1031 Exchanges - The Tax Derred Exchange
Published on Saturday, 11 June 2011 10:57 Written by Lawrence D. Brudy & Associates, Inc.
1031 exchanges have increased dramatically since the Tax Reform Act of 1986, and have continued to remain popular due to favorable regulations for taxpayers.
Exchanges under IRC Section 1031 are often referred to as tax-free, nontaxable, or tax deferred exchanges. Section 1031 provides an exception from current recognition of a realized gain. This gain is deferred until the property acquired in the exchange is subsequently disposed of in a taxable transaction.
Every 1031 exchange involves two properties. First, there is the relinquished property, which is the property that the taxpayer seeks to dispose of in the transaction. The second property is the replacement property. This is the property that the taxpayer seeks to acquire in the exchange.
All exchanges under Section 1031 also involve three main parties, as well as other ancillary parties, such as the real estate agents, accountants, attorneys, and settlement agents. The three main parties include a buyer, who will be purchasing the above mentioned relinquished property, the seller, who will be purchasing the replacement property, and finally, there is the Qualified Intermediary (QI). The QI acts as a sort of middleman in the exchange, in that it will acquire the replacement property and in turn convey it to the taxpayer. The Intermediary is typically and should be an entity and not an individual, simply because death or incapacity of an individual would obviously prevent the Intermediary from completing the exchange. It is extremely important that the Intermediary be trustworthy and able to ensure that funds will be held in trust for the taxpayer. Should the Intermediary hold such funds simply as Principal, liens or judgments against the Intermediary may attach to such funds.
There are many requirements under I.R.C. §1031 that must be met in order to effect a tax-deferred exchange. First and most obvious, real or personal property are required. Second, the property involved must be held for a qualified purpose. Qualifying property must be either held for use in the taxpayer’s trade or business or held for investment. Such property may be exchanged for property to be held for either of these two issues. The taxpayer’s purpose for holding the replacement and relinquished property is determined when the exchange takes place and the taxpayer has the burden of proof of whether the property is held for a proper purpose.
The next and third requirement is that the property relinquished must be like-kind with the replacement property. While the definition of “like-kind” for real property is broad, the definition of what is “like-kind” or “like-class” for personal property is much more restrictive. All real property is generally like-kind to all other real property, with only minor exceptions. The application of Section 1031 requires a comparison of both properties in order to ascertain whether the character and nature of the transferred rights in and to the respective properties are substantially alike. There are many factors to be considered in this analysis, such as the rights of the parties, the nature of the title conveyed, and the duration of the interests.
The final and fourth requirement is that an exchange is required. An exchange requires a reciprocal transfer of property, and the intent to exchange is not dispositive on the question of whether or not an exchange occurred. The exchange must be structured correctly. Although the intent to exchange is not a requirement, the courts will inevitably look to the intent of the taxpayer at the time of the exchange if the activities of the parties do not compel the conclusion that a sale occurred.
There are many advantages of a Section 1031 exchange. The principal advantage however is the ability to use the entire equity in a relinquished property in order to acquire a replacement property. Taxpayers who have held onto properties for years simply because of tax consequences of selling have the freedom to move their equity into more appropriate properties. Section 1031 also allows for taxpayers that own raw or unimproved land to generate cash flow by deferring tax on the gain created by a demand to put such property to a new use.
Regardless of the advantages to the taxpayer, the most important aspect of an exchange under Section 1031 is to ensure that all requirements are met and all timelines are followed. If these are overlooked the transaction will not be considered a tax-free exchange. There are few qualified persons that may act as Intermediary in a Section 1031 exchange, and it is important to know these requirements as well and choose an Intermediary that is familiar with the rules and regulations regarding Section 1031 exchanges.
Contact Darcy M. Dayton, Esq. at (724) 935-1400 for more information