An Overview for Section 1031 Exchanges
“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.”
Frequently Asked Questions:
No, in fact the first tax free exchange dates back to the 1920’s and Section 1031 of the IRS code was first introduced in 1921. The early exchanges involved two parties who simply traded properties. The concept of “like-kind” exchanges gained momentum, in common practice, as an investment and tax deferral tool in 1990 with a re-write of Section 1031. At that time, it became legal to sell one type of investment property and buy any other type of real estate (multi-family, beach property, vacant land, commercial property, etc.). The code was also updated to include specific rules and timetables that must be followed for the transaction to qualify as a successful 1031 Exchange.
A 1031 Exchange is one of the few strategies available to defer the recognition of capital gain and depreciation recapture taxes on the sale of qualifying property. The 1031 Exchange allows you to sell and subsequently acquire properties in order to reallocate, consolidate or diversify your investment portfolio without paying tax on any capital gain or depreciation recapture taxes.
Typically, by selling your investment property, you will trigger federal and state capital gain and depreciation recapture taxes, which will leave you with less equity to reinvest. This makes it difficult to trade-up in real estate value and/or increase your cash flow when you have to recognize and pay these tax liabilities. By completing a 1031 exchange, you can defer your capital gain and depreciation recapture tax liabilities and therefore keep 100% of your net proceeds from the sale of your investment properties available to reinvest in other like-kind replacement properties.
A 1031 Exchange is a mechanism by which you can dispose of certain real property and defer the payment of your capital gain and depreciation recapture taxes by exchanging the real property (the “Relinquished property”) for qualified “like-kind” property (the “Replacement property”).
Individuals, C-Corporations, S-Corporations, General Partnerships, Limited Partnerships, Limited Liability Companies, Trusts, and any other taxpaying entity, who own qualifying property, may perform a 1031 Exchange to defer capital gains and depreciation recovery taxes.
Simultaneous (Concurrent) Exchange: The sale of the Relinquished Property and the purchase of the like-kind Replacement Property occurs at the same time. While this was the original intent of the 1031 Tax Code, this type of exchange is rarely performed today.
Forward (Deferred) Exchange: This is the most common form of 1031 Exchange transactions today. A Forward or Deferred Exchange occurs when there is a time delay between the sale of the Relinquished Property and the purchase of the “like-kind” Replacement Property. A Forward (Deferred) Exchange is subject to specific time limits and guidelines established by the IRS.
Reverse Exchange: A less common structure, a Reverse Exchange occurs when the Replacement Property is purchased first, prior to selling the Relinquished Property to the actual buyer. Reverse 1031 exchanges are also referred to as parking transactions or parking arrangements.
Build-to-Suit (Improvement or Construction) Exchange: This type of exchange allows the taxpayer to build on, or make improvements to, the like-kind replacement property, using the exchange proceeds before they actually take title to the property.
Personal Property Exchange: Personal property can also be exchanged for other personal property of like-kind or like-class as long as the personal property has been held for investment, income production (rental) or use in a business. Examples of Personal Property Exchanges include artwork, race horses, agricultural and construction equipment, antique cars, patents, franchise licenses, airplanes and fleets of cars or trucks.
Only two types of real property qualify for a 1031 Exchange – Investment Property and Property held for use in trade or business. Principal residences, vacation homes and time shares do not qualify.
Among the types of real property that are eligible for 1031 Exchange treatment are multi-family apartment buildings, single-tenant net-leased properties, hotels, factories, commercial office buildings, shopping centers, farmland, quarries and oil fields. In general, any type of real estate may be traded for another type of real estate as long as it satisfies the qualified use test.
Yes, the Title Holding Trust is a fully revocable, grantor trust, that can be terminated, altered, amended or updated by the trustor and/or beneficiary at any point in time. A full or partial assignment of a beneficial interest in the Title Holding Trust is treated as a conveyance of the underlying property held in the Title Holding Trust.
Yes, as long as the underlying beneficiaries of both Title Holding Trusts are exactly the same the transaction will qualify for tax-deferred exchange treatment under Section 1031 of the Internal Revenue Code. Both properties do not need to be held in a Title Holding Trust. You could sell Relinquished Property, that was held in a Title Holding Trust, and acquire Replacement Property, that is held in your individual name as long as the individual was also the beneficiary under the Title Holding Trust.
