.2d 60 (1962), “1031 and its predecessor are mandatory, not optional; a taxpayer cannot elect not to use them.” Although in most cases it is in the taxpayer’s best interest to invoke the benefits of a 1031 Exchange, there may be times when a taxpayer may not wish to do so. As the court pointed out, however, Section 1031 is mandatory.
Complimentary Downloads
To learn ten reasons why a 1031 exchange makes sense, download the complimentary eBook by clicking here. To view a library of complimentary 1031 exchange eBooks for individuals, trusts, corporations, franchise owners, ranchers and farmers, timberland owners, lawyers, CPAs, Realtors and escrow and title officers visit the Atlas 1031 Exchange Resource page.
1031 Exchange Rules: Reporting a Like-Kind Exchange
Internal Revenue Service Form 8824, “Like-Kind Exchanges,” is the two-page form to report gain or loss on a 1031 exchange. The form is filed along with the taxpayer’s federal income tax return to support their intent to initiate and secure the 1031 tax deferral for gain or loss from property held for and replaced by property held for productive use in a trade, business or for investment. When exchanging real estate, the title or closing attorney submits a 1099 to the Internal Revenue Service and provides a copy to the taxpayer. The 1099 reflects the gross sales amount received for the real property. Form 8824 represents the taxpayer’s reporting on how those funds were utilized.
Form 8824 Part I
In Part I, information asked on the exchange includes:
- Description of the relinquished and the replacement property,
- Date the relinquished property was acquired and transferred to other party,
- Date the replacement property was formally identified,
- Date replacement property was received, and
- Whether or not a related party was involved directly or indirectly through a qualified intermediary with a related party including your spouse, brother or sister, parent, grandparent, child, grandchild, or related corporation, S corporation, partnership, trust or estate
Do not report the 1031 exchange on Form 8824 if the exchange was structured to avoid the related party rules; instead report the disposition of the property sold as if the exchange had been a sale.
Form 8824 Part II
If the 1031 exchange was with a related party, the related party’s name, relationship to you, identifying number and address are requested. To understand more about related parties, view
Form 8824 Part III
In Part III, the realized gain or loss, recognized gain and basis of the property sold and acquired are reported. If more than one exchange is completed in the taxable year, Form 8824 should be filed as a summary reflecting the total recognized gain from all the exchanges and the total tax basis for all replacement property. In addition, the taxpayer should include a statement showing individual property information for each exchange. Be sure to review Instruction to Form 8824 for further insight.
Finally, gain from the exchange is reported on Form 4797 for sales of business property or Schedule D for capital assets. Gain received from an installment loan in an exchange is provided on Form 6252. As always, seek the counsel of your CPA to understand specific taxpayer reporting requirements.
Learn ten reasons why a 1031 exchange makes sense by clicking here.
We Can Help
Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.