This Friday Free for All we will go back to basics. We will look at 1031 tax-deferred exchanges, what they are, their benefits, how they work and the rules involved.
Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such property is exchanged for property of like-kind to be used either for productive use in a trade or business or for investment. There are numerous benefits to completing a 1031 exchange beyond the immediate tax deferral. They include:
- Time value of deferred gain
- Greater buying power
- Increased income potential
- Less management responsibility
- Diversification of investments
- Consolidation of properties
- Relocation of investment property or business
- Tax may be forgiven upon death of Taxpayer (heirs may receive stepped up basis)
- Defers capital gains, depreciation recapture and could avoid the 3.8% Net Investment Income Tax
In a 1031 exchange, you are not swapping or exchanging in the context of two-party barter. Rather, an exchange involves the sale of business use or investment real property followed by the subsequent purchase of like-kind real property from a third party linked together by paperwork and completed with the required timelines. The definition of like-kind is very broad and liberal and it applies to the nature or character of the property, not the type. The key is that both the relinquished and replacement properties are held for business or investment use. Some examples of frequently exchanged real property include office buildings, warehouses, duplexes, DSTs, tenant-in-common interests, mineral rights and so on.
Regardless of the like-kind asset you sell or purchase, to maximize your tax deferral, you must acquire replacement property of equal or greater value and equity. The value of the relinquished property is its net selling price, or the contract sales price less routine transaction expenses. The equity in the relinquished property is the net after all routine transaction expenses and mortgage payoff(s). Any trade down in value or equity is referred to as “boot” and is subject to capital gains tax.
There are two time deadlines in an exchange. Both start with the closing of the first relinquished property when title is conveyed from the Exchanger to the buyer. They are the 45-Day Identification Period and 180-Day Exchange Period. There are no extensions to these deadlines unless you are affected by a federally declared disaster.
The 45-Day Identification Period requires the written identification of like-kind property you wish to acquire during the exchange. All properties must be unambiguously identified in writing, the identification must be signed by all parties to the exchange, received by midnight of Day 45 and follow identification guidelines. The 180-Day Exchange Period runs concurrently with the 45-Day Identification Period and requires the purchase of all chosen identified replacement property.
Any taxpayer, from an individual to an entity such as a partnership, LLC, trust or corporation, can complete a 1031 exchange. To meet the same taxpayer requirement, however, title to the replacement property must be taken the same way it was held on the relinquished property. There is one exception: the use of a disregarded entity for tax purposes. In a disregarded entity, such as a single-member limited liability company (LLC), the business entity is not separate from its single-member owner and the underlying taxpayer remains the same. This means all income, expenses and losses are reported on the single-member owner’s tax return.
Whether you are an individual taxpayer or entity, under the regulations a Qualified Intermediary (QI), such as 1031 CORP., must facilitate your 1031 exchange. The QI is an independent party that cannot be your close relative, partner, employee or a professional advisor you have worked with in the past two years, such as your attorney, accountant or real estate professional. As the QI, 1031 CORP. prepares all pertinent exchange documentation, coordinates details with the closing agents, controls (and safeguards) your exchange proceeds and keeps you aware of your deadlines. The Exchange Team at 1031 CORP. keeps the exchange process simple for you.
Our Exchange Team is always available to answer your questions and help you put section 1031 to work for you.