The 1031 Exchange is quite possibly the most powerful investment tool available to property owners. Exchanging gives investors the ability to move from investment to investment, whether it is real estate, heavy equipment, business assets, artwork or aircraft, while keeping their equity intact. IRS Code 1031 allows investors to defer paying both Federal and State capital gains taxes and depreciation recapture when they sell a investment property and buy another investment property of “like kind” through an exchange transaction. Thus, investors can buy the property they want and build their wealth faster by utilizing the exchange process.
From the time of closing on their relinquished property, the investor has 45 days to nominate potential replacement properties and a total of 180 days from closing to acquire the replacement property.
The exchange must be set up prior to the closing of the investor’s relinquished property. The investor cannot have actual or constructive receipt of the funds. The investor or their agent should contact an Exchange Accommodator as soon as possible to begin setting up the exchange and also inform Escrow of their intention to complete a 1031 exchange.
The investor must ID the replacement property prior to midnight on the 45th day. The investor normally nominates three potential properties of any value. Then, acquires one of these three properties within 180 days. Typically, a common address (unambiguous description) will suffice. It is also a good idea to have a pending offer. If the investor needs to identify more than three properties, then the combined values of all properties cannot exceed 200% of the relinquished property’s value.
In order for an investor’s exchange to be completely tax deferred, the value and equity of the replacement property should be equivalent to or higher than that of the relinquished property. Investors can decrease mortgage levels by bringing cash into the replacement property, but they cannot increase mortgage levels and take cash out of the transaction without a tax implication. If they take cash out or go down in value on their replacement, then they would pay taxes on a portion of the transaction.
It is very important to review how title is held on the investor’s relinquished and replacement properties and consider potential financing requirements. The vesting needs to be consistent, in order to maintain the IRS “continuity of vesting” requirement.
What is Like-Kind?
The question of "what is like-kind property" often confuses investors. Section 1031 of the Internal Revenue Code allows real estate investors or business owners to trade property held for productive use in trade or business or for investment for similar property without paying capital gains tax. Similar classes of property are called "like-kind." The class of real estate is very broad and includes vacant land, office buildings, houses, warehouses, shopping centers and any other form of real estate held for investment purposes. Any form of investment real estate can be traded for any other without being taxed. Even leases with more than 30 years remaining are considered investment property and can be traded for other real estate. There is hardly any form of real estate that the typical investor might acquire in his lifetime that cannot be traded for any other.
What Time Periods Must You Work Within?
The traditional like-kind exchange is referred to as a "simultaneous exchange." A and B both own investment property, and both want to swap. On the day of settlement, A conveys a deed to B, and B conveys a deed to A. This is the traditional, classical 1031 exchange. Congress was concerned about the expansion of this like-kind exchange concept. Accordingly, in 1984 it puts two major limitations on the Starker (non-simultaneous) exchange. First, the property to be received by the taxpayer must be identified as such before the 45th day after the date on which the property is transferred. Second, the new property must be received no later than 180 days after the taxpayer transfers his original property, or the due date with extension of the taxpayer’s return for the year the transfer is made.
Is it Possible to Combine a IRC 1031 Exchange with the Universal Exclusion?
It is possible to work with both IRC 1031 and the Universal Exclusion on the same parcel of property. Examples of this situation would include:
Is it possible to purchase the replacement property prior to disposing of the relinquished property?
Through the use of the Reverse Exchange a property may be acquired today to replace a property yet to be relinquished. This technique though complex is currently gaining in popularity due to the issuance of Revenue Procedure 2000-37. There are three primary versions of this transaction in use today.
Does All Construction Need to be Completed within 180 Days in an Improvement Exchange?
To answer this question properly we must first address the identification of an improvement exchange property. The identification will qualify if the normal identification rules are followed and if "as much detail is provided regarding construction of the improvements as is practicable at the time the identification is made." Property not completed will still qualify. The Replacement Property will qualify as like-kind property even if it is only partially constructed (e.g., 20 percent complete) as of the date the Replacement Property is conveyed to the Exchanger, provided the Replacement Property is real estate. The IRS takes the position that personal property will not be treated as like kind unless it is 100 percent complete as of the date it is conveyed to the Exchanger. Treas. Reg. § 1.1031(k)-1(e)(5), Examples (ii) and (iii).