Advisors looking for tax-deferral opportunities for clients might want to consider 1031 exchanges. A 1031 like-kind exchange occurs when a taxpayer sells business property and replaces it with similar or like-kind property without having to pay federal income taxes on the transaction (though when the last exchange property in the chain is sold, tax will be due on the entire gain). The Internal Revenue Service established regulations in 1991 that outline safer guidelines for tax-deferred exchanges under Code Section 1031. Prior to that time, exchanges were more subject to challenge under audit examinations.
The 1991 regulations established use of an intermediary and escrow accounts for holding the “exchange funds.” While exchanges can occur without the services of an intermediary, it is wise to structure these exchanges in compliance with IRS guidelines. What are the basic rules for a 1031?
First, the property to be exchanged must be qualified, defined as real estate property held for investment or income-producing purposes or equipment used in a trade or business operation. Non-qualified property includes personal residences, land, inventory, partnership interests, and stocks and bonds.
Also, the replacement property must be transferred into the exact same name as the exchanged property and be “like-kind” in nature. One property may be exchanged for two properties, but a personal residence cannot be exchanged for investment property. Moreover, it is recommended to replace property with one that has equal or greater value. If your client trades down in value and so-called “boot” is exchanged, then tax consequences will result. The term “boot” is defined as the taxable portion of money or other non-qualified property received by the taxpayer. Non-qualified property includes debt reduction “boot” when a taxpayer’s debt on replacement property is less than the debt on the exchange property. This happens when the taxpayer is trading down in the exchange.
These are the types of 1031 exchanges:
Simultaneous Exchange. In this most common exchange, the closing of the exchange and replacement properties occurs on the same day, succeeding each other.
Delayed Exchange. This describes an exchange when the replacement property is closed on at a later date than the exchange property. There are strict guidelines established by the IRS for completion of a delayed exchange–the closings must be completed within the 45-day or 180-day rules established by the Code.
Reverse Exchange. This takes place when the replacement property is purchased and closed on before the exchange property is sold. In this case, often referred to as a “title-holding” exchange, an intermediary holds title to the replacement property under an exchange agreement until a buyer is found and closing occurs on the original piece of property.
Improvement (Construction) Exchange. This occurs when a taxpayer acquires a property and arranges for development and enhancements to the property before it can be considered as replacement property. In order to qualify for the 1031 exchange, these improvements cannot take place after the taxpayer has taken title to the property. Therefore, the intermediary must take title until the construction is completed. The IRS does not consider this type of exchange under the provisions of its established regulations and tax reversals could result, should the IRS undertake an examination. Nevertheless, this type of exchange is common.
When a taxpayer is interested in executing a 1031 exchange on his business property, he does not need to advertise his intention to the intended buyer. However, there is generally accommodation language in the contract identifying this intent, and efforts to secure the cooperation of the buyer should stipulate that the purchaser will not incur any additional liability or expense.
When the terms of the contract are satisfied and a closing date is established, then the intermediary is contracted in an exchange agreement with the seller, and that intermediary substitutes as the seller for the actual closing.
The exchange agreement has provisions to assign the seller’s contract to the intermediary, who then receives the proceeds due to the seller at closing and places them into an escrow account. The taxpayer has no rights to these funds. The seller must obtain replacement property and enter into a purchase contract within the 45-day or 180-day guidelines. The intermediary is then assigned in contract to purchase the replacement property with the escrow funds.
The first phase of a delayed exchange is to close on or identify the replacement property within 45 days from the date of transfer of the exchanged property. If not, a signed notification from the taxpayer must be delivered to the intermediary identifying that one of the following rules have been followed:
Three-Property Rule. This identifies up to three potential properties for the transaction, regardless of value.
200% Rule. This identifies more than three probable replacement properties, as long as the fair market value of the group does not exceed 200% of the market value of the exchanged property.