Internal Revenue Code section 1031
Under Section 1031 of the United States Internal Revenue Code (26 U.S.C. § 1031), the exchange of certain types of property may defer the recognition of capital gains or losses due upon sale, and hence defer any capital gains taxes otherwise due.
To qualify for Section 1031 of the Internal Revenue Code, the properties exchanged must be held for productive use in a trade or business or for investment. Stocks, bonds, and other properties are listed as expressly excluded by Section 1031 of the Internal Revenue Code, though securitized properties are not excluded. The properties exchanged must be "like-kind", i.e., of the same nature or character, even if they differ in grade or quality. Personal properties of a like class are like-kind properties. Personal property used predominantly in the United States and personal property used predominantly elsewhere are not like-kind properties.
Real properties generally are of like-kind, regardless of whether the properties are improved or unimproved. However, real property in the United States and real property outside the United States are not like-kind properties.
Taxpayers may wonder whether items such as equipment used on a property are included in the lump-sum sale of the property, and if they are able to be deferred. Under Treasury regulation §1.1031(k)-1(c)(5)(i), property that is transferred together with the larger item of value that does not exceed 15% of the fair market value of the larger property does not need to be identified within the 45 day identification period but still needs to be exchanged for like kind property to defer gain.
Cash to equalize a transaction cannot be deferred under Code Section 1031 because it is not like-kind. This cash is called "boot" and is taxed at a normal capital gains rate.
If liabilities assumed by the buyer exceed those of the seller (taxpayer), the realized gain of the seller will be not only be realized, but recognized as well. If however, the seller assumes a greater liability than the buyer, the realized loss cannot offset any realized and recognized gain of receiving boot such as cash or other personal property considered boot.
Originally, 1031 cases needed to be simultaneous transfers of ownership. But since Starker vs. U.S. (602 F.2d 1341), a contract to exchange properties in the future is practically the same as a simultaneous transfer. It is under this case, decided in 1979, that the rules for election of a delayed 1031 originated. To elect the 1031 recognition, a taxpayer must identify the property for exchange before closing, identify the replacement property within 45 days of closing, and acquire the replacement property within 180 days of closing. A Qualified Intermediary must also be used to facilitate the transaction.
Section 1031 Like-Kind Exchanges
Section 1031(a) of the Internal Revenue Code (26 U.S.C. § 1031) states the recognition rules for realized gains (or losses) that arise as a result of an exchange of like-kind property held for productive use in trade or business or for investment. It states that none of the realized gain or loss will be recognized at the time of the exchange.
It also states that the property to be exchanged must be identified within 45 days, and received within 180 days.
1031(b) states when like-kind property and boot can be received. The gain is recognized to the extent of boot received.
1031(c) covers cases similar to those in 1031(b), except when the transaction results in a loss. The loss is not recognized at the time of the transaction, but must be carried forward in the form of a higher basis on the property received.
1031(d) defines the basis calculation for property acquired during a like-kind exchange. It states that the basis of the new property is the same as the basis of the property given up, minus any money received by the taxpayer, plus any gain (or minus any loss) recognized on the transaction. If the transaction falls under 1031(b) or (c), the basis shall be allocated between the properties received (other than money) and for purposes of allocation, there shall be assigned to such other property, an amount equivalent to its Fair Market Value at the date of the exchange.
1031(e) stipulates that livestock of different sexes do not qualify for like kind exchange.
1031(h)(1) stipulates that real property outside the United States and real property located in the United States are not of like kind.
The sale of the relinquished property and the acquisition of the replacement property do not have to be simultaneous. A non-simultaneous exchange is sometimes called a Starker Tax Deferred Exchange (named for an investor who challenged and won a case against the IRS). See Starker v. United States, 602 F.2d 1341, 79-2 U.S. Tax Cas. (CCH) paragr. 9541, 44 A.F.T.R.2d 79-5525 (9th Cir. 1979). For a non-simultaneous exchange, the taxpayer must use a Qualified Intermediary, follow guidelines of the Internal Revenue Service, and use the proceeds of the sale to buy more qualifying, like-kind, investment or business property. The replacement property must be “identified” within 45 days after the sale of the old property and the acquisition of the replacement property must be completed within 180 days of the sale of the old property.
