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Section 1031 Tax-Deferred Exchanges
Tax-deferred exchanging is an investment strategy that should be considered by anyone who owns
investment real estate. Anyone involved with advising or counseling real estate investors,
including real estate agents, lawyers, accountants, financial planners, enrolled agents,
tax advisors, escrow and closing agents, and lenders, should know about tax-deferred exchanging.
What is a Tax-Deferred Exchange?
A tax-deferred exchange is simply a method by which a property owner trades one property for another
without having to pay any federal income taxes on the transaction. In an ordinary sale transaction,
the property owner is taxed on any gain realized by the sale of the property. But in an exchange,
the tax on the transaction is deferred until some time in the future, usually when the newly
acquired property is sold.
These exchanges are sometimes called "tax free exchanges," because the exchange transaction itself is not taxed.
Tax-deferred exchanges are authorized by Section 1031 of the Internal Revenue Code.
The requirements of Section 1031 and other sections must be carefully met, but when an exchange
is done properly, the tax on the transaction may be deferred.
In an exchange, a property owner simply disposes of one property and acquires another property.
The transaction must be structured in such a way that it is in fact an exchange of one property
for another, rather than the sale of one property and the purchase of another.
Today, a sale and a reinvestment in a replacement property are converted into an exchange by means of
an exchange agreement and the services of a qualified intermediary Ð a fourth party who helps to
ensure that the exchange is structured properly.
The IRS's new regulations make exchanging easy, inexpensive, and safe.
Misconceptions about Exchanging
People often fail to consider tax-deferred exchanging as an investment strategy because they are
misinformed about the requirements of exchanging. However, once their misconceptions have been
cleared up, property owners usually find that Section 1031 is worth considering. One common source
of confusion is that people often mistake exchanging for a rollover of a principal residence (under
Section 1034 I.R.C.). In both cases, the tax is deferred, but in the case of Section 1034, the taxpayer
must rollover, or replace, his or her principal residence by buying a new principal residence within 24
months of selling the old one. No exchange is required. On the other hand, Section 1031 requires that an
exchange take place. Both Section 1031 and Section 1034 are strategies available to taxpayers, but they
are used in different circumstances and have different requirements.
Here are a few other common misconceptions about Section 1031 exchanges:
Myth: Exchanges require two parties who want each other's properties.
Fact: Two-party exchanges are possible, but in reality, such two-party swaps rarely occur.
Today, an exchange is accomplished with the help of a qualified intermediary and usually involves
four principal parties: the exchangor (the taxpayer), a buyer for the relinquished property,
a seller of the replacement property, and the intermediary. The parties often do not know each
other, and their properties may even be located in different states.
Myth: The like-kind requirement limits an exchangor's options.
Fact: Property must be exchanged for "like-kind" property. But "like-kind" simply means that real
property must be exchanged for real property. All real property is like-kind, so a fee simple
interest may be exchanged for a tenancy-in-common interest; one property may be exchanged for more
than one property. A duplex may be exchanged for a fourplex; a single family residence may be
exchanged for a motel; vacant land may be exchanged for an office building, etc. However,
real property may not be exchanged for personal property.
Myth: In an exchange, title on the exchanged property must pass simultaneously.
Fact: The properties do not have to close at the same time. However, the replacement property
must close within 180 days after closing on the relinquished property. When the two transactions
do not close at the same time, the exchange is called a deferred exchange.
Advantages and Disadvantages of Exchanging
The primary advantage of a tax-deferred exchange is that the taxpayer may dispose of property without
incurring any immediate tax liability. This allows the taxpayer to keep the "earning power" of the
deferred tax dollars working for him or her in another investment. In effect, this money can be
considered an "interest free loan" from the IRS. And this "loan" can be increased through
subsequent exchanges. Moreover, this tax liability is forgiven upon the death of the taxpayer, which
means that the taxpayer's estate never has to repay the "loan." The heirs even get a stepped up
basis on such inherited property; that is, their basis is the fair market value of the inherited
property at the time of the taxpayer's death.
The taxpayer should also consider the disadvantages of a tax-deferred exchange.
These include the following:
(1) There will be a reduced basis in the replacement property, resulting from the carry-over
of the basis of the relinquished property. This means that more gain will be realized when
the property is sold than would have been the case if the property had been acquired through
a straight sale and purchase.
(2) There will be increased transactional costs for entering into and completing a tax-deferred
exchange. These costs include possible additional escrow fees, attorney's fees, accounting fees,
and the intermediary's fees where applicable.
(3) The taxpayer may not (without tax consequences) use any of the net proceeds from the
disposition of the property for anything except reinvestment in real property.
Before deciding whether or not to engage in an exchange, the taxpayer should carefully analyze all
of his or her options. A decision should NOT be based solely on the tax consequences of the transaction.
Rather, business considerations should play the dominant role in the decision. Business considerations
include, but are not limited to:
• the need or desire to consolidate (or diversify) investments;
• the need or desire to obtain greater appreciation on the real property;
• the need or desire to increase cash flow;
• the need or desire to relocate a business investment;
• the need or desire to transfer into (or out of) a high basis (or low basis) property;
• the need or desire to eliminate management problems.
