A 1031 exchange is defined by the Internal Revenue Code (IRC) Section 1.1031 as “No gain will be recognized on property held for productive use in business or investment when exchanged for like kind property held for productive use in business or investment.” This means property either real or personal property held for the proper intent can be sold and gain deferred when real or personal property is acquired. The result is the federal and state capital gain and recaptured depreciation taxes are postponed, deferred until the sale of the replacement property. This deferral is referred to by the Internal Revenue Service as a tax free exchange given no tax is paid.
1031 Exchange Requirements
There are many 1031 exchange rules depending on whether real or personal property, US resident or non resident alien, forward or reverse exchange. Common to all 1031 exchanges are the following rules:
- qualified intermediary is required by the IRS to correctly structure the exchange
- a related party to the taxpayer either by family (siblings, spouse, or lineal descendants) or entity should more than 50% of the value of stock is directly or indirectly owned by an individual must hold the property acquired for two years and if selling the replacement property must also be initiating a 1031 exchange
- a disqualified person is prohibited from acting as a qualified intermediary
- proper intent implying property is held for qualified use
- Foreign nonresident must comply with FIRPTA requirements when selling U.S. real property
- net equity and debt retired at sale is equal to or greater in the replacement property, otherwise the difference is taxable
- replacement property is identified by the forty fifth calendar day post closing preferably to the qualified intermediary
- the exchange period ends on the 180th calendar post closing unless a presidentially disaster notice is posted on the IRS website defining the effected counties
- the taxpayer who sells is the taxpayer who buys
- real property is exchanged for real property while personal property is exchanged for like kind class and character of personal property
- US property is exchangeable for property in the US while international property may be exchanged for property internationally
- conveyed rights must be essentially alike including character of title conveyed, rights of parties and duration of interests
- taxpayer cannot receive, pledge, borrow or otherwise obtain benefits of the exchange account per § 1.1031(k)-1(g)(6).
Depending upon whether the exchange is a forward, reverse, simultaneous or leasehold improvement will determine the steps the qualified intermediary will use to accommodate the exchange in accordance with IRS regulations.
1031 exchanges can be simple and complex, yet each must comply with IRC 1031 requirements. Every year Regulations, Revenue Procedures, Revenue Rulings, Private Letter Rulings, Technical Advice Memorandums and other types of advice is provided by the IRS to assist interpreting the 1031 statute. Work with a qualified intermediary current on case law interpretations to assure appropriate guidance and accommodation.
Do you qualify for a 1031 exchange?
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A 1031 exchange is a great way to defer taxation. However when a 1031 is not appropriate or is appropriate but cannot be completed, a deferred sales trust may be the answer as a Plan B. Taxes can be deferred indefinitely according to the desires of the property seller and the trust can provide an income stream to the seller. When a property is found, either the trust can be ended, taxes paid and the remainder of the trust assets be used to buy the new property or perhaps the trust assets can be used as collateral for a new loan on the new property and the best part is that the 1031 rules do not apply to the new property. The trust may also be the answer when a property has high debt, little basis and if sold, all of the sales proceeds go to the debt, taxes and fees so the owner has no reason to sell. The DST may provide that reason.