Section 1031 is most often used in connection with sales of real property. Some exchanges of personal property can qualify under Section 1031. Exchanges of shares of corporate stock in different companies will not qualify. Also not qualifying are exchanges of partnership interests in different partnerships and exchanges of livestock of different sexes. However, as of 2002 IRS ruling (see Tenants in common 1031 exchange), Tenants in Common (TIC) exchanges are allowed. For real property exchanges under Section 1031, any property that is considered "real property" under the law of the state where the property is located will be considered "like-kind" so long as both the old and the new property are held by the owner for investment, or for active use in a trade or business, or for the production of income.
In order to obtain full benefit, the replacement property must be of equal or greater value, and all of the proceeds from the relinquished property must be used to acquire the replacement property. The taxpayer cannot receive the proceeds of the sale of the old property; doing so will disqualify the exchange for the portion of the sale proceeds that the taxpayer received. For this reason, exchanges (particularly non-simultaneous changes) are typically structured so that the taxpayer's interest in the relinquished property is assigned to a Qualified Intermediary prior to the close of the sale. In this way, the taxpayer does not have access to or control over the funds when the sale of the old property closes.
At the close of the relinquished property sale, the proceeds are sent by the closing agent (typically a title company, escrow company, or closing attorney) to the Qualified Intermediary, who holds the funds until such time as the transaction for the acquisition of the replacement property is ready to close. Then the proceeds from the sale of the relinquished property are deposited by the Qualified Intermediary to purchase the replacement property. After the acquisition of the replacement property closes, the Qualifying Intermediary delivers the property to the taxpayer, all without the taxpayer ever having "constructive receipt" of the funds.
The prevailing idea behind the 1031 Exchange is that since the taxpayer is merely exchanging one property for another property(ies) of “like-kind” there is nothing received by the taxpayer that can be used to pay taxes. In addition, the taxpayer has a continuity of investment by replacing the old property. All gain is still locked up in the exchanged property and so no gain or loss is "recognized" or claimed for income tax purposes.
Although it is not used in the Internal Revenue Code, the term “Boot” is commonly used in discussing the tax implications of a 1031 Exchange. Boot is an old English term meaning “Something given in addition to.” “Boot received” is the money or fair market value of “Other Property” received by the taxpayer in an exchange. Money includes all cash equivalents, debts, liabilities or mortgages of the taxpayer assumed by the other party, or liabilities to which the property exchanged by the taxpayer is subject. “Other Property” is property that is non-like-kind, such as personal property, a promissory note from the buyer, a promise to perform work on the property, a business, etc.
There are many ways for a taxpayer to receive “Boot”, even inadvertently. It is important for a taxpayer to understand what can result in boot if taxable income is to be avoided.
The most common sources of boot include the following:
- Cash boot taken from the exchange. This will usually be in the form of "Net cash received", or the difference between cash received from the sale of the relinquished property and cash paid to acquire the replacement property(ies). Net cash received can result when a taxpayer is "Trading down" in the exchange (i.e. the sale price of replacement property(ies) is less than that of the relinquished.)
- Debt reduction boot which occurs when a taxpayer’s debt on replacement property is less than the debt which was on the relinquished property. As is the case with cash boot, debt reduction boot can occur when a taxpayer is "Trading down" in the exchange.
- Sale proceeds being used to pay non-qualified expenses. For example, service costs at closing which are not closing expenses. If proceeds from the sale are used to service non-transaction costs at closing, the result is the same as if the taxpayer had received cash from the exchange, and then used the cash to pay these costs. Taxpayers are encouraged to bring cash to the closing of the sale of their property to pay for the following: Non-transaction costs: i.e. Rent prorations, Utility escrow charges, Tenant damage deposits transferred to the buyer, and any other charges unrelated to the closing.
