“Does a 1031 exchange make sense?” is a common question investors and business owners ask themselves when selling property. The answer is that it depends on a number of facts including how long the asset has been held, what is the taxpayer’s adjusted gross income, is the taxpayer married or an individual, what is the recognized gain or tax due on the sale and finally, is the intent to replace the asset? If the responses are that a 1031 exchange does make sense, what are the tangible benefits?
1031 exchange
Misinformed Call for Demise of the 1031 Exchange
“Should tax reform include the removal of Treasury Regulation Section 1031 tax deferred exchanges?” is a question that, for the misinformed, the answer appears to be “Yes.” The discussion underway is how to reform the tax code affecting billions of dollars of tax subsidies for individuals and corporations. As one of two hundred tax appropriations annually quantified by the bipartisan Joint Committee on Taxation, the 1031 exchange is estimated to cost $42 to $47 billion over a five year period. The manner in which these numbers are determined has changed tripling the previous $15 billion estimate. Here are the previous estimates:
1031 Exchange versus Traditional Sale
What is the difference between a Section 1031 Exchange and a traditional sale? It is important to understand what a 1031 exchange is, what it does and what is required to provide the contrast with a traditional sale.
1031 Exchange
A 1031 exchange is a Treasury Department Regulation and Section in the Internal Revenue Code that allows taxpayers to defer the capital gains and recaptured depreciation taxes when selling real and personal property held in the productive use of a trade, business or for investment. In addition to the exchange regulations and section 1031, Treasury and Internal Revenue Service issue rules and guidance including regulations on new legislation, revenue procedures, revenue rulings, private letter rulings, technical advice memorandums and chief counsel advice memorandums.
Three Benefits of a 1031 Exchange
A 1031 exchange enables a taxpayer, both United States resident and non-resident foreigner, to defer capital gains and recaptured depreciation taxes when exchanging real and personal held for productive use in a trade, business or for investment property for like-kind real and personal property. The tax deferral can represent upwards of 40 percent of the property’s sale price.
1031 Exchange Rules: Disqualified Person
When a taxpayer sells a property, capital gains taxes are typically due on the realized gain from the sale. One option that many taxpayers utilize to avoid the immediate payment of capital gains taxes is to enter into a Section 1031 exchange instead of a traditional sale. Transactions that qualify for Section 1031 treatment allow the taxpayer to defer the capital gains taxes due on the realized gain. The basic premise of a 1031 exchange contemplates relinquishing the original property in exchange for a replacement property. The properties exchanged must be of “like-kind” and the entire transaction must be completed within a specified time period.
Constructive Receipt
In addition, a 1031 exchange transaction will be disqualified if the taxpayer actually or constructively receives money, or non-like-kind property, before the taxpayer actually receives the replacement property. The Internal Revenue Code allows for four safe harbors options to ensure that this requirement is met, including the use of a Qualified Intermediary. By using a Qualified Intermediary, the taxpayer can be assured that he or she will not be in actual or constructive possession of the proceeds in violation of the rules for the exchange. In order to take advantage of the Qualified Intermediary safe harbor provision, the person or entity that acts as the Qualified Intermediary must not be a “disqualified person” as defined by Treas. Reg. §1.1031(k)-1(k).
Disqualified Person
For purposes of a Section 1031 exchange, a disqualified person is someone who is considered an agent of the taxpayer at the time of the exchange. Family members, or related persons, of a disqualified person are also disqualified. 1031 exchange rules provide examples of some situations where the Qualified Intermediary could be considered an agent of the taxpayer including, “a person who has acted as the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period ending on the date of the transfer of the first of the relinquished properties in a like-kind exchange.”
The Regulations further define a disqualified person by clarifying that “services to the taxpayer with respect to exchanges intended to qualify for non–recognition of gain or loss under section 1031, and routine financial, title insurance, escrow, or trust services for the taxpayer by a financial institution, title insurance company, or escrow company, are not taken into account.” Finally, entities that are controlled by the taxpayer are also disqualified. For purposes of a 1031 exchange only, this includes corporations, partnerships, and any other entity that the taxpayer, or a related party, owns either directly or indirectly, more than a 10 percent interest.
Financial Institution
An example of how the rules regarding disqualification of a Qualified Intermediary, can be found in Private Letter Ruling 200630005. In that fact pattern, a specialty finance company wished to expand its services through a subsidiary company owned wholly by the primary entity. The subsidiary would be used as a Qualified Intermediary for transactions entered into by the primary entity. The Internal Revenue Service concluded that the primary “is a financial institution and the making of loans to customers, including loans to finance the acquisition of replacement property in a like-kind exchange where (the subsidiary) is the qualified intermediary, constitute routine financial services. The primary’s sale, or offering for sale, of properties that it owns as replacement property in a like-kind exchange utilizing the subsidiary QI services makes neither the primary nor the subsidiary, the agent of a customer utilizing their services in a like-kind exchange, so long as the finance company does not act as the taxpayer’s real estate agent or broker.”
If you are considering a 1031 exchange and have questions about whether your transaction may include a disqualified person, contact our office for a complimentary consultation or click here to ask a question.
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.