1031 TAX DEFERRED EXCHANGE
Generally, when you sell real estate held for investment or business use, you have to pay tax on the gain from the sale of your property.
However, Section 1031 of the Internal Revenue Code allows you to defer paying capital gains taxes.
WHAT IS A 1031 EXCHANGE?
A 1031 Exchange is shorthand for Section 1031 of the IRS code of 1986, which states that:
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
Generally, this rule allows for a like-kind exchange of investment property with capital gains taxes being deferred into the future, as long as certain steps are followed within the required timelines and the use of the property is within allowable guidelines.
How does a 1031 Tax Exchange work?
Internal Revenue Code section 1031 was written by Congress specifically to allow anyone who meets its requirements to sell their property and defer paying tax on the gain. It is important to note that a 1031 real estate tax-free exchange is not a tax loophole.
The main point of a 1031 tax-deferred property exchange is that capital gains taxes on real estate held for investment can be deferred indefinitely if the owner of qualifying property exchanges, rather than sells it.
The savings from the exchange will vary by the size of the investment, your own income, and other factors (such as state tax rates). Under certain circumstances, this rate can be as high as 20%, with an additional 3.8% passive income tax for high-income households.
Does my property qualify for a 1031 Exchange?
Many types of property can be used in a 1031 exchange, including raw land, residential or commercial rental, industrial, certain leasehold interests, a farmer’s farm, a doctor’s own office, and percentage ownership in investment property. Any real estate for real estate will do, as long as it is held for investment or used in productive trade for business.
Not all properties qualify for a 1031 exchange, however. Properties held by a developer as inventory, dealers in property, securities or other evidence of indebtedness or interest, stocks, bonds and notes, certificates of trust or beneficial interests, or any interest in a partnership, are all outside the scope of 1031 exchanges and do not qualify for tax-deferred treatment.
In addition, essentially all personal use property will not qualify for 1031 exchange treatment. The safest course of action is to assume that if you use the property for yourself, then you cannot exchange it.
How long do you have to do a 1031 Exchange?
There are 2 time limits for the 1031 Exchange!
The first condition is that a qualifying like-kind replacement property is “identified” within 45 calendar days of the closing for the relinquished property. The identification requires a written notification to the Qualified Intermediary listing the addresses or legal descriptions of up to three potential replacement properties.
The second condition is that the purchase of the replacement property must be completed within 180 calendar days after the close of the relinquished property. After the period of 45 calendar days has passed, the exchange may not change its Property Identification List and must purchase one of the listed replacement properties or the exchange fails.
Because of the strict calendar day requirements, after the initial 45 calendar day identification period, the exchange has only 135 calendar days to complete the exchange or else it will fail. Holidays and weekends do not stop the clock. The IRS is very strict on this point and it is a common source of failed exchanges.
The 1031 exchange must show on the same year’s tax return. If the taxpayer is unable to complete the exchange in the same tax year, then they will have to request an extension to complete the exchange prior to filing their tax return.
TYPES OF 1031 EXCHANGE
Generally speaking, there are four different types of a 1031 tax-deferred exchange. Each of them has its advantages, and which one will be used in your case depends on your specific circumstances.
This is a rather straightforward but rare exchange of property. In it, the entire process of selling the relinquished property, holding the sales proceeds in escrow, transferring the sales proceeds to the seller of the replacement property, who then transfers the replacement property’s deed to the exchange, is more or less instant (can occur as multiple closings in one day).
The delayed forward exchange is similar to the simultaneous exchange in general flow. An exchanger sells his property (the relinquished property) to a buyer, with the sales proceeds held in escrow by Southern Exchange Services, acting as the QI under an agreement with the exchanger in this example.
When the exchanger buys the replacement property, Southern Exchange Services uses the escrowed funds from the prior sale of the relinquished property, to pay for the replacement property. The difference from a simultaneous exchange is that there is a time delay between when the relinquished property is sold and when the exchanger acquires the replacement property (as the exchanger has to identify suitable like-kind property).
