What Is A 1031 Exchange

All the people in United States know that the capital gains taxes can be a hard hit to the income of any person. If you know What Is A 1031 Exchange you can easily utilize it to save a lot of money that   you would have otherwise had to pay as capital gains tax.

Section 1031 of the Internal Revenue Code of the United States allows any person who has invested in real estate to defer payment of his capital gains tax dues as well as a depreciation recapture tax dues. These taxes are levied on sale of the original property of that person which he has subsequently sold out. A number of people who invest in real estate are able to use this section and make changes in their   investment portfolio. They do not have to bother about taxes involved.

In order to get the advantage of this section, you must purchase an IRS 1031 exchange property. The said transaction must be completed in a defined period. Section 1031 of the Internal Revenue Code also lays down the defined period. To begin with, you are given a time of 45 days. You have to earmark a set of three properties either of which you would purchase. The purchase of any of these earmarked properties must be completed within 180 days. Please note that the 45 days are included in the 180 days.

Apart from this you are also required to make sure that the reinvestment is at least 100% of the money that you earned after from the sale of property in your ownership earlier. You must keep in mind that if you fail to meet the 100 % investment criteria, the tax deferment would automatically become null and void.

The process involves a number of legal aspects. You would be required to take the assistance of a Qualified Intermediary. The Qualified Intermediary can be any person who is eligible for the role. Your lawyer, broker or accountant are not considered eligible, nor is an employee. The role of Qualified Intermediary is to take control of funds involved in the transaction. He is required to forward the money to closing agent who is selling the new property to you.

You must keep in mind that tax code of United States is a dynamic entity. The Internal Revenue Service, the Congress and the courts of United States can and frequently make amendments to the Internal Revenue Code according to their allocated powers. This means that what is correct today may not remain correct forever or the other way round.

Even if you are aware of what is a 1031 tax exchange, it is strongly recommended that you should take the assistance of your tax lawyer before you proceed in this direction.

1031 Exchange Laws In Simple Words

Capital gains tax deferment is available to tax payers in respect of exchange of like-kind US located real properties held for productive use or investment. The 1031 Exchange Laws provide this benefit. These are part of US internal revenue code (IRC) section 1031 of the income tax laws.

The basis of the above benefit lies in the recognition that no loss or gain occurs to a tax payer in case he/she exchanges one real property owned by him for productive use in business or trade or solely for investment purpose with another like property.

Exchanges of stocks, bonds, notes, securities, debt instruments, certificates of trust, and interests in partnership are not covered under section 1031.

The replacement property or the property to be received in exchange must be identified by the tax payer within 45 days of the date of sale of the property relinquished by him/her.

Further, the replacement property must be purchased by the tax payer within 180 days of a certain date. This date is the earlier one of the date of sale of the property relinquished by him/her and the due date of the tax return of the fiscal in which the tax payer sells the relinquished property.

In case gain occurs to a tax payer for non-like property exchanges covered under the subsections (a) of sections 1035, 1036, or 1037 of the income tax laws and in case the replacement property is a composite property, part of which is covered under the above provisions and in which respect no gain occurs and part of which is other property and involves cash profit too, then the profit to the tax payer shall be recognized in an amount not exceeding the cumulative sum of  the cash profit and the market value of such other property.

In case loss occurs to a tax payer for non-like property exchanges covered under the subsections (a) of sections 1035, 1036, or 1037 of the income tax laws and in case the replacement property is a composite property, part of which is covered under the above provisions and in which respect no gain or loss occurs and part of which is other property and involves cash too, then no loss to the tax payer shall be recognized.

Exchanges of different genders of livestock are not covered under section 1031.

In case a tax payer sells a property to a related person, the latter cannot resell it before 24 months have elapsed after acquiring it. Further, if the related person resells it for cash, potential abuse of the provisions of section 1031 may be triggered. In case a tax payer buys the replacement property from a related person, again potential abuse of the provisions is triggered. As such, in both cases, such transactions are not allowed.
In case a tax payer violates any provisions of the 1031 Exchange Laws, capital gains tax will be leviable.

Important 1031 Exchange Guidelines

The IRS has issued guidelines to enable tax payers implement them and take the capital gains tax deferment benefit under section 1031 of the income tax laws. These are known as 1031 Exchange Guidelines. They apply to forward, concurrent, reverse, leasehold improvement, or build-to-suit property exchanges under section 1031 of the income tax laws.

The tax return (and the name of the tax payer that appears on it) that specifies the sale of the relinquished property must match with the tax return (and the name of the tax payer that appears on it) that specifies the purchase of the replacement property. Further, the names on both these should also match with each of the names on the titles of the relinquished and replacement properties respectively

The tax payer must invest at least the sale value proceeds of the relinquished property in the purchase of the replacement property to take 100% capital gains tax benefit. In case the sale value of the relinquished property is more than the purchase value of the replacement property, capital gains tax will be leviable on the difference between the sale value and the purchase value.

The only exception to this is if the Qualifying Intermediary holds the net cash proceeds of the two transactions and does not transfer them to the tax payer.

The tax payer (known as the Exchanger) has a period of 45 days after the date of sale of the relinquished property to identify potential replacement properties to the Qualifying Intermediary.

In the case of a reverse exchange, the Exchanger has 45 days in which to make the identification of the relinquished property (to be sold). The Exchanger also has 180 days after the date of purchase of the replacement property to sell the relinquished property.

The Exchanger needs to identify a maximum of three replacement properties, the cumulative value of which is equal to or greater than the value of the relinquished property.

Further, the Exchanger may identify any number of replacement properties with the restriction that their cumulative value must not exceed 200% of the value of the relinquished property. Further, if they exceed that value, the Exchanger must close on at least 95% of them before the end of the 180 days replacement property purchase deadline.

The Exchanger must purchase the replacement property within the 180 days from the date of sale of the relinquished property.

The 1031 Exchange Laws do not cover any clause on the time for which a property has been owned by a tax payer before relinquishment. However, the IRS always checks this time to know the intent of the tax payer. In case the property has been held for only a short period, the tax payer’s intention to own the property solely for investment is suspect.

Some other aspects of the 1031 Exchange Guidelines include whether the property relinquished was itemized on Schedule E and whether it was rented.