Internal Revenue Code 1031 offers the real estate investor a powerful tax strategy that when properly used enables him or her to build wealth at much faster rate. IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.
The exchange can include like-kind property exclusively or it can include like-kind property along with cash, liabilities and property that are not like-kind. However, if you receive cash, relief from debt, or property that is not like-kind, you may trigger some taxable gain in the year of the exchange. There can be both deferred and recognized gain in the same transaction when a taxpayer exchanges for like-kind property of lesser value.
The tax code provides that the capital gain on disposition of certain types of property is not recognized (known as "non-recognition treatment") if that property is exchanged for property of a like-kind. The taxpayer disposes of his or her currently owned property (the "relinquished property") for other property acquired in the exchange (the "replacement property"). The value of the replacement property must be equal to or greater that the value of the property relinquished in the exchange in order to obtain complete tax deferral. Value, for these purposes is generally the purchase price, adjusted for closing costs.
For example, if a taxpayer relinquishes property for a purchase price of $100,000.00 and incurs closing costs of $10,000.00, that taxpayer must acquire replacement property having a value of $90,000.00 (the purchase price less the closing costs). The value of property acquired is the purchase price of the replacement property plus the closing costs incurred in that transaction.
There’s no limit on how many times you can do an exchange. You can roll over the capital gain from one piece of investment real estate to another and then to another and another. Although you may have a profit on each exchange, you avoid taxes and when you die you take those taxes you avoided with you and your heirs receive a step up in basis.
The 1031 Exchanges are not simple. They have to be done precisely according to the IRS code, otherwise, complications may be quite severe.
This is how the 1031 process works:
1. Select a Qualified Intermediary
The IRS requires that the proceeds from the sale of the property (the “relinquished property”) be held by a Qualified Intermediary (a “QI”) until the replacement property is purchased. The taxpayer must assign to a QI their interest as seller of relinquished property. An “exchange agreement” is executed between the taxpayer and the Qualified Intermediary. You can not act as your own facilitator. In addition, your agent (including your real estate agent or broker, investment banker or broker, accountant, attorney, employee or anyone who has worked for you in those capacities within the previous two years) can not act as your facilitator.
Be careful in your selection of a qualified intermediary as there have been recent incidents of intermediaries declaring bankruptcy or otherwise being unable to meet their contractual obligations to the taxpayer. These situations have resulted in taxpayers not meeting the strict timelines set for a deferred or reverse exchange, thereby disqualifying the transaction from Section 1031 deferral of gain. The gain may be taxable in the current year while any losses the taxpayer suffered would be considered under separate code sections.
2. Include the exchange cooperation clause as an addendum to contract.
It is important to include language in the contract of sale for both the sale of your relinquished property and the purchase or your replacement property that requires the counterparty to cooperate in the exchange. The entire exchange is transparent to your buyer or seller, and there are no delays or costs to them in cooperating.
3. The QI signs HUD1 at settlement of the relinquished property.
4. Deed is direct from exchange to buyer, the QI does not go into the chain of title
5. The QI must be notified within 45 days after settlement of potential replacement properties. The identification must be in writing, signed by you and delivered to the qualified intermediary. However, notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient.
6. The replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier. For example, if you sell your relinquished property on December 15, 2014, and submit your tax filing for 2014 on April 1, 2015, then the acquisition of the replacement property must happen on or before April 1, 2015, and not the typical 180 days after sale. To avoid this trap, have your tax preparer file a timely extension. At closing of replacement property, assigns the rights in the contract to the QI and the QI then signs HUD1 as purchaser. Deed is direct to exchanger, the QI never goes into the chain of title.
7. Any remainder is returned but may be taxable as boot.
It is critical that you and your tax representative adjust and track basis correctly to comply with Section 1031 regulations. Gain is deferred, but not forgiven, in a like-kind exchange. You must calculate and keep track of your basis in the new property you acquired in the exchange.
When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.
Consult a tax professional or refer to IRS publications listed below for additional assistance with IRC Section 1031 Like-Kind Exchanges.