1031 Exchanges
A 1031 Exchange (Tax-Deferred Exchange) is one of the most powerful tax deferral strategies remaining available for taxpayers.
Anyone involved with advising or counseling real estate investors should know about tax-deferred exchanges, including Realtors, lawyers, accountants, financial planners, tax advisors, escrow and closing agents, and lenders. Taxpayers should never have to pay income taxes on the sale of property if they intend to reinvest the proceeds in similar or like-kind property.
The Advantage of a 1031 Exchange is the ability of a taxpayer to sell income, investment or business property and replace with like-kind replacement property without having to pay federal income taxes on the transaction. A sale of property and subsequent purchase of a replacement property doesn’t work, there must be an Exchange.
THE BASIC RULES FOR A 1031 EXCHANGE
1. The relinquished property must be qualifying property.
Qualifying property is property (or equipment) held for investment purposes or used in a taxpayer’s trade or business. Investment property includes real estate, improved or unimproved, held for investment or income producing purposes. Property used in a taxpayer’s trade or business includes his office facilities or place of doing business, as well as equipment used in his trade or business. Real estate must be replaced with like-kind real estate. Equipment must be replaced with like-kind equipment.
2. Replacement property title must be taken in the same names as the relinquished property was titled.
If a husband and wife own property in joint tenancy or as tenants in common, the replacement property must be deeded to both spouses, either as joint tenants or as tenants in common. Corporations, partnerships, limited liability companies and trusts must be in title on the replacement property the same as they were on the relinquished property.
3. The replacement property must be like-kind.
For real estate exchanges, like-kind replacement property means any improved or unimproved real estate held for income, investment or business use. Improved real estate can be replaced with unimproved real estate. Unimproved real estate can be replaced with improved real estate. A 100% interest can be exchanged for an undivided percentage interest with multiple owners and vice-versa. One property can be exchanged for two or more properties. Two or more properties can be exchanged for one replacement property. A duplex can be exchanged for a four-plex. Investment property can be exchanged for business property and vice versa. However, as referenced above, a taxpayer’s personal residence cannot be exchanged for income property, and income or investment property cannot be exchanged for a personal residence, which the taxpayer will reside in.
4. Any boot received in addition to like kind replacement property will be taxable (to the extent of gain realized on the exchange).
This is okay when a seller desires some cash or debt reduction and is willing to pay some taxes. Otherwise, boot should be avoided in order for a 1031 Exchange to be completely tax-free.
The term “boot” is not used in the Internal Revenue Code or the Regulations, but is commonly used in discussing the tax consequences of a Section 1031 tax-deferred exchange. Boot received is the money or the fair market value of “other property” received by the taxpayer in an exchange. Money includes all cash equivalents plus liabilities of the taxpayer assumed by the other party, or liabilities to which the property exchanged by the taxpayer is subject. “Other property” is property that is non-like-kind, such as personal property received in an exchange of real property, property used for personal purposes, or “non-qualified property.” “Other property” also includes such things as a promissory note received from a buyer (Seller Financing).
5. A rule of thumb for avoiding “boot” is to always replace with property of equal or greater value than the relinquished property.
Never “trade down.” Trading down always results in boot received either cash, debt reduction or both. Boot received is mitigated by exchange expenses paid.