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Review the Fundamentals of Section
1031 Like-Kind Exchanges
Taxpayers planning to sell,
purchase, or construct real property
should review the possibility of
conducting an Internal Revenue Code
Section 1031 like-kind exchange to
defer the incurrence of federal and
general state income taxes on the
capital gain. To qualify, property
owners must exchange real or
personal property (relinquished
property) for other property of a
like-kind (replacement property).
For example, Javier Cortez owns an
apartment building valued at
$500,000. He wants to sell the
building to purchase another
investment property but avoid
incurring capital gains taxes.
Following detailed IRC rules, he can
accomplish this through a 1031
exchange.
Defining Like-Kind Property
The definition of like-kind real
property is very broad; the
replacement property does not have
to be the same type as the
relinquished property. For example,
Javier could exchange his
multifamily building for an office
or retail property or for a
tenancy-in-common or fee interest.
Also, the replacement property is
not limited to a single building;
Javier could purchase a portfolio of
three small buildings.
Personal property may be exchanged
for other like-kind or like-class
property, but the definition of
like-kind personal property is more
restrictive than that applied to
real property. For example, the
exchange of a truck for a car likely
would not be allowed, while the
exchange of one car for another car
or a computer for a printer is
treated as an exchange of like-kind
property.
Real property is not like-kind to
personal property, but combinations
of the two may qualify under Section
1031 rules. For instance, Javier
could not exchange his multifamily
building and its furnishings solely
for real or personal property in a
completely tax-free exchange, but he
could exchange the property for a
combination of real and personal
property, such as a restaurant and
its furnishings and equipment.
However, exchanges involving both
real and personal property may
result in the recognition of some
gain as it is unlikely that equal
values of personal property of a
like-kind are exchanged. This form
of multiple property exchange is
subject to specific rules and can
result in the recognition of gain
even in the absence of any money
transfer.
Not allowed are transfers of certain
property inventory or other property
held primarily for sale, such as
subdivided lots held for sale, and
interests in partnerships or real
estate investment trusts.
Use
Requirements and Holding Period
Taxpayers must have held the
relinquished property for use in a
trade or business or for investment.
Under this requirement, personal
residences are not eligible.
Vacation homes may qualify as
investment property if the
taxpayer's personal use is limited
or the home has been rented. Since
Javier's multifamily building is an
investment property, it is eligible
for an exchange so long as he
selects a replacement property to
hold as an investment.
While no formal rule exists, the
Internal Revenue Service
historically has taken the position
that the taxpayer must hold both the
relinquished and replacement
properties in a qualified use for a
certain time period. Thus, the IRS
might challenge the exchange if
Javier sold the replacement property
shortly after the exchange.
Taxpayers should consult with a tax
adviser concerning the appropriate
holding period for property.
Recognition of Gain or Loss
To defer total gain, both the value
and net equity of the taxpayer's
replacement property must equal or
be greater than the value and net
equity of the relinquished property
at the time of the exchange. In
Javier's case, the replacement
property must have a value of at
least $500,000 and the value must
exceed by $300,000 (net equity) any
debt assumed in connection with the
replacement property.
If the value of the replacement
property is less than $500,000 or
the net equity is less than
$300,000, Javier would be taxed on
the greater of the trade down in
value or equity, limited to the gain
he would have recognized if the
property simply had been sold for
its fair market value.
The
Qualified Intermediary
Most like-kind exchanges are
deferred exchanges. To complete a
deferred exchange, the taxpayer must
transfer the relinquished property
for other like-kind property and not
for money. Therefore, the taxpayer
cannot gain actual or constructive
receipt of the relinquished
property's proceeds before
purchasing the qualifying
replacement property. Tax
regulations impose strict
limitations on the taxpayer's access
or control over the proceeds and
expressly limit the right to
receive, pledge, borrow, or
otherwise obtain the benefits of the
money.
Thus, deferred exchanges require the
use of a qualified intermediary to
hold the sale proceeds and acquire
the replacement property. Certain
persons that provide other services
on behalf of the taxpayer are
disqualified to act as a qualified
intermediary. Many companies
specialize in acting as a qualified
intermediary for a fee. Consult a
tax adviser to make certain that a
qualified person is acting as the
intermediary in the case of a
deferred exchange.
For example, Javier chooses an
acquaintance, Robert, as the
qualified intermediary. He assigns
his rights under the relinquished
property sales agreement to Robert
who holds the sale proceeds in an
account or in a qualifying escrow
until purchasing the replacement
property on Javier's behalf.
Deferred Exchange Timing
Strict timing rules apply to
deferred exchanges. Generally, the
taxpayer must identify the
replacement property or properties
in writing to the intermediary
within 45 days of the relinquished
property's sale. Within 180 days of
the transfer of the relinquished
property, the taxpayer must receive
the replacement property. The
180-day period is limited to the due
date of the taxpayer's tax return
unless that return is extended.
Tax rules also place restrictions on
the taxpayer's right to use or
pledge the relinquished property
sale proceeds during the 180-day
exchange period. In Javier's
situation, he sold the multifamily
property to another investor for
$500,000 and placed the proceeds in
an escrow account held by Robert.
Within a month he identified in
writing two small medical office
buildings as the replacement
property. Two weeks later, Robert
purchased the medical office
buildings for $500,000 using the
relinquished property sale proceeds
and transferred the title to Javier.
By following the guidelines, Javier
successfully completed a deferred
exchange and avoided incurring
federal and state taxes.
Consult a tax professional for more
information about Section 1031
tax-deferred exchanges.
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