What is a 1031 Exchange?
Individuals and companies who sell appreciated property (real estate or personal property) are subject to capital gains tax under the Internal Revenue Code. Under IRS’s 1031 Exchange rules, however, an exchange is not considered to be a sale and no capital gain is recognized or subject to tax. The basis of the relinquished property becomes the basis of the replacement property and tax is deferred until such time as the replacement property is “sold.” If the replacement property is later exchanged for another replacement property (not “sold”), tax is also deferred. So, as long as your business, rental or investment properties are disposed of in 1031 Exchanges, the capital gains tax will continue to be deferred.
1031 Exchanges are sometimes referred to as “Like-Kind Exchanges,” “Starker Exchanges,” “Tax Free Exchanges” and “Delayed Exchanges,” but they all mean the same thing — if you comply with the rules and are willing to reinvest in “like kind” property, you can dispose of your appreciated property and reinvest all of your proceeds without paying anything to the IRS thereby keeping more cash working (and property earning income and appreciating) than you would if you paid the tax each time you dispose of appreciated income or investment property. If you (the “exchanger”) die owning the last of a series of 1031 Exchange properties, the property will normally receive a “stepped-up basis” thereby causing the entire built-up capital gains tax to be permanently avoided.
For real estate exchanges, “like kind” property means any kind of real estate (vacant or improved) that you do not live in (in other words, investment, business or rental property). For personal property exchanges, “like kind” is much more problematic, and you should thoroughly discuss any anticipated personal property exchange with your tax advisor.
In order for a 1031 Exchange to be completely tax deferred, you must trade even or up in value between the sale prices of all of your relinquished properties and all of your replacement properties (there is no limit to the number of relinquished properties and the number of replacement properties you can have in one 1031 Exchange). Assuming your 1031 Exchange has only one relinquished property and only one replacement property and you sell your relinquished property for $400,000, the purchase price of your replacement property must be at least $400,000. If you had one or more mortgages on your relinquished property, your replacement property must have one or more mortgages placed upon it (no later than the date you acquire it) at least equal to the aggregate of any mortgages that you paid off on your relinquished property and all of the cash proceeds from the sale of your relinquished property must be reinvested directly into your replacement property when you close the purchase of your replacement property. In other words, you must trade even or up in both equity and debt. Of course, the proceeds from sale of relinquished property must be escrowed with a Qualified Intermediary (QI) company such as U.S. 1031 Exchange Services, Inc. between sale of relinquished property and reinvestment in replacement property. It is possible to trade down in value where you either don’t reinvest all the cash in the replacement property or have less mortgage on the replacement property, but you will pay tax if you do this, so be sure to discuss such a situation with your tax advisor to determine if you are willing to pay the tax before entering into a trade-down 1031 Exchange.
What does a Qualified 1031 Exchange Intermediary do?
A Qualified 1031 Exchange Intermediary prepares necessary documents including the Exchange Agreement, and enters into the Exchange Agreement with the exchanger. Then, as required by the Exchange Agreement, the Exchange Intermediary acquires the relinquished property from the exchanger, transfers the relinquished property to the buyer, acquires the replacement property from the seller and transfers the replacement property to the exchanger to complete the exchange. Although both the relinquished property contract and the replacement property contract are assigned to the Exchange Intermediary, it is not necessary for the Exchange Intermediary to actually take title to either property because the IRS rules allow direct deeding of the relinquished property from the exchanger to the buyer and direct deeding of the replacement property from the seller to the exchanger to complete the exchange. Between the closing of the relinquished property and the closing of the replacement property (which can be as much as 180 days apart), the Exchange Intermediary normally holds the proceeds from the relinquished property in escrow so that the exchanger does not violate the rule against actual or constructive receipt of those funds before they are reinvested in the replacement property.
Where Can Relinquished And Replacement Properties Be Located?
U.S. 1031 Exchange Services, Inc. can provide Qualified Intermediary Services no matter where in the United States your relinquished and/or replacement properties are located. However, subject to a couple of exceptions, properties outside the United States cannot be used as either relinquished or replacement properties in 1031 Exchanges.
Who Can Do A 1031 Exchange?
United States citizens (whether individuals or domestic companies) who would otherwise be subject to capital gains tax under the Internal Revenue Code can defer taxes by participating in 1031 Exchanges. Remember, however, that foreign persons (non-resident aliens) and foreign companies who own income/investment property in the United States may also take advantage of 1031 Exchange tax deferral. In other words, you do not need to be a United States citizen or have a “green card” in order to take advantage of exchange treatment for your income and investment properties, so long as they are located in the United States.
Types Of Exchanges
There are simultaneous exchanges in which the relinquished property and replacement properties are transferred on the same day to complete the exchange. But this does not happen very often. Usually, exchanges are delayed so that, after the relinquished property is transferred to a buyer, the exchanger takes up to 45 days to identify replacement property (up to three properties can be identified even if you only expect to purchase one, unless the “200 percent rule” applies), and then the exchanger has 180 days after the relinquished property closing (or the due date of the exchanger’s tax return including all extensions if such date would be earlier than 180 days) to close upon at least one of the identified properties. IRS “safe harbor” rules for such exchanges have been in effect since 1991.
There are also reverse exchanges where the exchanger needs to close on the replacement property before he has sold the relinquished property. This can be done by the Exchange Intermediary “warehousing” (taking title to the property temporarily so the exchanger does not own both the relinquished property and the replacement property at the same time). Either the relinquished property or the replacement property can be warehoused, depending on the circumstances. Effective September 15, 2000, IRS issued Rev. Proc. 2000-37 which provides “safe harbor” rules for reverse exchanges.
Also, there are construction (build-to-suit) exchanges where the exchanger needs to have a building constructed on vacant property before taking title. This kind of exchange is the most complicated.
U.S. 1031 Exchange Services, Inc. can assist with all kinds of exchanges, but reverse and construction exchanges are more expensive than regular simultaneous or delayed exchanges. Ask us for details.
1031 Exchanges are not for everyone. If you sell relinquished property and pay the taxes due, the balance will be free to invest any way you wish (no restrictions). On the other hand, a 1031 Exchange requires you to reinvest in “like kind” property which is likely to be a less liquid investment. Also, an unfavorable tax ruling could void the intended tax deferral and result in immediate tax liability, including tax penalties. Also, the 1031 Exchange related fees and costs could potentially outweigh any tax benefits. In fact, Jeff usually advises that even the basic exchange fee of $700 charged by U.S. 1031 Exchange Services, Inc. may not be worth it if the tax savings is not greater than $5,000.