Managing a 1031 Tax Free Exchange is not difficult – but it does require adherence to strict 1031 Tax Free Exchange rules and regulations. For these reasons, you must enter into a 1031 Exchange with the advice of a tax professional and the assistance of a Qualified Intermediary working on your behalf.
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- Manage exchange transactions precisely to maximize tax benefits.
- What is 1031 Tax Free Exchange?
- Who should consider a 1031 Exchange?
- What qualifies for a 1031 Tax Free Exchange?
- Misconceptions About Exchanging
- Advantages of Exchanging
Under normal circumstances, when you sell a property you have to pay tax on the gain. Gain is caused by taking depreciation deductions for tax purposes or by the property appreciating in value during its ownership.
A Section 1031 tax deferred exchange, named for the Internal Revenue Code Section it refers to (also known as a Starker Exchange, Tax Free Exchange, or Like-Kind exchange), allows an exception to the capital gains tax. When you sell your business or investment real estate, replace it with a different business or investment property, and complete an exchange, you can defer payment of the capital gains tax normally required on these sales. If your plans include using the money from the sale of a business or investment property to buy more of the same, a 1031 Exchange provides greater proceeds for your next investment-more than you could gain through the re-investment of after-tax proceeds.
A 1031 Exchange is not a tax loophole. It is a section of the Internal Revenue Code, written by Congress, to allow anyone who meets all the requirements to sell their property and defer paying taxes on the gain. Back to Top.
Anyone who is thinking about selling a business use or investment property should consider affecting a 1031 Exchange. An Exchange offers the astute investor an opportunity to reinvest the federal capital gains that would normally be handed over to the IRS and put that money to work for himself. You work too hard to simply pay the tax without carefully considering this reinvestment option. Essentially, 1031 Exchanges should be thought of as an interest-free loan from the IRS; one in which the principal may be increased through subsequent exchanges and may never require repayment, if you plan properly. Back to Top.
QUALIFIED PROPERTIES The classification of properties exchanged determines if the property qualifies for Section 1031 treatment.
A. The IRS’s 4 classifications of Real Estate:
- Property held for personal use. (Personal Property)
- Property held primarily for sale. (Dealer Property)
- Property held for productive use in a trade or business. (Business Property)
- Property held for investment. (Investment Property)
The last two qualify for Section 1031 tax deferral, the first two do not. Both the property received and the property sold must be of “Like Kind”. It is your use of the property that determines its classification. What the other party does with the property does not affect your tax status.
B. Like-Kind Property
Like-kind refers to your use of the property and not to its grade or quality.
“1031″ property may be mixed as to type and still be like-kind. As an example, you may exchange land for a duplex, or a commercial building for a retail store, etc. (See page 14.)
Property held outside the USA and its territories does not qualify for exchange with property held within the USA.
C. Partnership Interests
Your interest in a partnership cannot be traded for an interest in another partnership. Exception: The partnership as an entity can exchange real estate it owns for other like-kind real estate.
D. Transfer Between Spouses
There are no income tax consequences in entering into financial transactions between spouses. In addition, most transfers incident to a divorce are tax free. However, transactions with a former spouse are normally subject to tax unless they qualify for nonrecognition under the provisions of Section 1031.
E. Sale/Lease Back As An Exchange
A lessee’s interest in a lease with a term of 30 years or longer in real property is considered like-kind to other real property. In addition, property which is subject to a lease can be, even if the lease is for a term of 30 years or longer, the subject of a tax free exchange. However the receipt of prepaid lease payments in an exchange for a 30-year or longer lease is taxed as ordinary income and will not qualify for tax-free exchange treatment.
F. Business Assets
The personal property assets of one business can be exchanged for like-kind assets of another business and will be held as a like-kind exchange under Section 1031. The real property is treated the same as any other exchange. The like-kind requirements for personal property are much more stringent than for real property (e.g., a truck cannot be exchanged for a car, nor can a barge be exchanged for a cargo ship).
G. Vacation Homes & Properties
This type of property does not qualify if it is used solely for personal use. It may qualify if rented, and must pass a use test each year. Back to Top.
1. Many still believe that you must “swap” properties. Although this was required in the original code, this is rarely done in present times. 1031 Exchanges now enable one to sell their property to someone totally unrelated to the person from whom they are purchasing their replacement
2. Many believe only investors of large commercial properties can utilize the benefits of Section 1031. The great thing about 1031 Exchanges is that it applies to all investment properties, large and small. It will work the same way for a corporation selling a large shopping center as it would for an individual selling a single-family home used as a rental property in a vacation area.
3. Many believe you must acquire a property of “similar use or service.” While 1031 Exchanges are also known as “like-kind” exchanges, like-kind simply applies to real property held for business use or investment. Therefore, an investor may sell raw land and acquire a five-unit apartment building or sell a warehouse and acquire raw land. He can sell one property and acquire three or sell four and acquire one. Virtually any type of real property used for business use or investment will qualify.
4. Many believe 1031 Exchanges are very complicated and not worth doing. The fact is that when working with a qualified intermediary who specializes in Section 1031 tax-deferred exchanges, the exchange process is very simple. The intermediary will keep you aware of your time deadlines and ensure you do everything in strict compliance with IRS regulations. Back to Top.
1. The Exchanger will have more buying power because the federal income taxes are deferred. This will enable him to leverage himself up greater than he could had he paid the tax liability. The additional equity to reinvest will make him a more solid buyer and help him get easier financing.
2. Investors can do exchange after exchange to create a pyramiding effect. This tax liability is forgiven upon the death of the investor as the heirs get a stepped-up basis on the inherited property.
3. The Exchanger will have greater selling power because he does not have to inflate the sales price to try to cover some of the capital gains that would normally be due upon the sale of an investment property. It will enable him to be more flexible with the selling price.
4. The Exchanger can acquire a replacement property with greater income potential. He can sell raw land and acquire income-producing property. Perhaps, he wants to acquire a building with additional units or in an easier to rent location.
5. The Exchanger has the opportunity to consolidate several hard to manage properties into one easy to manage property or diversify several small properties into one large property. It provides an excellent opportunity to relocate or expand a current business or investment.
6. An exchange can also help an investor acquire a less management-intensive property. Back to Top.
Please consult your tax advisor for specific information relating to your exchange.