Once all of the factors have been considered, a taxpayer may, or may not, decide to engage
in a tax-deferred exchange.
Impact of the Tax Reform Act of 1986
The Tax Reform Act of 1986 greatly increased the use of tax-deferred exchanges for real property
investments by doing several things. First, it eliminated the capital gains rate, so all income
was taxed at the same rate, regardless of whether it was capital gain, earned income, or unearned
income. By eliminating the more favorable capital gains rate, the Act caused taxpayers to search
for alternatives to simply selling their investment property and paying tax on the gain at their
applicable tax rate. The reestablishment of capital gains rates in 1990 at a maximum of 28% will
continue to make exchanges desirable.
Second, the 1986 Act eliminated both short-term depreciation schedules and the use of accelerated
depreciation. The new cost recovery periods of 27.5 years for residential rental property and 31.5
years for nonresidential property reduced the significance of depreciation in evaluating real property
investments. The availability of depreciation deductions to shelter other income have been severely restricted.
In short, the Tax Reform Act of 1986 has greatly enhanced the attractiveness of exchanging under Section 1031.
The Justification for Tax-Deferral
Allowing a taxpayer to defer the tax in an exchange transaction encourages prudent investments.
In an ordinary sale transaction, a person sells property for cash. He or she can use a portion of the cash
acquired in the transaction to pay tax on the gain. The net proceeds can then be reinvested in another
investment. But when someone exchanges real property for more real property, he or she does not receive
cash from the transaction. Therefore, the investor theoretically may have no cash available with which to pay a tax.
If taxes were assessed on an exchange, the investor would have to liquidate another investment to get the
cash needed to pay the tax, or exchange into a less valuable property and accept cash for the difference
and then use the cash to pay the tax. If the tax on a like-kind exchange was not deferred, exchanging
one property for another would necessarily result in unwise investment practices.
By deferring the tax due on an exchange, Congress has given taxpayers the ability to move from one
investment directly into another, without having to liquidate other investments, or settle for less
valuable property.
The Parties and Properties in an Exchange
There are four parties involved in a typical tax-deferred exchange: the Taxpayer,
the Seller, the Buyer, and the Intermediary.
• the Taxpayer (also called the Exchangor): the Taxpayer has property and would like to exchange it for new property.
• the Seller: the Seller is the person who owns the property that the Taxpayer wants to acquire in the exchange.
• the Buyer: the Buyer is the person with cash who wants to acquire the Taxpayer's property.
• the Intermediary: the Intermediary plays a role in almost all exchanges today. He or she neither begins nor ends the transaction with any property.
He or she buys and then resells the properties in return for a fee.
Notice that the party who will end up with the Taxpayer's relinquished property is NOT the same party who owned
the property that the Taxpayer will end up with. The typical exchange is NOT a swap whereby two individuals swap
properties with one another.
Notice also that there is only one Taxpayer/Exchangor. While there will be tax consequences to everyone involved in
the exchange, our concern is with the Taxpayer/Exchangor who will receive the benefits of Section 1031.
The properties involved in an exchange have special names, too:
• The Relinquished Property: the property originally owned by the Taxpayer and which the Taxpayer would
like to dispose of in the exchange.
• The Replacement Property: the new property, that is, the property that the Taxpayer would like to acquire in the exchange.
In order for an exchange to be completely tax-deferred, the replacement property must have a fair market value greater
than the relinquished property and all of the Taxpayer's equity or more must be used in acquiring replacement property.
This is known as trading up in value and up in equity, and it is essential for a totally tax-deferred exchange.
Here is an example of the parties and properties involve in a typical exchange:
Party Owns/Has Wants
Taxpayer (Tom) Tacoma Apartments Boston Apartments
Buyer (Bart) Cash Tacoma Apartments
Seller (Sally) Boston Apartments Cash
Intermediary (Irving) Nothing Nothing (except to buy and sell the properties for a fee)
Relinquished Property: Tacoma Apartments (FMV $500,000)
Replacement Property: Boston Apartments (FMV $750,000)
Tom owns an apartment complex in Tacoma worth $500,000.
He believes the Tacoma Apartments are no longer appreciating in value and accordingly wants to
dispose of them. However, he doesn't want to pay tax on the disposition of the Tacoma Apartments,
he wants to acquire a larger property Ð the Boston Apartments.
Sally owns the Boston Apartments, worth $750,000. She feels that the Boston Apartments are no
longer a good investment for her. She doesn't want any other real estate; instead, she wants
to sell the Boston Apartments for cash.
Bart has money. He would like to buy the Tacoma Apartments for cash.
Through the assistance of Irving, the Intermediary, each of the parties will end up with what he
or she wants. When the exchange is complete, Tom will own the Boston Apartments,
Bart will own the Tacoma Apartments, and Sally will have cash.