- Excess borrowing to acquire replacement property. Borrowing more money than is necessary to close on replacement property will not result in the taxpayer receiving tax-free money from the closing. The funds from the loan will be the first to be applied toward the purchase. If the addition of exchange funds creates a surplus at the closing, all unused exchange funds will be returned to the Qualified Intermediary, presumably to be used to acquire more replacement property. Loan acquisition costs (origination fees and other fees related to acquiring the loan) with respect to the replacement property should be brought to the closing from the taxpayer’s personal funds. Taxpayers usually take the position that loan acquisition costs are being paid out of the proceeds of the loan. However, the IRS may take the position that these costs are being paid with Exchange Funds. This position is usually the position of the financing institution also. Unfortunately, at the present time there is no guidance from the IRS on this issue which is helpful.
- Non-like-kind property which is received from the exchange, in addition to like-kind property (real estate).
Exchangers are advised to follow the following guidelines:
1. Always to trade "across" or up, but never trade down in order to avoid receipt of boot, either as cash, debt reduction or both. The boot received can be off-set by qualified costs paid by the Exchanger.
2. Always to bring cash to the closing of the replacement property to cover loan fees or other charges which are not qualified costs. (See above)
3. Not to receive property which is not like-kind.
4. Not to over-finance the replacement property, since financing should be limited to the amount of money necessary to close on the replacement property in addition to exchange funds which will be brought to the replacement property closing.
The §1031 exchange begins on the earliest of the following:
- the date the deed records, or
- the date possession is transferred to the buyer,
and ends on the earlier of the following:
- 180 days after it begins, or
- the date the Exchanger's tax return is due, including extensions, for the taxable year in which the relinquished property is transferred.
The identification period is the first 45 days of the exchange period. The exchange period is a maximum of 180 days. If the Exchanger has multiple relinquished properties, the deadlines begin on the transfer date of the first property. These deadlines may not be extended for any reason.
A deadline that falls on any weekend day or holiday does not permit extension. For example, if your tax return is due April 15th, but that date falls on a Saturday, then your tax return due date is forwarded to the first business day following April 15th, or Monday, April 17th. However, if a deadline falls on a Sunday, the requirements for the exchange must be met no later than the last business day prior to the deadline date, i.e. the prior Friday.
Identified replacement property that is destroyed by fire, flood, hurricane, etc. after expiration of the 45 day Identification Period does not entitle the Exchanger to identify a new property. However, the exchange may be terminated by this event so long as it is (a) specified in writing (such as a contingency in the sales contract); (b) is outside the control of the exchangor or any party to the exchange; and (c) is the only or last property that the exchangor is entitled to purchase under the exchange rules.
Mistakenly identifying condominium A, when condominium B was intended, does not permit a change in identification after the 45 day Identification Period expires. Failure to comply with these deadlines may result in a failed exchange.
IRS rules control the length of time that the replacement property must be held before it may either be sold or used to enter into a new tax deferred exchange. In highly appreciating markets, people may take the opportunity of selling their personal residence (where no capital gain is due below $250,000 for a single person or $500,000 for a married couple) and moving into a former rental property for a specified time period in order to turn it into their new personal residence. With recent legislation, however, capital gains taxes on such a transaction are no longer completely avoided. The taxpayer will now owe a diminishing amount of capital gains taxes on the conversion of property from rental to personal residence once the final disposition of the property occurs.
In order to qualify for this exchange, certain rules must be followed:
- Both the relinquished property and the replacement property must be held either for investment or for productive use in a trade or business. A personal residence cannot be exchanged.
- The asset must be of like-kind. Real property must be exchanged for real property, although a broad definition of real estate applies and includes land, commercial property and residential property. Personal property must be exchanged for personal property. (There are some complicated rules surrounding this — for example, livestock of opposite sex are not considered like-kind property for the purpose of a 1031 exchange, and property outside the United States is not considered of "like-kind" with property in the United States.)
- The proceeds of the sale must be re-invested in a like kind asset within 180 days of the sale. Restrictions are imposed on the number of Replacement Properties which can be identified as potential Replacement Properties. More than one potential replacement property can be identified as long as you satisfy one of these rules:
- The Three-Property Rule - Up to three properties regardless of their market values. All identified properties are not required to be purchased to satisfy the exchange; only the amount needed to satisfy the value requirement.
