TAPF Articles

Definition

1031 exchanges are IRS-sanctioned processes involving the exchange of like-kind property with no immediate tax liability to the exchanger (the owner of the property being exchanged). These types of exchanges are used primarily for real estate operations but some assets, either depreciable or non-depreciable, could be eligible for an exchange as well. The IRS necessitates the presence of a neutral third party to facilitate the exchange. This third party is commonly referred to as accommodator, qualified intermediary or facilitator.

Benefits of an Exchange

A 1031 exchange can be a potent investment tool especially for property or business owners. This is because properties that are retailed or handed over for gain is subject to taxation, which can accrue rapidly. As the seller, you can be liable for taxes, which could reach a whopping 40% or more. In a 1031 exchange on the other hand, the property owner can keep all the property’s equity for re-investment purposes. This means that exchanger could acquire a replacement property with improved cash flow, better location and a reduction of management.

Properties Qualified for an Exchange

Like-kind property is generally defined as any real property within the USA or some of its territories. Property that is possessed for productive use in a business or for investment may be qualified to be exchanged as like-kind property. For example, a duplex can be exchanged for a raw land. Personal property on the other hand, is not like-kind real property. An industrial building cannot be exchanged for a private jet for instance. Personal property is evaluated based upon its General Asset Class, its NAICS categorization and its character and nature.

What Cannot Qualify?

In 1986, the IRC 1031 was amended to exclude certain properties from being exchanged. One of these is property held primarily for sale such as property sold right away after completion of improvements or after acquisition, business inventory such as cars for a car dealership, and developed lots. Also excluded are personal residences. However, the portion of a personal residence utilized for business or investment use may be eligible. Example of this is a home office. Other exclusions are stocks, bonds, notes, partnership interests, and other verifications of indebtedness.

Foundations of a 1031 Exchange

1. When a property is transferred, it must not be a sale. It must be an exchange, which means that the exchanger relinquishes a property but must receive replacement property in return.

2. The properties being exchanged must be of similar classes. The relinquished property must be like-kind to the replacement property.

3. The napkin test must be satisfied in order for an exchange to be completely not liable for taxation. This means that the value of the replacement property should be greater than or equal to the value of the relinquished property (the property given up by the exchanger).

4. The party renouncing the relinquished must receive the replacement property.

Are There Timeline Requirements for the Exchange?

The exchanger is given 45 days to identify the probable replacement properties and acquire the final replacement property in 180 days. The first 45 days are measured from the closing day of the relinquished property. Note that the entire exchange has to be carried out within 180 days, not 225 days.

What are the Rules for Identification?

The exchanger is obliged to provide an explicit account of the probable replacement properties earlier than twelve midnight of the 45th day measured from the close of the relinquished property. A legal report or property address is enough. In addition, a submitted purchase agreement is also considered to be sufficient identification. Furthermore, properties purchased and closed within the 45 days can qualify as identification.

Exceptions

Although personal residence is excluded from being exchanged, second homes such as vacation homes can now qualify for 1031 exchanges based on some guidelines determined by the Internal Revenue Service on February 2008.