Whenever you sell business or investment property for a gain you typically have to pay tax on that gain. The IRS has created an exception to this rule known as the Section 1031 exchange. These exchanges are also referred to as like-kind exchanges, deferred exchanges, tax free exchanges, and Starker exchanges. If at the time you sell a piece of property for a gain you then reinvest the proceeds into a similar type of property, you can defer paying taxes on the gain. For individuals and families with highly appreciated real estate such as a farmland, Section 1031 can be a powerful tool.
Before we begin discussing who and what types of property qualify under Section 1031, a couple of definitions are in order. First there is the client, which is the person or entity trying to achieve the 1031 exchange. Next we have the relinquished property, which is the property the client owns but wants to get rid of. Finally we have the replacement property, which is the property the client wants to buy.
Property that Qualifies for 1031 Treatment
In order to qualify under Section 1031, both the relinquished property and the replacement property must be held either for productive use in a trade or business or for investment. The use is determined by how it is actually being used by the client, not by how other parties are using it or how it could be used. Mutual funds, stocks, bonds, inventory, personal property, partnership interests, and real property outside of the United States do not qualify for 1031 exchanges.
All real property is considered of like-kind. A vacant lot can be exchanged for a hotel, a commercial office building, or for an apartment building. Though all real property is of like-kind, the client’s principal residence does not qualify since it is not being held for productive use in a trade or business or for investment.
Livestock are eligible for 1031 exchanges but they must be of the same sex to be considered of like-kind. A bull may be exchanged for another bull but not for a cow.
Mechanics of a 1031 Exchange
There are two basic types of 1031 exchanges, simple and deferred. A simple exchange involves a buyer and a seller essentially trading property. As you can imagine this type of exchange is uncommon because the likelihood of a buyer and seller wanting each other’s property is slim. A deferred exchange involving a buyer, a seller, and an intermediary is much more common.
In a deferred exchange the client either sells before buying or buys before selling. In this scenario the key to completing the 1031 exchange properly is the intermediary. The intermediary is the one who either holds title to the replacement property purchased first or holds the cash from the relinquished property sold first until the other transaction in the exchange closes.
It is also important that all real estate contracts dealing with 1031 exchange property contain special language to ensure that the other parties are obligated to cooperate with the client in achieving the 1031 exchange.
Timing is Crucial
Finally there are timing requirements that must be followed. The client must identify suitable replacement property within 45 days of when the relinquished property is transferred. The client may identify up to 5 potential properties. The client must then close on the replacement property within the earlier of 180 days after the date the relinquished property is transferred, or the date in which the client’s income tax is due for the tax year in which the transfer took place. The transfer date is typically the closing date for the sale.
Section 1031 exchanges provide excellent opportunities to tax plan. In order to receive the benefits you must take care in mapping out the transaction and you must follow all the steps.