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26 USC Section 1031 - Like
Kind Exchanges
As
Pertaining to Real Property
The following information is provided by Lori
Meadows, Attorney at Law, 24407 Lauder Place, Orange Beach, AL 36561,
lmeadows@gulftel.com, 251-942-5541, Fax 251-974-5541
Sec. 1031 - Exchange of property held for productive use or investment.
A) Non-recognition of gain or loss from exchanges solely in kind.
(1) In general: No gain or
loss shall be recognized on the exchange of property held for productive use in
trade or business or for investment if such property is exchanged solely for
property of like kind which is to be held either for productive use in a trade
or business or for investment.
(2)
Exceptions:
(a) Stock in trade or other property held primarily for sale,
(b)
Stocks, bonds, or notes,
(c)
Other securities or evidences or
indebtedness or interest,
(d)
Interests in a partnership,
(e)
Certificates of trust or beneficial
interests, or
(f)
Chose in action
(3)
Requirement that the property be identified and that exchange be
completed not more than 180 days after the transfer of exchanged property.
For purposes of this
subsection, any property received by the taxpayer shall be treated as property
which is not like-kind if:
(a)
Such property is not identified as property to be received
in the exchange on or before the day which is 45 days after the date on which
the taxpayer transfers the property relinquished in the exchange, or
(b)
Such property is received after the
earlier of
(i) The day which is 180 days after the date on which the taxpayer transfers
the property
relinquished
in the exchange, or
(ii) The due date (determined with regard to
extension) for the transferor’s return of the tax
imposed by this chapter for
the taxable year in which transfer of the relinquished property occurs.
Realtors are often the first to recognize the potential
benefits of a Section 1031 exchange. When a seller is going to replace
qualifying real estate with other replacement real estate, a Section 1031 tax
deferred exchange should be suggested. Taxpayers should never have to pay taxes
on the sale of real property if they intend to reinvest the proceeds in
like-kind property.
Advantages: The 1031 exchange gives the taxpayer
the ability to sell income, investment or business property and replace it with
like-kind property without having to pay income taxes on the transaction at that
point in time. This in essence equates to an interest-free loan from the
government in the amount of the tax owed. It also enables the investor to
reinvest more of the proceeds into the property subsequently purchases
(replacement property) from the disposition of the property sold (relinquished
property).
Setting the Stage for the Exchange
Once you determine that the
property for sale does qualify, and the seller believes it to be in
his/her best interest to participate in a 1031 Exchange, then certain
language should be inserted in the contract to document this
intention. (It should be noted that this language is not mandatory, but
advisable.)
For a Seller: “A material part of the consideration
to the seller is the option to qualify this transaction as a tax deferred
exchange under Section 1031 of the IRC. Purchaser agrees to cooperate in the
exchange provided purchaser incurs no additional liability, cost or expense.”
For a Buyer: “This offer is conditioned upon the
seller’s cooperation to allow the purchaser to participate in an exchange under
Section 1031 of the I.R.C. at no additional liability, cost or expense to
Seller. Seller hereby grants buyer permission to assign this contract to an
Intermediary not withstanding any other language to the contrary in this
contract.”
If a realtor knows that a buyer intends to assign the
contract to an intermediary in connection with an exchange, it is best to
reference the buyer as “John Doe or Assigns” on the contract. If there is a
paragraph which limits the buyer’s ability to assign the contract, it should be
eliminated as part thereof or use the language above to allow for
such assignment.
In order to effect a totally tax deferred exchange, the
taxpayer must purchase replacement property equal or greater in purchase
price (value) and debt than the property sold. To extent that the taxpayer
is “short” in either of these, they will be deemed to have received “boot” and
will be liable for taxes owed. Never “trade down.” Trading down will
always result in boot received, either by cash, debt reduction, or both.
The Qualified Intermediary: The role of the
qualified intermediary is essential in effecting a tax deferred exchange.
During the exchange period the taxpayer must avoid actual or constructive
receipt of monies from the sale of the relinquished property. If either of
these is present, the exchange will be disqualified. The qualified intermediary
fulfills the role of handling the funds and affecting the transfer of the
properties in a manner acceptable to the I.R.S., so as to not disqualify the
exchange. The qualified intermediary enters into an exchange agreement with the
taxpayer to acquire the relinquished property from the taxpayer, transfer the
relinquished property to its buyer, acquire the replacement property and
transfer the replacement property to the taxpayer. The qualified intermediary
holds the proceeds from the sale of the relinquished property and applies the
proceeds to the acquisition of the replacement property.
The qualified intermediary must not be a disqualified
person. Accountants, attorneys, and realtors who served the taxpayer in their
professional capacities within the prior two years are disqualified from serving
as a qualified intermediary for a taxpayer in an exchange.
Basic Rules for a 1031 Tax Deferred Exchange
- The Exchange Property must be qualifying property.
Both the relinquished property and
the replacement property must have been held/be held for a business or
investment purpose.
Property bought with the
intention of being “flipped” or put on the market for resale does not qualify.
Property which is held for inventory also does not qualify.
How long does property have to
be held in order to not be deemed to be bought for resale?
In general, the consensus is that
a year is a safe period of time to hold the property. But, the IRS will look at
the “facts and circumstances” of each individual transaction.
- Replacement property title must be taken in the same
name(s) as the relinquished property was titled.
If title was held as joint tenants
with rights of survivorship then all title holders must purchase the replacement
property and in the same manner. If they held the relinquished property as
tenants in common, then the titleholders (taxpayers) can “split off” their
interest having to reinvest their portion of the sales price of the relinquished
property into a new replacement property to accomplish a totally tax deferred
exchange.
- The replacement property must be of like-kind.
For real estate exchanges, this
merely means real property for real property. Unimproved real estate can be
exchanged for improved real estate. Also, a 100% interest can be exchanged for
an individual percentage with multiple owners. One property can be exchanged
for multiple properties and vice versa. (Caution: Taxpayer still has to make
sure that they are reinvesting at least the total ‘sales price” of their
relinquished property in their percentage ownership.
- The replacement property must be identified within 45
days of the transfer of the relinquished property.
If the replacement property is
closed on within the 45 days, this serves as identification and no formal
identification is needed. If not, the property must be identified in a letter
written to the qualified intermediary and delivered, mailed, faxed, or otherwise
sent within the 45 day period. The letter must contain unambiguous description
of the replacement property (ie: street address, legal description).
Three Property Rule:
Any three properties may be identified by taxpayer without regard to the market
value of the properties. It is advisable that the taxpayer
identify up to three units in their identification letter. If one of the
properties was to no longer be available the taxpayer has other options.
Once the 45 day period runs, there is no possibility of designating additional
properties or substituting a new property for one already on the list.
200% Rule: If the taxpayer
wishes to identify more than 3 properties, the value of all properties identified
are limited to 200% of the value of the property sold. This rule is very
limiting so the three property identification is preferred.
- The replacement property must be received and the
exchange completed to later than the earlier of 180 days after the transfer of
the relinquished property or the due date (with extensions) of the income tax
return for the tax year in which the relinquished property was transferred.
There are no extensions granted!
For more information on 1031 Tax Exchanges, please contact:
Lori Meadows, Attorney at Law, 24407
Lauder Place, Orange Beach, AL 36561,
lmeadows@gulftel.com, 251-942-5541, Fax 251-974-5541
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