- The 200% Rule - Any number of properties as long as the aggregate fair market value of all replacement properties does not exceed 200% of the aggregate Fair Market Value (FMV) of all of the relinquished properties as of the initial transfer date. All identified properties are not required to be purchased to satisfy the exchange; only the amount needed to satisfy the value requirement.
- The 95% Rule - Any number of replacement properties if the fair market value of the properties actually received by the end of the exchange period is at least 95% of the aggregate FMV of all the potential replacement properties identified. In other words, 95% (or all) of the properties identified must be purchased or the entire exchange is invalid.
Difficulties involved in meeting limits
Frequently, the most difficult component of a 1031 exchange is identifying a replacement property within the first 45 days following the sale of the relinquished property. The IRS is strict in not allowing extensions.
A 1031 exchange is similar to a traditional IRA or 401(k) retirement plan. When someone sells assets in tax-deferred retirement plans, the capital gains that would otherwise be taxable are deferred until the holder begins to cash out of the retirement plan. The same principle holds true for tax-deferred exchanges or real estate investments. As long as the money continues to be re-invested in other real estate, the capital gains taxes can be deferred. Unlike the aforementioned retirement accounts, rental income on real estate investments will continue to be taxed as net income is realized.
An alternative to a 1031 exchange for someone who wants to defer capital gains tax, but who does not want to continue to hold property is a structured sale. This method offers both buyer and seller many benefits and is regarded as an excellent possibility for those looking to retire from or exit from the real estate or business market. However, capital gains tax will be assessed as the payments are received by the seller, unlike a 1031 exchange, whereby the capital gains tax can be deferred indefinitely for the exchanging individual.
How a 1031 exchange is accomplished
The following sequence represents the order of steps in a typical 1031 exchange:
Step 1. Retain the services of tax counsel/CPA. Become advised by same.
Step 2. Sell the property, including the Cooperation Clause in the sales agreement. "Buyer is aware that the seller's intention is to complete a 1031 Exchange through this transaction and hereby agrees to cooperate with seller to accomplish same, at no additional cost or liability to buyer." Make sure your escrow officer/closing agent contacts the Qualified Intermediary to order the exchange documents.
Step 3. Enter into a 1031 exchange agreement with your Qualified Intermediary, in which the Qualified Intermediary is named as principal in the sale of your relinquished property and the subsequent purchase of your replacement property. The 1031 Exchange Agreement must meet with IRS Requirements, especially pertaining to the proceeds. Along with said agreement, an amendment to escrow is signed which so names the Qualified Intermediary as seller. Normally the deed is still prepared for recording from the taxpayer to the true buyer. This is called direct deeding. It is not necessary to have the replacement property identified at this time.
Step 4. The relinquished escrow closes, and the closing statement reflects that the Qualified Intermediary was the seller, and the proceeds go to your Qualified Intermediary. The funds should be placed in a separate, completely segregated money market account to insure liquidity and safety. The closing date of the relinquished property escrow is Day 0 of the exchange, and that’s when the exchange clock begins to tick. Written identification of the address of the replacement property must be sent within 45 days and the identified replacement property must be acquired by the taxpayer within 180 days.
Step 5. The taxpayer sends written identification of the address or legal description of the replacement property to the Qualified Intermediary, on or before Day 45 of the exchange. It must be signed by everyone who signed the exchange agreement, and it may be faxed, hand delivered, or mailed either to the Qualified Intermediary, the seller of the replacement property or his agent, or to a totally unrelated attorney. Send it via certified mail, return receipt requested. You will then have proof of receipt from a government agency.
Step 6. Taxpayer enters into an agreement to purchase replacement property, again including the Cooperation Clause. "Seller is aware that the buyer's intention is to complete a 1031 Exchange through this transaction and hereby agrees to cooperate with buyer to accomplish same, at no additional cost or liability to seller." An amendment is signed naming the Qualified Intermediary as buyer, but again the deeding is from the true seller to the taxpayer.