The build-to-suit exchange is more complex than either the simultaneous or delayed exchange because it requires building a new structure or renovating an existing structure that is like-kind to the relinquished property.
This construction period generates additional requirements to oversee construction with the funds from the relinquished property sale. Typically, this process requires another entity not found in the standard 1031 exchange contracts, an Exchange Accommodation Titleholder (EAT) acting as the Holding Entity, that receives a fee interest in the replacement property to allow it to perform its construction duties using proceeds from the sale of the relinquished property.
In a delayed build-to-suit exchange, the process is essentially identical to that of a build-to-suit exchange, except that a time delay exists between the sale of the relinquished property and the identification and construction start of the replacement property.
However, all improvements and construction must be finished by the time the transaction is complete – that is, within 180 days. Because of the 180-day period, there are real limitations to structuring a successful build-to-suit exchange and an expert is absolutely needed to remain compliant.
The reverse exchange is the opposite of a delayed exchange in that the replacement property is acquired first, then the relinquished property is sold. This type of exchange has both “safe harbor” and “non-safe harbor” varieties, though the “safe harbor” varieties are more common. In fact, there may be some difficulties with having a non-safe-harbor reverse exchange recognized by the IRS as the regulations are not clear on this point.
In the case of a reverse exchange, the property has to be transferred to an exchange accommodation titleholder along with signing a qualified exchange accommodation agreement. When it comes to the 1031 reverse exchange time limit, it is the same as a regular 1031 exchange – within 45 days of the transfer, a property for exchange has to be identified, while the transaction needs to be completed within 180 days. Reverse exchanges occur frequently and Southern Exchange Services can facilitate the process as the EAT.
RULES FOR A 1031 TAX-FREE EXCHANGE
Replacement property acquired in an exchange must be “like-kind” to the property being relinquished. All qualifying real property located in the United States is like-kind. Personal property that is relinquished must be either like-kind or like-class to the personal property which is acquired. Property located outside the United States is not like-kind to property located in the United States.
In addition, this type of exchange applies only to property “held for productive use in business, or trade or for investment”. In other words, a 1031 exchange can’t be commercial to residential or residential to commercial unless in the case of residential rental property.
On the other hand, the “like-kind” is rather liberal, as the 1031 exchange allows you to exchange an apartment for raw land, for example.
It is crucial to keep in mind that if the investor touches or in any way controls funds used for a 1031 exchange, the IRS will disallow the exchange, meaning that tax on the capital gains must be paid.
Since the IRS views property involved in a 1031 exchange as a continuation of the original real estate investment, the same taxpayer holds title to the replacement property and the relinquished property.
‘Boot’ is the difference that arises in case the value of the replacement property is less than the value of the relinquished property. Since the investor didn’t transfer all of their gains to the replacement property, capital gains tax on the boot must be paid for in the same year when the 1031 exchange took place.
You can identify three properties as potential purchases without taking their market value into consideration.
As long as the cumulative property value doesn’t exceed 200% of the value of the property sold, you are able to choose unlimited replacement properties.
Finally, you can identify as many properties as you want, provided that you acquire properties valued at at least 95% of their total.
1031 EXCHANGE SERVICES IN LOUISIANA
With such strict criteria and time limits for executing a successful 1031 exchange, you need 1031 experts familiar with the minutest detail of the exchange closing process who can help you with the IRS 1031 tax form and many other aspects of the exchange.
Southern Title is one of the few companies in all of Louisiana with nearly two decades of experience in this area.
Contact our 1031 exchange experts to learn about how you could potentially defer the capital gains due on the sale of your investment property.
If you are ready to begin a 1031 tax-deferred exchange you should contact our affiliate, Southern Exchange Services, to begin your transaction. Alternatively, you could sign up for our Louisiana Real Estate Commission licensed 1031 Exchanges class.
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