No, you must sell real estate and acquire other replacement real estate in order to qualify for a 1031 tax deferred exchange. The pay down or pay off of debt on another property, whether your principal residence or investment property, is not an acquisition of real estate and will not qualify as a tax deferred exchange under Section 1031 of the Internal Revenue Code.
The primary issue that needed to be addressed and clarified by the Internal Revenue Service (“IRS”) was whether a vacation property, a second home or a primary residence that had been converted to investment or business use property would be considered “qualified use property” and therefore qualify for 1031 Exchange treatment.
The purchase of a vacation property or a second home will qualify as replacement property in a tax-deferred exchange transaction if the following safe harbor requirements are met:
- The subject property is owned and held by the investor for at least 24 months immediately following the 1031 Exchange (“qualifying use period”); and
- The subject property was rented at fair market rental rates to other people for at least 14 days (or more) during each of the following two (2) years; and
- The investor limits his or her personal use and enjoyment of the property to not more than 14 days during each of the following two (2) years, or ten percent (10%) of the number of days that the subject property was actually rented out to other people during each of the following two (2) years.
A Qualified Intermediary or QI is required to successfully complete a 1031 Exchange. The QI is a recognized person or company designated by the Exchanger as a “safe harbor” to hold the transaction funds and facilitate the exchange from the Relinquished Property to the Replacement Property. Qualified Intermediaries include –
- CPA so long as the CPA has not performed work for the Seller in the last two years.
- Attorney so long as the attorney has not performed any work for the Seller in the last two years.
- Companies established to act as safe harbors – Investors Title Exchange Corporation, Lawyers Title Exchange and Starker Services.
Yes. The Internal Revenue Service will disqualify a 1031 exchange if the investor has the ability to access, control or receive, or could have received, the sale proceeds after the sale of the Relinquished Property.
The 1031 Exchange deadlines consist of the 45 calendar day identification period and a 180 calendar day total exchange period, from the sale date of the relinquished property
The identification process is essentially the same as any other 1031 Exchange transaction. The only difference is you are identifying a fractional interest or partial interest in the replacement property and not 100% of the property. Your identification must be as specific as possible, and should include the exact fractional interest that you intent to acquire.
No, you do not have to reinvest 100% of your net sales proceeds, however, the amount that you do not reinvest will be subject to depreciation recapture and capital gain income tax. Only the amount that you reinvest will be tax-deferred. This is called a partial 1031 exchange and will result in, what is referred to as, mortgage boot and/or cash boot. Mortgage boot and cash boot are the taxable proceeds not utilized in the exchange. You will need to reinvest 100% of your net sales proceeds if you want to defer 100% of your tax liabilities.
The Internal Revenue Service has placed certain restrictions on your rights to receive, pledge, borrow, or otherwise obtain the benefits of your 1031 Exchange funds, including when the Qualified Intermediary can release the funds to the Investor. The Investor can receive the unused 1031 exchange proceeds at any time after the 45 day identification period expires and the Investor has either:
(1) Not identified any like-kind replacement properties, or
(2) The investor has acquired all of his identified like-kind replacement properties. If the investor has not acquired all of the identified like-kind replacement properties, then the unused proceeds cannot be released until the 181st day after the closing of the Relinquished Property.
No. These deadlines are actually part of the Internal Revenue Code and cannot be extended for any reason except by a Presidential Disaster Declaration. The deadline is not extended if it falls on a Saturday, Sunday or legal holiday.
Yes, taxpaying entities of any type are typically allowed to structure and complete tax-deferred exchange transactions as long as the real property is an Investment Property or Property used in Trade or Business.
No. Your relinquished properties and your like-kind replacement properties must be like-kind property in order to qualify for 1031 exchange treatment. If you sell an interest in qualifying real property, you must also acquire an interest in qualifying real property. An interest in a Real Estate Investment Trust (REIT) is actually a security interest and not an interest in real property even though the REIT itself owns real property.