1031 Exchanges: Tax Deferrals with Commercial Property
The sale or exchange of business or investment property normally generates a taxable gain or loss – but under certain conditions, a taxpayer can delay the reporting of gain. A 1031 exchange refers to one such instance – an exchange of property held for either investment or for productive use in a trade or business for property of like kind. One of the most common situations involving like-kind exchanges is the exchange of real estate held for business or investment.
The like-kind exchange tax rules are governed by Section 1031 of the Internal Revenue Code (hence the reference to 1031 exchanges). These rules derive largely from a “continuity of investment” theory; that current taxation is improper because the taxpayer’s capital is still tied up in the same basic kind of investment, which might also mean that the taxpayer may not have enough liquid assets to pay a tax anyway.
Such 1031 tax deferrals are clearly valuable; one investment property may be traded for another and the underlying investment amount could conceivably continue to grow, tax-deferred, for many years. This deferral of income tax liabilities can be of great help as an investor considers how to reposition or rebalance his portfolio.
The popularity of 1031 exchange programs has increased recently. Many persons who might be ready to sell long-held investment property may have a very low tax basis in the property. Moreover, this basis may have been reduced even further by many years of depreciation deductions. In cases like these, those who would like to sell would normally be faced with significant federal and state income taxes due upon such a sale.
A properly structured 1031 exchange can solve the income tax problem by providing tax deferral for those taxpayers who want to sell their low-basis investment property but do not want to pay punitive federal and state income taxes. However, to qualify for this Section 1031 tax deferral, taxpayers must make a new real estate investment. This “replacement property” can take the form of another “whole” replacement property or a fractionalized property, such as a tenant-in-common (TIC) form of ownership or an interest in a Delaware Statutory Trust.
In order to qualify for 1031 tax deferral, the following primary conditions must be met:
- The property being exchanged, and the new property being received, must be held for rental, investment, or be used in a trade or business;
- The property must be exchanged rather than sold;
- The property received must be of like kind to the property transferred;
- The exchange does not have to be simultaneous, but the replacement property must be identified within 45 days, and actually received within 180 days (or sooner, if that year’s tax return is coming due), after the transfer of the relinquished property
There are many finer points to the 1031 exchange, however. One rules is that a person cannot have access to, or control over, the funds while the exchange is in process, so the taxpayer may identify a qualified intermediary with whom the funds are entrusted in order to avoid this problem.
Taxpayers may identify more than one property for replacement, but they must meet one of three important 1031 criteria:
- The 3-property rule allows a taxpayer to specify up to three potential replacement properties
- The 200% rule allows a taxpayer to specify more than three properties so long as their aggregate value is not more than 200% of the relinquished property
- The 95% rule allows a taxpayer to specify any number of properties so long as he acquires properties before the end of the exchange period with a total fair market value equal to 95% or more of the replacement properties identified.
A 1031 exchange provides taxpayers the opportunity to defer taxes due upon the transfer of a property, and as such these transactions are valuable wealth-building tools. The rules are flexible and demanding at the same time; taxpayers can identify several possible replacement properties and can exchange for properties of greater value, but deadlines and other rules are strictly enforced. A 1031 exchange can be an important tool for tax deferral, but taxpayers must be armed with some background knowledge and the help of a skilled accommodator or other intermediary.
Realty Mogul as an institution does not advise on any personal income tax requirements or issues. Use of any information from this article is for general information only and does not represent personal tax advice either express or implied. Readers are encouraged to seek professional tax advice for personal income tax questions and assistance.