Deferring Gains Through 1031 Exchanges
For individuals who are sitting on large gains in investment or business property, a 1031 exchange may be a viable option for deferring those gains. While these transactions tend to be complex, working with an expert who knows the rules regarding the exchanges and the options available for replacement property can help you decide if this would be an appropriate step to take.
This article will address the purpose of a 1031 exchange, the three types of exchanges, and the rules for them.
What Is a 1031 Exchange?
Generally, when a taxpayer sells an investment property, he or she will recognize capital gains on the sale. Section 1031 of the IRS Code offers an exception that allows the taxpayer to defer those gains if he or she uses the proceeds to purchase another investment property. Because this is a tax-deferral strategy, it is most effective if you believe that you will be in a lower tax bracket in the future and will be able to realize gains at a lower level, or if you intend to hold the replacement property (or continue exchanging property) until your death. The cost basis of the replacement property may be adjusted in the hands of your heirs to reflect the fair market value as of the date of your death, thereby erasing all of the built-in gains.
How Does a 1031 Exchange Work?
There are three different variations on the 1031 exchange:
- In a simultaneous exchange, the property is sold and the proceeds are immediately used to purchase replacement property.
- In a deferred exchange, property is sold, the proceeds are held by a qualified intermediary, and replacement property is identified within specific time frames.
- In a reverse exchange, the replacement property is purchased and the title is parked through an exchange accommodator. The relinquished property is later sold and title is acquired from the exchange accommodator.
What Are the Rules?
The rules for 1031 exchanges are somewhat complex and very stringent. If any of the requirements is missed, the tax deferral is lost.
- Same taxpayer: Both the relinquished and replacement property must be owned by the same taxpayer. This can be an individual or an entity, such as a trust or business.
- Type of property: The Tax Cuts and Jobs Act of 2017 repealed the ability to exchange personal property such as art, livestock, and collectibles. The Code section now permits exchanges of real property held for productive use or investment. The properties being relinquished and purchased must be held for use in a trade or business rather than for personal use. For this reason, a primary or vacation home generally will not qualify for an exchange.
- Like-kind property: Both properties must be similar enough to be considered “like-kind.” Property is considered to be like-kind when it is of the same nature, character, or class. Most real estate is considered like-kind: vacant land could be exchanged for land with a building on it.
- Qualified intermediary: The client must enter into an exchange agreement with a qualified intermediary to identify the transaction as a 1031 exchange. The exchange agreement must contain language that prohibits the taxpayer from receiving the proceeds of the sale. If a taxpayer takes possession of the proceeds, the transaction will not qualify as a 1031 exchange.
- Time limits: There are specific time frames that must be satisfied if an exchange is not simultaneous:
- Replacement property must be identified within 45 days of the closing of the relinquished property. The identification must be made to the qualified intermediary in writing.
- The replacement property must be received or closed upon and the exchange completed no later than 180 days after the sale of the relinquished property or the due date (with extensions) of the income tax return for the year in which the relinquished property was sold, whichever is earlier.
- Value and quantity of replacement property: The value of the replacement property must be equal to or greater than the value of the relinquished property for complete tax deferral. If the replacement property is purchased for less than the relinquished property was sold for, the difference will be taxable. Additionally, when the exchange is being done with real estate, there are rules surrounding the number of replacement properties that may be aggregated for an exchange.
- Up to three properties may be identified regardless of value.
- If four or more properties are identified, the aggregate value cannot exceed 200 percent of the value of the property sold.
- If the identified value exceeds 200 percent, the taxpayer must close on at least 95 percent of the properties identified.
- Reporting: 1031 exchanges must be reported on IRS Form 8824 in the year in which the exchange occurred.
In addition to the above rules, many practitioners recommend holding the replacement property through at least two tax returns to limit the risk of the IRS viewing the transactions as a sham exchange, done solely for the purposes of deferring gains.
Because the rules for these exchanges are so complex, it is imperative that you work closely with your tax advisor, financial advisor, and other experts to ensure that your tax-saving goals are met.