Tax Deferred 1031
TAX DEFERRED EXCHANGE
A tax deferred exchange is an approved method to sell investment properties and acquire one or more “like-kind” properties without paying any federal capital gain taxes. When the exchange meets the criteria of the Internal Revenue Code Section 1031 and the regulations promulgated by the IRS, taxes are deferred until sometime in the future. The delayed exchange is the most frequently used type of exchange and is specifically authorized by statutory amendment (Tax Reform Act of 1984). These exchanges are often referred to as “Starker” exchanges (after the name of the litigant whose case determined the tax law). Timing is critical: the replacement property must be identified and acquired within a statutory time period commencing with the close of escrow of the relinquished property.
The requirements to complete a successful tax-deferred exchange include the following:
- Each parcel of real property involved in the exchange must be held for investment or for use in a trade or business.
- The replacement property must be “like-kind” property. The definition of “like-kind” at this point is broad. One may, for instance, exchange between improved and unimproved real estate, and between residential and commercial property. However, personal property may not be exchanged for real property. Nor may foreign real property be exchanged for domestic property.
- Timing is paramount: The replacement property or properties must be properly identified no later than 45 calendar days and must close no later than 180 days following the close of escrow for the sale of the exchanger’s Phase 1 property (the relinquished property). The 180 days may be shortened where the Phase 1 closing occurs between October 15 and December 31, unless the taxpayer files a timely extension with the IRS by April 15th of the following year.
- In order to defer recognition of all gain, the exchanger must acquire replacement property that:
a. Is equal to, or greater than, the net sales price of the relinquished property, and
b. Uses an equity amount that is equal to or greater than the equity from the sale of the relinquished property as the down payment of the replacement property.
The exchanger may choose to receive a portion of his or her equity at the close of escrow on the sale of the Phase 1 relinquished property without jeopardizing the exchange. However, the equity received will be taxable. Certain items such as prorated interest, property taxes, insurance, and rent are considered operating expenses reported on Schedule E of the exchanger’s tax return. If sales proceeds are used to pay these expenses in escrow, the amount used will be considered “Boot” or taxable gain. The net effect is neutral since these expenses are deductible. Sales proceeds used to transfer tenant security or rent deposits to the buyer are considered “Boot” or taxable gain without an offsetting deduction. Exchangers may pay for these non-sales cost items by making a separate deposit into the escrow to eliminate the problem. Although the specific requirements are stringent, considerable flexibility is available in the exchange process. For example, the exchanger may exchange an investment property for several, or conversely, may consolidate several investment properties by replacing them with one property.
In certain co-tenancy situations, one owner may select a Section 1031 tax deferred exchange, while another owner may opt to sell his or her interest in the property, or exchange into another property separately. A single piece of real estate may be allocated between personal and investment use. For instance, the exchanger may own a duplex and live in one unit and rent the other. The percentage value of each will be reflected in the replacement property or properties.
Although a shareholders interest in a partnership, corporation, or trust may not be exchanged, the entity itself may exchange property under Section 1031.