If you are thinking of selling property that could result in a large tax bill, consider a 1031 exchange. A 1031 exchange, named after Section 1031 of the U.S. Internal Revenue Code, is not a “tax free” exchange as it is sometimes referred to, but rather a way to defer capital gains tax on the sale of a business or investment property by using the proceeds to buy a similar property. Due to the complexity of 1031 exchanges, it is recommended that you consult with a tax professional before attempting an exchange. This article will provide a brief description of the 1031 exchange, the steps involved and a few of its many benefits.
Property that qualifies for I.R.C. § 1031 treatment is real property that is held for productive use in a trade or business or for investment purposes. Specific properties that do not qualify under I.R.C. § 1031 include property that is held primarily for sale and property that is located outside the U.S. To qualify, property must be exchanged for “like-kind” property. As used in I.R.C. § 1031, “like-kind” refers to the nature or character of the property, not to its grade or quality. The fact that real estate is improved or unimproved is immaterial, as this relates only to the grade or quality of the property and not to its kind or class. For example, vacant land held for investment can be exchanged for an office building held for rental purposes.
Property that does not qualify for I.R.C. § 1031 treatment is referred to as “boot.” Boot includes money, including cash equivalents plus liabilities of the taxpayer assumed by the other party, and other nonqualifying property specifically excluded under I.R.C. § 1031 (e.g., personal property). The exchange of boot along with qualified property does not cause the transaction to fall outside I.R.C. § 1031, but the boot received by the taxpayer can be subject to tax. Regulations permit the netting of liabilities given and received, but a taxpayer’s ability to reduce the amount of boot received by netting applies only when the boot received is in the form of relief from liabilities. When the boot received is other property or money, the taxpayer may not reduce this amount either by transferring cash or non-like-kind property, or by assuming or taking property subject to a liability.
In a traditional two party 1031 exchange, the taxpayer conveys “relinquished” property to the buyer; and in return, the buyer conveys the “replacement” property to the taxpayer. These types of exchanges are rare as the odds of finding a buyer that wants to exchange properties are slim. For that reason, the majority of 1031 exchanges are deferred, in which the taxpayer disposes of the relinquished property and subsequently acquires the replacement property. In a deferred exchange, the taxpayer must meet the identification and receipt requirements, and the transaction must constitute an exchange of properties as opposed to a transfer of property and money. Under the identification requirement, the taxpayer must identify the replacement property within 45 days after the taxpayer transferred the relinquished property. Up to three properties can be identified without regard to their fair market values or an unlimited number of properties can be identified if (a) the combined fair market value of the replacement properties does not exceed 200 percent of the combined fair market value of the relinquished properties or (b) the taxpayer acquires at least 95% of the value of the properties that are identified. Under the receipt requirement, the taxpayer must receive the replacement property prior to the earlier of (a) 180 days after closing on the relinquished property, or (b) the federal tax return due date (including extensions) for the year in which the exchange occurred.
One of the key regulations of a 1031 exchange is that the taxpayer cannot take actual or constructive receipt of any funds used to acquire the replacement property. Regulations provide four safe harbors which will typically prevent the IRS from challenging the transaction on a constructive receipt or agency theory. The four safe harbors include (1) security or guarantee arrangements, (2) qualified escrow accounts and trusts, (3) qualified intermediaries and (4) interest and growth factors. The safe harbor for qualified intermediaries is the most common. Under the regulations, a qualified intermediary must acquire and transfer the relinquished and replacement properties by acquiring and transferring legal title to the property or, if the taxpayer desires to keep the intermediary off the chain of title, the taxpayer can assign their rights in the respective purchase and sale contracts to the intermediary. Taxpayers who cannot qualify for, or do not want to structure the transaction to fall within the safe harbors, must rely on common law for determining whether the exchange will qualify under I.R.C. § 1031. Transactions that do not fall within the safe harbors of the regulations will be scrutinized by the IRS. Under common law, the taxpayer may use an intermediary, escrow agent or trustee to complete the transaction. In these cases, the taxpayer must not have access to the funds and the intermediary, escrow agent or trustee used must not be an agent of the taxpayer.
1031 exchanges are an effective way to defer capital gains tax, thus freeing more capital for the taxpayer’s investment in replacement property. With this additional capital, a taxpayer can acquire more valuable property, consolidate or diversify their assets or alter the nature of their investment (e.g., increase cash flow by replacing vacant land with rental property). If you have built in gain from property that is used in a trade or business or for an investment, consider a 1031 exchange to grow your wealth and trade up to a bigger and better investment.
Joseph Heck is an attorney at Fryberger Law Firm. He can be reached at Fryberger’s Cloquet office at (218) 879-3363.
The material in this article is for informational purposes only and not for the purpose of providing legal advice. You should contact your attorney to obtain advice with respect to any particular issue or problem.
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