For individuals who are sitting on large gains in investment or business property, a 1031 exchange may be a viable option for deferring those gains. This article explains the benefits of a 1031 exchange, describes the three types of exchanges, and summarizes some of the key rules surrounding them.
Generally, when a taxpayer sells an investment property, he or she will recognize capital gains on the sale. Section 1031 of the IRS Code offers an exception that allows the taxpayer to defer those gains if he or she uses the proceeds to purchase another investment property.
Because this is a tax-deferral strategy, it is most effective if you believe that you will be in a lower tax bracket in the future and will be able to realize gains at a lower level, or if you intend to hold the replacement property (or continue exchanging property) until you pass away.
When you pass away, the cost basis of the replacement property may be adjusted in the hands of your heirs to reflect the fair market value as of your date of death, thereby erasing all of the built-in gains.
Types of 1031 exchanges
There are three different variations on the 1031 exchange:
- In a simultaneous exchange, property is sold and the proceeds are immediately used to purchase replacement property.
- In a deferred exchange, property is sold, the proceeds are held by a qualified intermediary, and replacement property is identified within specific time frames.
- In a reverse exchange, replacement property is purchased and the title is parked through an exchange accommodator. The relinquished property is later sold and the title is acquired from the exchange accommodator.
The rules surrounding 1031 exchanges can be complex and very stringent. If you don’t follow any of the applicable requirements to the letter, the tax deferral may be lost. Below is a very high-level summary of the most important rules. An accountant or tax attorney can discuss the specific requirements and limitations.
Same taxpayer ownership
Both the relinquished and replacement property must be owned by the same taxpayer. This can be an individual or an entity, such as a trust or business.
The properties being relinquished and purchased must be held as an investment or for use in a trade or business rather than for personal use. So while a gas station, a working farm or an apartment building could qualify as an exchange, a primary or vacation home would not. Nor would personal property such as art and collectibles.
Both properties must be similar enough to be considered “like-kind.” This means they should be of the same nature, character, or class. Most real estate is considered like-kind: For example, undeveloped land could be exchanged for land with a warehouse built on it.
Use of qualified intermediaries
The taxpayer must enter into an exchange agreement with a qualified intermediary to identify the transaction as a 1031 exchange. The exchange agreement must contain language that prohibits the taxpayer from receiving the proceeds of the sale. If a taxpayer takes possession of the proceeds, the transaction will not qualify as a 1031 exchange.
Time limits for non-simultaneous exchanges
There are specific time frames that must be satisfied for deferred or reverse exchanges to qualify as 1031 exchanges.
- Replacement property must be identified within 45 days of the closing of the relinquished property.
- The replacement property must be received or closed upon and the exchange completed no later than 180 days after the sale of the relinquished property or the due date (with extensions) of the income tax return for the year in which the relinquished property was sold, whichever is earlier.
Value and quantity of replacement property
The value of the replacement property must be equal to or greater than the value of the relinquished property for complete tax deferral. If the replacement property is purchased for less than the relinquished property was sold for, the difference will be taxable. Additionally, when the exchange is being done with real estate, there are rules surrounding the number of replacement properties that may be aggregated for an exchange.
1031 exchanges must be reported on IRS Form 8824 in the year in which the exchange occurred.
Recommended holding periods
Many practitioners recommend holding the replacement property through at least two tax returns to limit the risk of the IRS viewing the transactions as a sham exchange, done solely for the purposes of deferring gains.
Since these transactions can be very complex, consulting with a tax advisor, financial advisor and other experts who know the rules surrounding the exchanges and the options available for replacement property can help you decide if this strategy aligns with your tax and estate planning objectives.
Dan Flanagan is a financial advisor located at Canby Financial Advisors, 161 Worcester Road, Framingham, MA 01701. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 508.598.1082 or at firstname.lastname@example.org
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