A:In a typical transaction, the property owner is taxed on any gain realized from the sale; however, through a Section 1031 Exchange, the tax on the gain is deferred until some future date.
Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or investment. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of “like-kind” while deferring the payment of federal capital gains taxes and some state capital gains taxes on the transaction.
The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer’s investment is still the same, only the form has changed. Therefore, it would be unfair to force the taxpayer to pay tax on a gain.
The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold for cash, the original deferred gain, plus any additional gain realized since purchasing the replacement property, is subject to tax.
A: Once the money is deposited into an Exchange account, funds can only be withdrawn in accordance with the Regulations. The taxpayer cannot receive any money until the Exchange is complete. If you want to receive a portion of the proceeds in cash, this must be done before the funds are deposited with the Qualified Intermediary.
Yes, but the holding requirements of Section 1031 must be met prior to changing the primary use of the property. The IRS has no specific regulations on holding periods. However, many experts feel that to be on the safe side, the taxpayer should hold the replacement property for a proper use for a period of at least one year. Recently, there has been a Private Letter Ruling issued which stated that a 2 year holding period is acceptable, but not mandatory.
A: A Qualified Intermediary is an independent party who facilitates tax-deferred exchanges pursuant to Section 1031 of the Internal Revenue Code. The QI cannot be the taxpayer or a disqualified person.
A: The Exchange ends the moment the taxpayer has actual or constructive receipt (i.e. direct or indirect use or control) of the proceeds from the sale of the relinquished property. The use of a QI is a safe harbor established by the Treasury Regulations. If the taxpayer meets the requirements of this safe harbor, the IRS will not consider the taxpayer to be in receipt of the funds. The sale proceeds go directly to the QI, who holds them until they are needed to acquire the replacement property. The QI then delivers the funds directly to the closing agent.
A: The IRS regulations are very clear. The taxpayer may not receive the proceeds or take constructive receipt of the funds in any way, without disqualifying the Exchange.
A: No, as long as the taxpayer has not transferred title, or the benefits and burdens of the relinquished property, they can still set up a tax-deferred Exchange. Once the closing occurs, it is too late to take advantage of a Section 1031 Tax-Deferred Exchange (even if the taxpayer has not cashed the proceeds check).
A: No, not in most situations. The IRS regulations allow the properties to be deeded directly between the parties, just as in a normal sale transaction. The taxpayer’s interests in the property purchase and sale contracts are assigned to the QI. The QI then instructs the property owner to deed the property directly to the appropriate party.
A: A taxpayer has 45 days after the date that the relinquished property is transferred to properly identify potential replacement properties. The Exchange must be completed by the date that is 180 days after the transfer of the relinquished property, or the due date of the taxpayer’s federal tax return for the year in which the relinquished property was transferred, whichever is earlier. Thus, for a calendar year taxpayer, the Exchange period may be cut short for any exchange that begins after October 17th. However, the taxpayer can get the full 180 days, by obtaining an extension of the due date for filing the tax return.
A: Unfortunately, there are no extensions available. If the taxpayer does not meet the time limits, the Exchange will fail and the taxpayer will have to pay any taxes arising from the sale of the relinquished property.
A: There are three rules that limit the number of properties that can be identified. The taxpayer must meet the requirements of at least one of these rules:
A: Potential replacement property must be identified in a writing, signed by the taxpayer, and delivered to their QI by midnight on the 45th day of their Exchange. The identification cannot be made orally.
A: No. Any property that is held for productive use in a trade or business, or for investment, may qualify for tax-deferred treatment under Section 1031. In fact, many Exchanges are “multi-asset” Exchanges, involving both real property and personal property. However, the property being exchanged must be “like-kind” to the property being acquired.
A: A Multi-Asset Exchange involves property that includes more than one type of asset. For example, the sale of a hotel will typically include the underlying land and buildings, as well as the furnishings and equipment. If the taxpayer wants to exchange the hotel for a similar property, he would exchange the land and buildings as one part of the exchange. The furnishings and equipment would be separated into groups of like-kind or like-class property, with the groups of relinquished property being exchanged for groups of replacement property.
Although the definition of like-kind is much narrower for personal property and business equipment, careful planning will allow the taxpayer to enjoy the benefits of an exchange for the entire relinquished property, not just for the real estate portion.
A: A Reverse Exchange, sometimes called a “parking arrangement,” occurs when a taxpayer acquires a Replacement Property before disposing of their Relinquished Property. A The actual acquisition of the “parked” property is done by an Exchange Accommodation Titleholder (EAT) or parking entity.
A: Yes. Although the Treasury Regulations still do not apply to Reverse Exchanges, the IRS issued “safe harbor” guidelines for Reverse Exchanges on September 15th, 2000, in Revenue Procedure 2000-37. Compliance with the safe harbor creates certain presumptions that will enable the transaction to qualify for Section 1031 Tax-Deferred Exchange treatment.
A: In a typical Reverse (or “parking”) Exchange, the “Exchange Accommodation Titleholder” (EAT) takes title to (“parks”) the replacement property and holds it until the taxpayer is able to sell the relinquished property. The taxpayer then exchanges with the EAT, who now owns the replacement property. An Exchange structured within the safe harbor of Rev. Proc. 2000-37 cannot have a parking period that goes beyond 180 days.
A: Yes. This is known as a Build-to-Suit, Construction or Improvement Exchange. It is similar in concept to a Reverse Exchange. The taxpayer is not permitted to build on property they already own. Therefore, an unrelated party or parking entity must take title to the replacement property, make the improvements, and convey title to the taxpayer before the end of the exchange period.
A: Boot is any property received by the taxpayer in the Exchange which is not like-kind to the relinquished property. Boot is characterized as either “cash” boot or “mortgage” boot.
A: Mortgage Boot consists of liabilities assumed or given up by the taxpayer. The taxpayer receives Mortgage Boot when he is relieved of debt on the replacement property. The taxpayer pays Mortgage Boot when he assumes or places debt on the replacement property. If the taxpayer does not acquire debt that is equal to or greater than the debt that was paid off, they are considered to be relieved of debt.
A: Cash Boot is any boot received by the taxpayer, other than Mortgage Boot. Cash Boot may be in the form of money or other property.