How does the tax deferral of Section 1031 work?
The tax code provides that the gain on disposition of certain types of property is not recognized (this is known as "non-recognition treatment") if that property is exchanged for property of a like-kind. In general terms, 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 bona fide closing costs.
For example, if a taxpayer relinquishes property for a purchase price of $100,000.00 and incurs closing costs of $7,500.00, that taxpayer must acquire replacement property having a value of $92,500.00 (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.
The consequence of acquiring replacement property of a lower value than the relinquished property is that the difference in value is taxable and not deferred.
While the tax liability on disposition of the property is deferred, the basis of the replacement property is carried over from and equal to the basis of the relinquished property, plus or minus adjustments related to the value of the property acquired and whether that value is equal to, less or more than the value of the relinquished property.
What is a reverse exchange?
A reverse like-kind exchange is one in which the replacement property is acquired prior to the closing on the transaction in which the currently owned property is relinquished. Although the Internal Revenue Service had not provided much guidance on reverse exchanges for many years, in 2000 the Service published Rev. Proc. 2000-37. The revenue procedure provides a safe harbor which should provide greater certainty to taxpayers seeking to complete reverse exchanges.
Does the Q.I. take title to the properties?
No, the Q.I. does not take title to the properties in a simultaneous or deferred exchange. In each case, the properties are deeded directly by the taxpayer to the buyer, and from the seller of the replacement property to the taxpayer. In a reverse exchange, however, title to either the relinquished property or the replacement property (but not both) must be conveyed to an "exchange accommodation titleholder" and then, at the conclusion of the exchange, to the party entitled to the conveyance of the property.
The regulations require the taxpayer to identify one or more replacement properties within 45 days following the closing on the relinquished property. Several rules govern the number of properties a taxpayer may identify [see Identification]. The 45 days are counted starting with the first day following the closing and end at midnight of the 45th day thereafter.
When may I receive the proceeds from the sale of property, it I decide to abandon my exchange?
The taxpayer is entitled to acquire replacement property through the end of the 180 day exchange period. The IRS Regulations require that the exchange agreement provide that the taxpayer has no right to receive, pledge, borrow, or otherwise obtain the benefits of money or other property before the end of the exchange period. Therefore, in most cases, any funds remaining in the exchange (and held by the Qualified Intermediary) will be disbursed to the taxpayer only after the conclusion of the 180 exchange period. Despite this restriction, funds may be disbursed at an earlier time by the qualified intermediary to the taxpayer, but only under the following circumstances:
i. After the end of the 45 day identification period, if no Replacement Property has been identified; or
ii. If the taxpayer has identified replacement property, after the taxpayer has received all of the identified Replacement Property to which the taxpayer is entitled; or
iii. After the end of the 45 day identification period, upon the occurrence of a material and substantial contingency which relates to the deferred exchange, is provided for in writing, and is beyond control of the taxpayer or a disqualified person.
The IRS has indicated in a Private Letter Ruling that these restrictions are fundamental to the safe harbors established under the Regulations and may not be modified by the taxpayer and the Qualified Intermediary. Therefore, Qualified Intermediaries strictly follow these regulations.
What does "like-kind" mean?
Under IRS Code Section 1031, in an exchange of real property, any property which is considered real property under state law is "like-kind" with any other property which is deemed real property under that state law. Therefore, for example, you may trade unimproved property for a shopping center, or, farmland for an office building. However, the rules for exchanges of personal property [for exchanges commenced prior to 2018 (see note at the top of this section regarding the elimination of exchanges of personal property as of January 1, 2018)] are much more restrictive and require a detailed analysis of the assets being relinquished and acquired.
What is the "holding for" requirement?
Property that is involved in a like-kind exchange must be held by the taxpayer for investment or for productive use in a trade or business. Investment property may be exchanged for trade or business property and, similarly, trade or business property may be exchanged for investment property.
How much property must I acquire in an exchange?
In order to fully benefit from the deferral provisions of §1031 (i) the value of all replacement properties acquired in the exchange must equal or exceed the value of the property relinquished in the exchange; and (ii) the amount of equity, and the amount loans secured by the property relinquished in the exchange, must be equal or less (in each case) to the amount of equity and loans secured by the replacement property.
What is a qualified intermediary?
A qualified intermediary ("Q.I.") is a person or entity which facilitates an exchange under the qualified intermediary safe harbor established by the regulations. The Q.I. performs several important exchange services:
1. the Q.I. takes assignment of the taxpayer's contractual right to sell the relinquished property;
2. the Q.I. takes assignment of the taxpayer's contractual right to acquire the replacement property,
3. the Q.I. holds (or makes arrangements for the holding of) the proceeds from the sale of the relinquished property. The taxpayer may not hold the proceeds (either directly or constructively through an agent) without causing the proceeds to be taxable as "boot."
4. the Q.I. prepares the documentation necessary to complete the exchange. The documentation includes an exchange agreement, assignment agreements, closing instructions and related documents to permit each transaction to close as part of the exchange.
When must the replacement property be acquired?
The taxpayer must acquire all replacement property within 180 days following the closing on the relinquished property. Similar to the identification rule, the 180 days are counted starting with the first day following the closing and end at midnight of the 180th day thereafter.