For taxpayers who own business or investment property, Section 1031 of the U.S. Internal Revenue Code allows the deferment of federal income taxes on the exchange of like-kind properties. These exchanges are also termed “Tax Deferred Exchanges”, “Like-Kind Exchanges,” and “Starker Exchanges.”
A 1031 Exchange allows the deferral of federal capital gains tax and most similar state taxes on the disposition of investment or business property, providing a taxpayer more money to invest into qualified replacement property.
For individuals, capital gains are usually taxed by the I.R.S. at a 15% tax rate, which does not take into consideration potential state tax or depreciation recapture (25%). C Corporations are taxed at a rate of up to 35% for capital gains.
The role of the Qualified Intermediary is crucial to the success of your 1031 Exchange. Up until 1990, there were no clear regulations for those taxpayers engaging in the exchange of properties. This was evident in the thousands of exchanges that were challenged and eventually disallowed by the IRS. Finally, in 1991, the IRS issued regulations governing tax-deferred exchanges. These regulations provided for the use of a Qualified Intermediary as a “Safe-Harbor” within which to conduct a 1031 Exchange.
Since Qualified Intermediaries are not currently licensed by any federal regulatory agency, it is important for you to research, among other things:
1. How knowledgeable is the Qualified Intermediary in regards to a 1031 Exchange?
2. What processes are followed to ensure the safety of your assets?
3. Is the Qualified Intermediary bonded and insured?
4. What are the fees for specific services?
5. Will you receive interest on your exchange proceeds?
6. Can my Qualified Intermediary provide tax or legal advice?
No. As your Qualified Intermediary, we are not allowed to provide specific tax or legal advice concerning your 1031 Exchange. We will cooperate with your tax advisor to make sure your transaction is completed smoothly.
There are five basic exchange structures:
You may keep a portion of the proceeds if you wish. However, the funds you decide to keep will be subject to potential capital gains and depreciation-recapture tax. The remaining funds received by the Qualified Intermediary and reinvested into replacement property will be tax-deferred. If you decide to withdraw cash from an exchange, please consult your tax advisor as to your potential tax liability.
Constructive receipt simply means that you have possession, use, or benefit of the closing proceeds. The bigger question you should ask is, “How do I avoid constructive receipt?” A properly executed exchange agreement with a Qualified Intermediary before the sale of the relinquished property will help ensure that you will not be in constructive receipt of the sale proceeds.
To defer your entire tax liability, you must meet a few requirements. First, the replacement property you purchase must, at the least, be valued equally to your relinquished property. This means that you must use all of your cash proceeds from the sale of the relinquished property toward the purchase of the replacement property. Also, if there was debt tied to the relinquished property, you must also place an equal amount of debt on the replacement property or inject new cash into the replacement property equal to the debt on the relinquished property. You will be required to pay taxes to the extent that you receive cash or other proceeds (“boot”) or are relieved of debt in the transaction.
Many types of property, both real and personal, can qualify for an exchange. The IRS states that any property qualifies if it has been held for investment or for productive use in a trade or business. We find it more important to look at the taxpayer’s purpose and intent in holding the property rather than the type of property to be exchanged.
The IRS has given little authority as to how long a relinquished property must be held before it can be exchanged. There has been one private letter ruling in which the IRS suggested that a minimum holding period of two (2) years would be sufficient. Though time held is a factor, a bigger issue is the IRS requirement that a qualified property should be held for investment or productive use in a trade or business. The longer you hold the property for the qualified purpose, the stronger your case will be should the IRS ever question your intent.
A property must be held for investment or productive use in a trade or business for it to qualify for a 1031 Exchange. A vacation home which is used more than sparingly by the taxpayer for personal use would be unlikely to qualify for an exchange. Matters such as personal use of the property, a documented fair market value rental history (actually rented or available for rent), and the ability to take investment depreciation can help determine the viability of an exchange of vacation property. Advice from a qualified tax advisor is important for determining whether a particular property is qualified.
Yes. Signing a contract on your relinquished property does not prevent you from entering into an exchange. If an earnest money deposit is accepted, it must be held by a qualified party. You must contact a Qualified Intermediary prior to closing on the sale of your relinquished property.
Yes. It is okay to sign a contract on your replacement property and pay an earnest money deposit prior to entering into an exchange, without affecting your exchange transaction.
You have until midnight on the 45th day following the closing on your relinquished property. This period is called the identification period.
Under the regulations, replacement property is treated as identified for purposes of a 1031 Exchange only if its designation as replacement property meets all of the following: (i) made in a written document; (ii) signed by the taxpayer; (iii) hand delivered, mailed, faxed, or otherwise sent; (iv) before the end of the identification period; (v) to the person obligated to transfer the replacement property or a person involved in the exchange other than the taxpayer or a disqualified person.
Though the regulations state that identifications may be hand-delivered, Banker Exchange, LLC requires clients to send in their identification by facsimile and certified mail in order to have substantial proof of delivery in a timely manner. An identification contained in the text of an e-mail is not acceptable, as it does not comply with the regulatory requirements.
The IRS Regulations place restrictions on the number of properties which may be identified during the identification period. There are three rules for identifying property:
No. You do not have to purchase all the properties listed on your identification unless it is the only way to comply with the 95% rule. To experience any tax benefit, though, you will need to close on at least one of your identified properties before the end of your exchange period.
You must close and take title to any or all replacement property within the lesser of:
There are special rules that deal with related parties within Section 1031 of the Internal Revenue Code. Whether you are family or business-entity related parties, you may be able to complete an exchange with the additional requirement that property received from the related property is held for a minimum hold period of two years. These transactions are highly fact-specific, and a qualified tax advisor is required to properly structure the exchange.
Property that is located in the United States may be exchanged for other property located within the United States or certain territories or possessions of the United Sates. But, when it comes to non-domestic property, it may only be exchanged for other non-domestic property. The IRS code §1031 (h)(1)and(2) states that (i) real property located outside of the United States is not like-kind to real property inside of the United States; and (ii) as well as personal property predominately used outside of the United States is not like-kind to personal property used predominately inside the United States.
No. In general, to qualify as replacement property, improvements to property must be made on property not currently owned by you. Exchange proceeds may not be used to pay down debt on property you already own.
Yes, this is called a reverse exchange.
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