1031 Exchange Rule

Daniel Penzing
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Six Things to Must Know Before Applying

#1: Only Certain Entities and Types of Assets Qualify for the 1031 Exchange

1031 exchange rules are a set of IRS-specified procedures that allow a business or individual to defer the impact of capital gains on the sale of an investment.

#2: You Need a Qualified Intermediary to Handle the Execution of the 1031 Exchange

As mentioned above, the 1031 Exchange requires that both the seller and purchaser of the property are aware of the tax deferred exchange. If you are in the position of being a seller looking to get the most value out of the property you sell, it’s imperative to work with a qualified intermediary.

The responsibility of this intermediary is to assist the parties in the 1031 Exchange by managing the key tasks required to execute the exchange properly.

The intermediary will work with the following parties:

  • The seller of the property
  • The buyer of the property
  • The financial institution where the sale proceeds are deposited
  • The financial institution where the funds are used to purchase the replacement property

All costs, including closing costs and expense reimbursements, will be split between the buyer and seller of the property. The intermediary will assume the responsibility of dividing these costs, as well as scheduling the deadlines and dates in coordination with the parties involved in the transaction.

An intermediary must be chosen before the seller starts advertising the property for sale to make sure that the seller is not currently in the process of negotiating with a potential buyer.

Lenders who originate loans that are being used to purchase the replacement property need to be made aware that a 1031 Exchange is being used to avoid any confusion or delays in the closing of the loan.

#3: The Properties Must Be “Like-Kind” to Qualify

#4: Timing Is Everything

There are specific rules and procedures to be followed when you are engaged in a 1031 exchange. The IRS has put together very specific guidelines for identifying the replacement property, securing the replacement property, selling the relinquished property, and reinvesting the proceeds from the sale of the relinquished property. If these guidelines are not satisfied, then the IRS could slap you with a substantial tax bill for what the 1031 exchange planner refers to as an incomplete or improper 1031 exchange.

A successful 1031 exchange must be conducted and completed as outlined by the Internal Revenue Service. In order to avoid the hassles associated with an incomplete or improper 1031 exchange, you must receive the help of an expert 1031 exchange tax specialist. This professional will provide you with the information and assistance necessary for conducting a rule compliant 1031 exchange.

Following are some things to keep in mind about the 1031 exchange rules:

The 1031 exchange must be completed within 180 days of selling the relinquished property.

The replacement property must be identified, located, and purchased prior to selling the relinquished property.

The sale of the relinquished property must be independent of the purchase of the replacement property.

The relinquished property cannot be sold at a loss, unless the proceeds from the sale of the relinquished property are reinvested in the replacement property. The replacement property must equal or exceed the adjusted sales price of the relinquished property.

#5: Both Properties Must Be Held for a Productive Purpose in Business or as an Investment

Under Section 1031 of the Internal Revenue Code of 1986, as amended, each property in a Section 1031 exchange must be held for productive use in a trade or business or for investment. Therefore, a property held solely for sale to customers in the ordinary course of a trade or business ordinarily would not qualify for non-recognition of gain or loss upon an exchange.

Example — Property Held for Investment (No Partner)

A taxpayer exchanges a parcel of real property held for investment for a replacement property held for investment. Both the relinquished and replacement properties are held for investment purposes. For purposes of this example, no partner is involved in this exchange.

If the taxpayer exchanges the replacement property for cash, the exchange will not qualify for non-recognition treatment. The original investment property has been exchanged for cash. Therefore, the exchange would not qualify under Section 1031.

However, if instead, the taxpayer exchanges the replacement property for a like-kind property under Section 1031, the exchange may qualify for non-recognition treatment under Section 1031. The investment property has been exchanged for another investment property. The taxpayer may continue to hold the replacement property as investment property. Under these facts, both properties will qualify as investment property as an IRC Section 1031 exchange.

#6: Your Gain Is Tax-Deferred, but It Is Not Tax-Free

An exchange of like-kind property is an exchange that takes the following characteristics:

  • Similarity
  • Identicality
  • Conservation
  • Exchange-Value

The basis of any non-residential property is its unused potential to generate a positive cash flow. The basis of any residential property is its utility for living. The exchange-value of like kind property is zero-sum or equal. If the exchange value is positive, then there is an economic gain, but if the exchange value is zero-sum, then there is no economic gain. Exchange-value is:

$$Exchange Value = frac{SalePrice – PurchasePrice}{PurchasePrice}$$

Once you have similarities, identicalities, conservation, and exchange-value, then you have the characteristics (or the hallmarks) of an exchange, and the gain is wholly deferred. The 1031 exchange rule states:

text{Exchange} Rightarrow Tax Deferral, not Tax-Exemption.

Tax-exemption usually requires specific language in a law, but tax-deferral is not so wordy. The IRS will not confer tax-exemption upon any exchange. It is up to you (the taxpayer) to make sure that your exchange meets the 1031 exchange rules requirements, which at least include the following:

A Word of Warning!

Not many institutions have the knowledge and expertise to properly help their clients avoid capital gains tax, let alone the tax liability in general. Without the intervention of a tax professional or plan advisor, a 1031 Exchange can be costly to all parties involved.

The United States federal government has an income tax. One of the many tax benefits to the government is to give its taxpayers an option to convert capital gains taxes into regular income taxes. It offers great incentives for the taxpayers to take advantage of this option, but the government has put some rules in place to prevent loss of revenue from any one source.

1031 Exchange rules are the regulations that control how the government will allow their clients to realize capital gains tax benefits. These rules were put in place to control the conversion of capital gains into income taxes. The 1031 Exchange rules can all be placed under two headings: Leveraged, and Non-Leveraged.

A Stress-Free Way to Do a 1031 Exchange

The 1031 exchange is a tax relief rule that was created by the IRS to promote capital investment in low-income neighborhoods and rural communities. It allows investors to defer taxes on property transactions, provided the sale proceeds are reinvested into a property designed for a business or investment.

1031 exchanges are a great way to make a profit with no tax complications. Before we take a closer look at how a 1031 exchange works, let’s take a look at the rule’s history.

The Historical Roots of 1031 Exchanges

The 1031 exchange was enacted into law in 1976 with the passing of the Tax Reduction Act. This legislation was created to stimulate equity partnerships and other types of investment in areas with low property values.

The 1031 exchange rule was based on a section from the tax code in 1954. The 1954 Internal Revenue Code stated that if you bought and sold investment property, you would pay taxes on any profits. On the other hand, if you reinvested those profits into real estate within 180 days, you would not be required to pay taxes.

In 1976, the IRS modified this rule by declaring that investors could defer any taxes as long as they reinvested their buyout funds into a new piece of investment property within six months.