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1031 Tax Deferred Exchanges
Section 1031 of the IRS Code allows sellers of business or investment properties to defer the recognition of capital gains on the sale of the property as long as the seller subsequently acquires another property used for business or investment within the required time frames and subject to certain rules.
Benefits to a 1031 Tax Deferred Exchange
Section 1031 allows an owner to defer the payment of capital gains taxes, thereby increasing or leveraging the buying power of the investor. In short, the money that would have been paid to the government in taxes can instead be invested in a replacement property.
Every seller of non-occupied property, including land, should consider structuring the sale as a 1031 exchange in order to defer any capital gains taxes that would otherwise be payable to the government.
Exchange of Property
The transaction must be structured as an exchange, not a sale and purchase. This involves the use of a qualified intermediary which is often an affiliate of a title insurance company. The investor will sign an exchange agreement, assignment of the purchase contract, and other documentation prepared by the qualified intermediary.
Like Kind Property Requirement
While the replacement property must be considered “like kind property”, the IRS definition is broad. For example, a rental home can be exchanged for an apartment building or retail property. A vacant parcel of land can be exchanged for a rental home or office building. Investment property for investment property fulfills the requirement.
Holding for Investment Requirement
The IRS Code does not specify a minimum time frame for which the investor must continue to hold the investment property to qualify for tax-deferral treatment. However, when the IRS examines exchange transactions, the investor must be able to show that he or she intended to hold the property for investment purposes at the time it was acquired. If an investor only holds his or her replacement property for a few months prior to selling it, the IRS may question whether the investor actually intended to hold the property for investment purposes.
Time Requirements and Identification
A 1031 exchange must be set up prior to the closing of the relinquished property. The best time is when the listing agreement is signed by the owner.
The investor has 45 days from the closing of the relinquished property to identify the replacement property. Proper identification of the replacement property is a requirement for a valid 1031 exchange, and the investor can only acquire property that has been properly identified during the 45-day identification period. Replacement property that is acquired (i.e., closes) within the 45-day period is considered properly identified. For property not purchased within the 45-day time frame, the identification must unambiguously describe the property (with an address or legal description), and must be made in writing, signed by the investor before midnight of the 45th day. If multiple relinquished properties are grouped together in one exchange, the 45-day time period starts to run as of the closing of the first property.
If an investor wants to identify more than one replacement property, there are several options. The two most common methods to identify multiple properties are:
- The "Three Property" rule: the investor may identify up to three properties without regard to their fair market value; or
- The "200%" rule: the investor may identify any number of properties so long as the total fair market value of all of the listed properties does not exceed 200% of the value of the relinquished property.
Once escrow closes on the relinquished property, the investor has the lesser of 180 days from the date of closing, or the date on which the investor’s tax return for the year the relinquished property was sold is due, to close the purchase transaction and complete the exchange. For exchanges closing in the final quarter of the year, the investor will need to get an extension to file his or her tax return to obtain the full 180 days.
Deferring All Tax
In order to defer 100% of the tax, the property that the investor is purchasing must be equal or greater in value, equity, and debt (but the debt can be replaced with cash) than the relinquished property. If any of these criteria are not met, the exchange may still be valid; however the transaction may be partially taxed.
Same Taxpayer Rule
In order for a transaction to qualify as a 1031 tax deferred exchange, the taxpayer for the relinquished property must be the same as the taxpayer for the replacement property. For example, if Jones owns the relinquished property, then Jones must become the owner of the replacement property. An exception to this requirement is that revocable living trusts and single member limited liability companies may be used, but disregarded for tax purposes. For example, Jones may acquire a replacement property in his own name or as trustee of his revocable living trust, or in the name of a single member limited liability company.
Selecting a qualified intermediary is an important decision. Knowledge, experience, and financial strength are critically important. We recommend the use of a title insurance company affiliate.
The rules that apply to 1031 tax deferred exchanges are subject to change at any time. Consequently, the reader should not rely on this presentation as legal advice. If you are intending to exchange property utilizing IRS Code Section 1031, you should obtain legal advice from a qualified real estate attorney and use the services of a knowledgeable, experienced qualified intermediary.