Tax law states that a gain made on the sale of real estate owned for business or investment purposes, is taxable, and the tax becomes due at the end of the current tax year.
Fortunately, Section 1031 of the Internal Revenue Code provides an exception to this. The code allows the owner to delay, or defer, any tax that may be due on the gain, provided certain conditions are met. Those conditions include:
- The types of property
- The timescales involved, and
- The process used.
The word “exchange” can refer to an actual exchange, or to a sale-and-purchase, or a purchase-and-sale The
transaction may be completed simultaneously, or may take as long as 180 days. What matters is that the strict terms of Section 1031 are met.
A critical element is that the entire transaction must be managed by an approved intermediary. Someone’s own attorney or real estate agent will not qualify as an approved intermediary. An “arm’s length” 1031 specialist may qualify. That specialist will know that they are an approved resource. We explain the terms and qualifications for a 1031 exchange, below.
The Types of Property That Qualify for 1031 Exchanges
The properties must be held for business and investment reasons, not personal ones, and must be inside the United States. Primary residences, for example, are excluded, as are a rental property in the USA being exchanged for one in, for example, Canada.
The properties must be “like-kind” which means they are similar in nature, character and class. Just to take two examples, raw land may beexchanged for land with improvements, an office building may be exchanged for an apartment block. Real estate in all its forms is considered like-kind, as long as the land the improvements stand on are part of the transaction.
The Types of Transaction that Qualify for 1031 Exchanges
The term “exchange” can include such transactions as:
- Immediately exchanging the owned property for a like-kind property of equal or greater value.
- Immediately reinvesting sale proceeds in another, like-kind, property; a sale-and-purchase.
- Setting up a pre-arranged “exchange” that is not completed simultaneously. The sale may be completed, and the proceeds held by the intermediary until the intended future purchase is complete. In this case, the seller has no more than 45 days to tell the intermediary which property they will purchase, and the purchase must be completed within 180 days of that, or by the time the tax return is due. During this time, the intermediary holds all sale proceeds in an escrow account.
- Setting up a pre-arranged purchase-and-sale. In this case the replacement property is purchased first, and the sale of the currently-owned property takes place within the 180 days. Again, the entire pre-arranged transaction must be managed by the intermediary, and all funds held in escrow.
In delayed transactions, the replacement properties must be suitably described. The intermediary will ensure all parties understand and abide by the details.
In all 1031 Exchange transactions, the parties are kept separate from the proceeds until the transaction is complete.
Determining Tax Basis and Liability
Tax liability is deferred not forgiven. It is essential to have a tax specialist track the basis of the currently-owned property, and continues to track the basis through ownership of the newly-acquired property. The basis may, of course, be transferred through further 1031 Exchange transactions until, the final property is ultimately sold, and the tax on the final gain becomes due. The tax basis will be affected by applicable depreciation, etc.
Some 1031 exchanges do include non-real estate property. If any of that property, such as production machinery or transport vehicles, is part of the exchange, then the tax liability will also be deferred. The IRS treats such property differently so, for example, a transport truck cannot be ”exchanged” for a passenger vehicle because they are not considered “like-kind.”
Reporting 1031 Exchanges to the IRS
Use Form 8824 to report the exchange, and submit it with your tax return for that year. The IRS strictly controls exchange liability, and monitors the details. It is essential that every “i” is dotted, and every “t” is crossed.
If a taxpayer does not strictly follow the letter of the law, the IRS may not only claim unpaid taxes, but also demand penalties.
1031 Exchanges are an effective way to defer tax liabilities. Following the rules takes experience, skill, and a detailed knowledge of the Tax Code. It you want to learn more about how you can defer tax liabilities by benefiting from a 1031 Exchange, please click this link to contact us so we can discuss your needs in detail, and plan the details accordingly.