Exchange Blog

A 1031 exchange represents a Section of the Internal Revenue Code that allows a taxpayer, whether an individual, husband and wife, trust, limited liability company or corporation, to defer federal and state capital gain and recapture depreciation taxes when selling real or personal property held in the productive use of a business or for investment. There are many rules to follow and it is the responsibility of the Qualified Intermediary (QI) to enforce the 1031 rules by effectively accommodating the 1031 exchange and holding the net equity in a manner to preserve principal and liquidity. The QI must be an independent, third party entity, separate from the taxpayer, who is not considered an employee, agent or related to the taxpayer.

Continue reading →

A 1031 exchange allows the taxpayer to defer federal and state capital gains and depreciation recapture when selling and replacing real and personal property held in a business or for investment. Deferring the gain represents additional working capital or an indefinite interest free loan to acquire the replacement property, totaling as high as forty percent of the relinquished or old property sales price. There are many types of exchanges that fit the transaction sequence, including forward, reverse, improvement and leasehold.

Continue reading →

In a 1031 exchange, the taxpayer sells and replaces real or personal property of equal or greater value within 180 calendar days of the initial closing given the property has been used and replacement will be held in the productive use of a business or for investment. The Internal Revenue Service (IRS) Code Section 1031 allows the taxpayer to indefinitely defer the federal and state capital gain and depreciation recapture taxes which can amount to forty percent of the relinquished or old property sales price. The tax is ultimately due when the replacement property is sold in a non-exchangeable transaction, or it can be deferred again in a subsequent 1031 exchange.

Continue reading →

In a 1031 exchange, the exchangor is deferring the federal and state capital gain and depreciation recapture tax on the sale of real property held in a business or investment when real property of equal or greater value is replaced within 180 calendar days of the initial closing. The tax deferral postpones the tax until the replacement property is sold. If another 1031 exchange is initiated, the tax is deferred. There is no limit to the number of 1031 exchanges an exchangor or taxpayer can initiate. The benefit of the tax deferral is the use of those otherwise paid out tax dollars as additional working capital towards the replacement property purchase. The 1031 exchange premise is that the economic position of the exchangor has not changed. The exchangor has not received cash or reduction in debt or benefit other than exchanging one asset for another.

Related Party

A 1031 exchange is subject to a number of rules that if not satisfied will likely result in the Internal Revenue Service overturning the tax deferral, resulting in a penalty, interest on the tax deferred, tax payment and the resources to respond to the audit. One of those rules is when the exchangor sells the relinquished or buys the replacement property from a related party.

Section 1031(f) of the Internal Revenue Code addresses related party exchanges. In general, a related party exchange where the property involved in the exchange is disposed of within two years after the exchange does not qualify for non-recognition of gain; however, Section 1031(f)(2)(C) does not allow non-recognition of gain if “it is established to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.” Section 1031(f)(4) goes on to state that “This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection.”

Property can be acquired from a related party given the related party is also initiating a 1031 exchange and not cashing out. If the seller can meet the non-basis shifting exception that the property basis is as low or lower than the exchangor’s basis in the exchangor’s relinquished property, then the related party transaction is acceptable.

In order to avoid triggering the “related party” prohibition, exchangors use a Qualified Intermediary, or QI, to facilitate the 1031 exchange. By doing so the exchangor technically avoids entering into a related party exchange; however, the facts and circumstances of the transaction may then trigger Section 1.1031(f)(4) and lead to non-recognition of gain nonetheless.

The purpose of prohibiting related party exchanges is to prevent exchangors from being able to use Section 1031 to shift the basis in property and then “cash out” shortly after the exchange. Prior to the implementation of Section 1031(f), related parties would often exchange a high basis property for a low basis property and then sell the low basis property for substantial gain without being required to pay capital gain taxes on the realized gain.

A related party is defined as any person or party, including entities that have a relationship to the exchangor described in Section 267(b) or Section 707(b)(1) of the Internal Revenue Code, including the following partial list:

• Members of the same family (siblings, spouse, ancestors and lineal descendants)

• Corporation where more than 50 percent of the value of the stock is owned directly or indirectly by or for one particular individual

• Two corporations that are in the same controlled group

• A grantor and a fiduciary of any trust

• A corporation and a partnership if the same person or persons own

o   More than 50 percent in value of the outstanding stock of the corporation, and

o   More than 50 percent of the capital interest or profit interest in the partnership

Understanding the parties involved in the exchange is an important aspect of every 1031 exchange; the lack of understanding could very well undermine the tax deferral. If you have a related party question, click on the button below to ask the Certified Exchange Specialist®.

A 1031 exchange allows taxpayers owning real and personal property in a trade, business or investment to defer the federal and state capital gain and depreciation recapture taxes when selling and replacing with like-kind real and personal property. The tax deferral postpones the tax payment until the replacement property is sold and the taxpayer cashes out. Should the taxpayer elect to initiate another 1031 exchange, the tax deferral continues. The tax does not go away,but rather is postponed given the replacement property has a purchase price equal to or greater than the relinquished or old property. Should the taxpayer replace less than the relinquished net selling price, then a tax is triggered on the difference, known as a partial exchange. The premise for the 1031 exchange is that the taxpayer’s economic position has not changed from the sale to the purchase; no benefit is received such as cash or reduction in debt. There are many rules to follow in a 1031 exchange, including the use of an independent, third party known as a Qualified Intermediary (QI), to accommodate the 1031 exchange.

Continue reading →