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1031 Exchanges Tax Deferral

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A 1031 Exchange ( Internal Revenue Code 1031) provides for the tax deferral of real and personal property. If done correctly, investors defer capital gain tax due in connection with the sale of property, enabling them to leverage their investment portfolio. It is applicable whenever a property owner intends to sell any property that is not their primary residence and falls under the definition of “like-kind” and plans to buy another “like-kind” property within 180 calendar days following the closing of the relinquished property. Your identification of replacement property must be received on or before midnight of the 45th days after the close of sale of the relinquished property. With respect to the exchange period, it ends on the earlier of the 180th day or the due date of your tax return for the taxable year in which the transfer of the relinquished property occurs.

 

What is IRC Section 1031

Section 1031 of the Internal Revenue Code allows an owner of investment property to exchange property and defer paying federal and state capital gain taxes up to 15% Federal, 25% depreciation recapture and applicable state taxes) if they purchase a “like-kind” property following the rules and regulations of the Internal Revenue Code. This allows investors to use all of the sale proceeds to leverage into more valuable real estate, increase cash flow, diversity into other properties, reduce management or consolidate holdings.

Like-Kind Property

There is some confusion regarding what type of property qualifies for a §1031 tax deferred exchange. The Internal Revenue Code Section 1031 states that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment. “Like-kind” property can include, but is not limited to, any of the following, provided it is held for investment:

 

· Single Family Rental

· Duplex

· Apartment

· Commercial Property

· Raw Land

 

For example, raw land can be exchanged for a single family rental, or apartments or a commercial building. Properties can be exchanged anywhere within the United States.

 

What is a Qualified Intermediary

 

A qualified intermediary agrees to assist the exchanger to affect a tax-deferred exchange. Also known as a facilitator or accommodator, a qualified intermediary cannot be the taxpayer, a related party, or an agent of the taxpayer.

 

Phase I begins when the Exchange Agreement is signed and the relinquished property is transferred to the Qualified Intermediary, through an Assignment Agreement. The property is then sold to the buyer and the cash proceeds are deposited into an exchange account.

 

Phase II begins once a purchase contract is signed with the seller. The QI is assigned the contract and purchases the replacement property with funds held from the sale of the relinquished property. The exchange is completed when the replacement property is transferred back to the taxpayer pursuant to the Exchange Agreement. Under the current rules for a §1031 Exchange, the IRS mandates that an actual exchange must take place in each §1031 Exchange transaction. The Exchanger must grant to the Qualified Intermediary their interest as seller of the relinquished property and their interest as Buyer of the replacement property. Because the Qualified Intermediary becomes an actual principal in the transaction a reciprocal trade is created, even when there are three or more parties involved in the exchange. If the Exchanger receives any of the proceeds from the sale of the relinquished property, those proceeds will be taxable.

 

The Qualified Intermediary will hold the proceeds from the sale in a separate exchange account until the funds are used to purchase the Exchanger’s replacement property. Also, there are legal documents to complete an exchange. The Qualified Intermediary will prepare these documents for each settlement officer handling the transaction.

 

What is “Boot?”

 

The term “boot” refers to any property received in an exchange that is not considered “like-kind.” Cash boot refers to the receipt of cash. Mortgage boot (also called “debt relief”) is a term describing an Exchanger’s reduction in mortgage liabilities on a replacement property. Any personal property received is also considered boot in a real property exchange transaction.

 

 

If the Exchanger receives cash or other property in addition to like-kind property, this may result in a taxable event. Contrary to popular belief, tax deferred exchanges are rarely two-party swaps. Most are delayed exchanges, whereby the Exchanger has 180 days between the sale of the relinquished property and the closing of the replacement property. They must identify the potential replacement property within 45 calendar days from closing on the relinquished property.

Reasons to Do a 1031 Exchange

 

A. Preservation of Equity-A properly constructed exchange provides 100% deferral of Federal and State capital gain taxes. This equals a deferral of all taxes due indefinitely.

 

B. Leverage-Many investors exchange from a property where they have a high equity position to one that is a more valuable property. A larger property produces more cash flow and provides greater depreciation benefits.

 

C. Estate Planning-Sometimes family members inherit one large property and disagree about what they want to do with it. By exchanging from one large property into several smaller properties, an investor can designate that, after their death, each heir will receive a different property, which they can either hold or sell.

 

 

Use of an SPE or LLC

 

A single member LLC is disregarded for tax-purposes, therefore a taxpayer can acquire replacement property as a single member LLC and the IRS will not consider it a different entity than the seller of the relinquished property. Any income taxes associated with the LLC are passed through to the designated single member. An individual, corporation, partnership, trust or other entity can be a single-member of a single-member LLC. Delaware provides ample statutory protection for the owners of the entity. Also, Delaware does not impose state income tax on the entity. Any LLC however, must be registered to do business in the state in which the property is located.