Step 7. When conditions are satisfied and escrow is prepared to close and certainly prior to the 180th day, per the 1031 Exchange Agreement, the Qualified Intermediary forwards the exchange funds and growth proceeds to escrow, and the closing statement reflects the Qualified Intermediary as the buyer. A final accounting is sent by the Qualified Intermediary to the taxpayer, showing the funds coming in from one escrow, and going out to the other, all without constructive receipt by the taxpayer.
Step 8. Taxpayer files form 8824 with the IRS when taxes are filed, and whatever similar document your particular state requires.
An alternative to the 1031 exchange
A Structured sale Annuity or "Ensured Installment Sale" is a capital gains tax deferral tool that enables the seller to gain benefits that other sales and capital gains deferral methods do not offer. It is a hybrid of the common installment sale and a structured annuity, and it enables the seller to collect a stream of payments, leverage equity, earn a pre-tax return, and other benefits. This method is a tool for those who want to do a 1031 exchange but cannot find a property within the time frame, and it allows the seller to have a backup plan. However, the capital gains taxes due on the property will still be due once each installment payment is made, thus causing the taxpayer to still pay the tax.
Examples of a 1031 exchange
An investor buys a strip mall (a commercial property) for $200,000 (his cost basis). After six years he could sell the property for $250,000. This would result in a gain of $50,000 on which the investor would have to pay 3 taxes typically- a federal capital gains tax, a state capital gains tax and a depreciation recapture tax based on the depreciation he or she has taken on the property since the investor purchased the property. If the investors invests the proceeds from the $250,000 sale into another property or properties (without touching the proceeds and using a Qualified Intermediary, then he would not have to pay any taxes on the gain at that time.
An owner of a detached house on 3 acres (12,000 m2) is transferred by his employer to another state. Rather than selling the home, which will no longer be his personal residence, he chooses to rent it out for a period of time. After ten years, he decides that he wants to sell it but, at the same time, he has a grown son who will be going to college in yet another state. He decides that he wants to buy an apartment building in the college town for the son and other students to rent while they are in school. His house has appreciated from $200,000 to $300,000. Therefore, he arranges for an IRC Section 1031 exchange, and buys the new property, thus avoiding the capital gain at that time.
Caution in the aforementioned example the investor would need to substantiate his or her [investment intent] to the IRS by showing an arm's length lease to the son and other students, and investor should declare income and take on offseting depreciation deduction.
In addition to the sale of real estate, selling an interest in real property may also qualify for a 1031 Exchange. An example of this would be the sale of an easement.
Warning: Like-Kind Exchange of Loss Property
While taxpayers generally prefer non-recognition for realized gains (so they do not have to recognize the gain currently and pay the resulting federal income tax currently), they usually prefer to recognize realized losses currently in order to obtain the tax benefit of the resulting deduction sooner. That means a like-kind exchange is bad news in the case of a realized loss. None of the loss will be recognized regardless of boot received.
Financial Aspects of 1031 Exchange Properties To Consider:
- Recourse versus non-recourse debt.
- Capital Structure: Is debt to equity ratio 50-50? Allocation of debt analysis when comparing existing proeprty's debt structure to new exchange property's debt structure.
- Is this a Class A property?
- Credit-worthiness of the tenant?
- Are the lease terms attractive to our investor?
- Exit Strategy? Is it 10 years or less, or open ended?
- Who is the property asset manager?
- what is the property asset manager's experience?
- Who the property manager?
- What is the property manager's experience?
- Passive versus active management
- Can we place our clients in a better net cash flow position on the new property than they were in the existing property?
- How are our clients impacted by a tenants-in-common or DST structure, since they are involved with other investors?
- Type of real estate asset class: Is it office, retail, industrial, apartment (mixed use)?
- What impact does the asset class have on the present and future economics of the deal?
- What is the asset manager's business plan for the property?
- Why was the property bought?
- What was the reason the seller sold the property?
- What are some of the long term potential growth aspects of the property not covered in the prospectus?
- What are the surrounding demographics of the location where the property is located, and how does this potentially affect the long term economics of the deal?