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, Email Lori, 251-942-5541, Fax 251-974-5541
Sec. 1031 – Exchange of property held for productive use or investment.
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
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.
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, Email Lori, 251-942-5541, Fax 251-974-5541