Section 1031 Tax Free Exchange
The primary tax tool available to RE investors for building wealth
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Section 1031 of the Internal Revenue Code has been in the U.S. tax law since 1921 when Congress determined that it was unfair to tax a farmer's seed corn, or the profits on trades of one property for another. Like Kind Exchange properties are therefore treated as one continuous property holding by the tax code.
Internal Revenue Code, Section 1031:
"No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of a like kind which is to be held either for productive use in a trade or business or for investment."
What is Like Kind?
There have been several attempts over the years to increase federal tax revenue by limiting investor’s use of 1031 exchanges.
Like-kind, tax-deferred exchanges under Section 1031 of the Tax Code remain untouched by the Taxpayer Relief Act of 1997. An earlier proposal by President Clinton sought to narrow the types of property eligible for the exchange to "like-use" properties; i.e., a rental property could be exchanged only with another rental property.
As before, real estate is real estate, meaning that all investment real estate is considered like-kind for purposes of Section 1031. As a result, the owner of a vacant investment property can consummate a tax-deferred exchange with the owner of an improved residential rental property.
A 1031 Tax Free Exchange is actually tax deferral, not a tax exemption To qualify for 100% tax deferral, the general rule is that the trade must be of equal or higher value in both market value and net equity. If the trader takes out any "unlike kind" property, usually personal property such as cash or net mortgage relief, that "boot" will be taxable even though the remainder of the trade is tax-deferred. Installment sale reporting is allowed on the taxable portion of a tax-deferred exchange.
There are many reasons to exchange rather than sell
Avoid income tax erosion of investment capital.
Avoid depreciation recapture and increase the depreciable basis by acquiring a larger depreciable building.
Minimize the need for new mortgage financing on a new property acquisition.
Dispose of an undesirable property that is difficult to sell and acquire one that will more desirable or easier to sell.
Acquire a property that better meets the owner's needs, such as one requiring less management time, greater cash flow or better prospects for appreciation.
Defer part of the capital gains tax by trading down to a smaller property, which better suits the owner's needs. An installment sale note can be used to spread the profit tax over many years.
Receive tax-free mortgage refinance cash to make other investments by refinancing either before or after (but not as part of) the tax-deferred exchange.
Build your wealth into a large estate without paying taxes on profits as you trade up.
Avoid capital gains taxes completely if the owner dies while owning the last property in the exchange chain. The property's equity will be included in the owner's estate for estate tax purposes.
Taking a tax loss
If there is a loss on the exchange of the 'like kind" property held for investment or use in a business or trade, that loss is not recognized because there is no tax to defer. A loss on the sale of a principal residence is never tax deductible.
When there is a loss on the disposal of an investment property, a sale or abandonment is often better than an exchange because the property owner can usually recognize it as an ordinary loss deduction, if the property was held for investment or use in a trade or business.
How to
There are many possible scenarios for constructing a successful 1031 exchange. Perhaps the simplest and easiest to explain could work as follows:
- Sell your $100,000 building for cash.
- The proceeds are held by an IRS authorized escrow agent, usually the trust department of a bank. The charge for the service will likely range from about $400 to a percentage of the proceeds.
- You will have 45 days from closing to find a new property to purchase, then 120 days to close on your new property.
If you had deprecated you old property to $50,000, your basis in the new property will be that same $50,000 plus any depreciable amount over $100,000 you pay for the new property.
How Much
Standard fees for a delayed exchange are about $350 for the relinquished property and $350 for the replacement, for a total of about $700.00. Interest is often split with the agent, depending upon the size of the transaction. Fees for improvement, reverse and personal property transactions are usually somewhat more and are customarily quoted depending upon the complexity of the transaction.
The rules
Some Help
Asset Preservation, Inc., is a leading national IRC 1031 "Qualified Intermediary". They claim to have facilitated over 45,000 tax deferred exchanges and say they provide a high level of experience, expertise and security.
Exchange Partners Inc.
Real Estate Exchange Services Online. REES makes exchanging easy and affordable. With one phone call, we provide intermediary and consulting services for 1031 tax deferred exchanges, including reverse and construction transactions.
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