Section 1031 of the Internal Revenue Code, which is generally referred to as the 1031 Exchange, allows the payment of income or capital gains tax when property is sold to be optional. The problem with the 1031 Exchange is that so few people seem to understand what it is, and therefore, few people attempt to utilize it.
In a 1031 Exchange, the seller is allowed to roll gains from a property transaction over to a new property, especially and most likely if the seller moves into an investment property and officially declares that it is his or her primary residence. This can occur if the sellers are married, and (a) have had the property for five years and (b) have lived in the property for at least two years; if so, they can exempt up to $500,000 in taxes after the final sale of the property. Another benefit of a 1031 Exchange is that capital gains taxes can be eliminated when a property owner dies. Heirs can receive a step up in basis on the date of the person’s death.
A real estate agent, certified public accountant or an attorney can help explain and maneuver through the rules that permit 1031 Exchanges. The main thing that a seller wanting to use a 1031 Exchange needs to keep in mind is that the technical jargon in the code simply refers to relinquished property, which means it is the property the seller no longer has, and replacement property is new property gained in the transaction.
These seven requirements can help determine if a transaction qualifies for a 1031 Exchange:
The ultimate use of the relinquished (old) property and the replaced (new) property property are like kind. This means the two properties are held for the same reason. For example, either both properties were used as investments or both properties were used for business. Property that a person buys strictly for resale does not qualify for a 1031 Exchange even if the plan is to buy more property for the same reason. Someone who buys a house to flip it does not qualify for 1031 either, but someone who buys a house and rents it can qualify, as this property is deemed investment property. One kind of investment (flipping) does not qualify, but the other kind (collecting rent) does qualify. Property can always be used as a 1031 Exchange if vacant land is bought with the proceeds.
The IRS allows 45 days for new property to be identified after the closing of relinquished (old) property. If a contract is not entered into by midnight of the 45th calendar day after closing, then explicit legal descriptions of up to three properties that the person conducting the transaction is considering must be presented. When identifying three potential properties, none can be valued at more than 200 percent of the relinquished (old or sold) property, or the 1031 may be disallowed. Basically, the IRS wants to ensure that the seller is serious about using the 1031 Exchange for its true intent and not just as a tax dodge.
The purchase of replaced (new) property must be closed upon by day 180 after the closing of the relinquished (old) property. The purchased property must be one of the three properties previously presented.
The person using the 1031 Exchange is not permitted to touch the money from the property he or she relinquished until the sale of the new property. An independent third party, referred to as an Exchange partner or intermediary, holds the money in the meantime. This intermediary is expected to prepare documents the IRS requires regarding both the sale of the relinquished property and the purchase of the replaced property. These funds must be held in a separate account during the process, and the taxpayer is allowed to collect the interest generated from these funds. If the documents are not prepared correctly, the 1031 Exchange will be declined.
The title on each property, both the relinquished property and the replaced property, must be the same. This means that if a husband and wife’s name are on the old title, they must both be listed on the new title, or the 1031 Exchange will be denied. There are ways to get around problems. For example, if the husband is the only name on a title, but the couple has to put both names on loan papers, there are legal ways for the process to work and qualify for a 1031 Exchange. The husband can quitclaim his interest and rename himself and his wife after the Exchange; then, both names will be legally included on the title.
In order for a 1031 Exchange to be allowed and 100 percent of the tax on the gain of the relinquished (old) property to be allowed, the replaced (new) property must be of equal or greater value. This rule also specifies that the replacement property must be of greater or equal value than the relinquished property and that all cash profits from the sale have to be reinvested. Closing expenses associated with the purchase can be added, as can capital improvements.
Sometimes a person finds a replacement property prior to relinquishing the original property. In that case, a third party, usually a created limited liability company, takes the title of the original property. The old property must be sold within 180 days after the new property is acquired. Once the sale goes through, the proceeds are directed to the taxpayer. Likewise, if the taxpayer must borrow funds to acquire the new property, this can be done through a third party so that the taxpayer will not have two properties titled directly to him or her. The title transaction is completed once the relinquished property is truly and finally relinquished.
Conclusion
Every 1031 Exchange has some issue that makes it unique. Although these seven points help explain most of the issues involved in conducting a 1031 Exchange, there are many issues that can pop up unexpectedly. It is advisable to contact an attorney or a CPA to ensure that each step of the transaction is completed accurately. Make a mistake, and the benefit of a 1031 Exchange can be lost.
Are you considering or involved in a 1031 Exchange? For more information, contact Jeremy Cyrier, CCIM at jeremy@mansardcre.com or by phone at 617-674-2043.