In a conventional sale of real estate, the American taxpayer will trigger capital gains tax ranging from 25%-40%, and in some cases more. Section 1031 of the Internal Revenue Code provides that no gain or loss will be recognized when property held for use in trade or business or for investment is exchanged for like-kind property. Put simply, taxpayers are permitted to trade property for other like-kind property without paying taxes (federal or state) on the transaction. Capital gains and depreciation recapture taxes are deferred.
Section 1031 and the exchange regulations allow sellers of real estate property to defer their capital gain if
· the property is used in a trade or business or held for investment,
· the property is exchanged for like-kind property, and
· certain time frames for identification and acquisition of the replacement property are met.
If a relinquished property is sold and replacement property acquired in conformity with the above conditions and all tax rules, the transaction will be characterized as an exchange rather than a sale. By having the transaction designated an exchange, the exchanger defers the capital gains tax by way of rolling over the adjusted basis from the relinquished property into the replacement property.
Trade, Business or Investment
To fall under Section 1031, a property must be used by the taxpayer in a trade or business or held for investment. This categorically prevents property used solely for primary residence. Such properties do not fall under Section 1031, but rather Section 121. Most tax professionals maintain that property must be used in a trade or business or held out for investment for two (2) years. Some, however, are satisfied with a year or at least one tax filing season for the property. Property bought with the intent to sell, such as in the case of “flippers,” are considered “inventory” by the IRS, and the sellers as “dealers.” This disqualifies these properties and sellers for Section 1031 treatment. Vacation and second homes may or may not qualify and must be analyzed on a case by case basis.
Like-Kind Exchange
Property satisfactorily used for trade or business or held for investment must be exchanged for like-kind property. This qualification does not require a one to one exchange of properties (i.e. a single family rental for another), but rather an exchange within the class of like-kind properties. Like-kind properties include land (raw, farm or agricultural), single family and multi family dwellings, industrial, commercial, retail, condominiums, and so on. In other words, an exchange between the like-kind class of real property will suffice. This prevents exchanges between different investments vehicles, such as selling stocks and purchasing real estate, or selling personal property and purchasing real property.
Exchange Time Frames
A 1031 exchange begins on the date of transfer recordation for the first relinquished property. In most transactions this is the day of closing. The exchanger then has 45 days to identify potential replacement property and close within 180 days. The 45 day identification must completed before 12:00am of the 45th day and the exchange must be completed (replacement property closed on) the earlier of the 180th day or the due date of the exchanger’s tax return.
Replacement Property Identification
In identifying replacement property, exchangers will fall into one of three classifications depending on the number of properties identified and their value.
3 Property Rule
The exchanger may identify any three properties as potential Replacement Property without regard to their fair market value.
200% Rule
The exchanger may identify any number of Replacement Property provided that the aggregate value of all the identified properties by the end of the 45 day period do not exceed 200% of the aggregate fair market value of all the relinquished properties.
95% Exception Rule
If the exchanger exceeds the 200% rule and identifies more potential Replacement Property than allowed, the exchanger will be required to receive 95% of the aggregate value of all the replacement property identified.
Additional Requirements
Fully Tax Deferred Exchange
For a fully tax deferred exchange, the exchanger must reinvest all the funds from closing of the relinquished property and purchase replacement property at equal or greater value. Any money received by the exchanger from the closing of the relinquished property or if non-allowable expenses are paid with exchange funds, both result in taxable “boot.” Likewise, if the exchanger purchases property lower in value than the relinquished property, the difference will be considered profit by the IRS and subject to tax. In addition, if the exchanger has debt (a mortgage) on their relinquished property they must either replace that debt with cash or a new mortgage of equal or greater value to avoid further tax implications.
Same Taxpayer
The IRS requires the taxpayer of the relinquished property also remain the same on the replacement property. Tax ownership, however, does not necessarily correspond to the same legal entity. For individuals and pass through entities such as a single member LLC or Revocable Living Trust that file under an individual Social Security Number the underlying individual must remain the same. For example, an individual may sell his property and purchase property under a single member LLC that passes through to the individual. For entities that file under the FEIN, the entity with the same FEIN must begin and complete the exchange. This usually arises in multimember LLC’s that are held out as partnerships.
Example
Susan purchased a rental property in 2015 for $400,000 and put an additional $50,000 in capital improvements. Her basis is now $450,000 and in 2021 she enters into contract to sell the rental home for $700,000. Assuming a combined capital gains tax rate of 30%, Susan would incur a $75,000 tax bill on her $250,000 profit. To defer the capital gains tax, Susan engages a Qualified Intermediary and enters into an Exchange Agreement. At closing, the settlement agent wires the funds to Susan’s exchange account. While the Qualified Intermediary safeguards the funds, Susan timely and validly identifies a duplex as replacement property before the 45 day deadline. Within 180 days from closing her sale, she forms a single member LLC, disregarded for federal income tax purposes and enters into contract then directs the QI to wire all the funds for the purchase of the identified replacement property priced at $900,000. Since Susan is the underlying taxpayer of the LLC she is complying with the same taxpayer requirements and successfully completes a 1031 exchange by exchanging investment property for other like kind investment property meeting the deadline requirements, remaining the same taxpayer throughout the exchange, and reinvesting all her equity into a property value higher than her sale.
Role of the Qualified Intermediary
To qualify for tax-deferred treatment, the exchanger cannot have actual or constructive receipt of the exchange funds. This chief underlying premise requires exchangers to use Qualified Intermediaries. Qualified Intermediaries facilitate exchanges by preparing documents and guiding exchangers through the process. More importantly, under the tax code, Qualified Intermediaries serve the unique role of providing the safe harbor in proving the exchanger did not have actual or constructive receipt of funds. By entering into an agreement with a Qualified Intermediary, the exchanger expressly agrees to not receive, pledge, borrow, or otherwise obtain the benefits of the exchange funds before the end of the exchange period. The transfer of funds is made possible through an assignment agreement wherein the Qualified Intermediary becomes the seller of the relinquished property and directs funds from closing to be wired directly into the exchange account.
Tax Deferral
In a 1031 exchange, taxes are not eliminated. Rather, the capital gains and depreciation recapture taxes are deferred. After a 1031 exchange, the taxpayer files Form 8824 with the IRS alerting them of the exchange. This form will not only put the IRS on notice, but will indicate the new basis in the replacement property. Instead of purchasing property at a stepped up basis, the relinquished property basis is rolled over into the replacement property. For example, if an exchanger sold $500k property with a basis of $250k and purchased replacement property for $600k, the new basis will be $350k (the previous basis including the additional purchase up in value between the sale and purchase).
*In addition to filing the required federal forms for an exchange, a taxpayer may also need to file applicable state forms depending on the state in which the relinquished property was sold. Exchangers should consult their CPA / Tax Advisor for clarification, guidance, and tax advice.