Specific Requirements for a Valid Exchange
In order for a transaction to qualify for tax-deferred treatment under Section 1031,
certain requirements must be met. We have already touched on some of those requirements briefly.
We will examine each of them in more depth now.
A. Qualified Property
In general, all property, both real and personal, can qualify for tax-deferred treatment.
However, some types of property are specifically disqualified, namely: stock in trade or other
property held primarily for sale; stocks, bonds, or notes; other securities or evidences of
indebtedness or interest; interests in a partnership; certificates of trust or beneficial interest;
and choses in action (i.e. interests in law suits).
In most instances, tax-deferred exchanges are conducted with real property.
B. The Purpose Requirement
Not every type of real property is eligible for tax-deferred treatment. Section 1031 says that
"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 like-kind which
is to be held either for productive use in a trade or business or for investment." That means that
to qualify for tax-deferred treatment, the taxpayer's property must be held for productive use in a
trade or business or for investment. And, in the exchange, the taxpayer must acquire property which
he or she intends to hold for productive use in a trade or business or for investment.
Any real property other than a principal residence or dealer property (property acquired for resale) qualifies.
C. The Like-Kind Requirement
Replacement property acquired in an exchange must be "like-kind" to the property being relinquished.
Like-kind means "similar in nature or character, notwithstanding differences in grade or quality."
All real property is like-kind, regardless of whether it is improved or unimproved and regardless of
the type of improvement or interest. Therefore, raw land may be exchanged for a duplex. A tenancy-in-common
interest may be exchanged for a fee simple interest. One property may be exchanged for more than one property.
Real property, however, is not like-kind to personal property.
A recently proposed amendment to Section 1031 would have required that replacement property be "similar or
related in service or use" to the property being relinquished in an exchange. This requirement would have
meant that an office building could only be exchanged for another office building, an apartment building for
another apartment building, raw land for raw land, and so forth. Inasmuch as this proposed amendment did not
pass, the definition of like-kind continues to be what it has been since 1921: all real property is like-kind.
Remember, though, that while real property can properly be exchanged for real property, the Purpose Requirement
discussed above still applies: that is, the property, no matter what kind or interest, must be held for productive
use in a trade or business or for investment.
D. The Holding Period
A currently unresolved issue is: How long must a taxpayer hold property in order for it to qualify for
tax-deferred treatment? The question applies both to the relinquished property and to the replacement property.
A proposed amendment to Section 1031 would have required that both the original property and the replacement
property be held for at least one year in order to qualify for tax-deferred treatment. Although that proposal
failed, the one-year period which has been a rough rule-of-thumb used by those dealing with exchanges will
continue to be used until a specific holding period is established by law or regulation.
The holding period is a fact or circumstance to be considered in determining whether the Purpose Requirement
has been met. For example, if a replacement property is acquired and then immediately sold, that might indicate
that the property was in fact acquired for resale and is therefore dealer property and consequently cannot qualify
for tax-deferred treatment.
E. The Exchange Requirement
Section 1031 specifically requires that an exchange take place. That means that one property must be exchanged
for another property, rather than sold for cash. The exchange is what distinguishes a Section 1031 tax-deferred
transaction from a sale and purchase.
Congress has had ample opportunity to eliminate the exchange requirement from Section 1031. If they intended for
a mere rollover to qualify under Section 1031, they most likely would have amended the Section at some time by
authorizing treatment as provided in Section 1034 for the replacement of a principal residence. They might have
done so when they adopted the 1984 Amendments.
Likewise, Congress could have eliminated the exchange requirement when it adopted the Tax Reform Act of 1986,
or again in 1989 when Section 1031 was amended to eliminate exchanges into or out of foreign properties, and to
restrict exchanges between related parties. But Congress did not do so. Today, deferred exchanges are accomplished
through intermediaries to ensure that they meet the exchange requirement of Section 1031.
F. Time Limits
The Tax Reform Act of 1984 imposed time restrictions of non-simultaneous (deferred) exchanges. For those
exchanges in which the taxpayer will acquire the replacement (or target) property after transfer of the relinquished
property, two time limits are established: The taxpayer is required to identify the target property within 45 days
after transfer of the relinquished property, AND the taxpayer must close on the replacement property before the
earlier of (a) 180 days after the transfer of the relinquished property, or (b) the due date of the taxpayer's
federal income tax return (including extensions) for the year in which the relinquished property is transferred.
The reason for these time limits is simply one of administrative convenience.
G. Alternative and Multiple Properties
Whether one property or more than one property is transferred by the taxpayer as part of one exchange, the number
of replacement properties that may be acquired is:
(1) Up to three properties, without regard to their fair market value. (The Three-Property Rule.)
(2) More than three properties, if the total fair market value of all these properties at the end of the 45-day
identification period does not exceed 200% of the total fair market value of all properties relinquished in the
exchange. (The 200% Rule).
If the taxpayer violates these rules, the penalty is severe; he or she is treated as if no property had been
identified. Any property actually received during the 45-day identification period, however, would still qualify
for tax-deferred treatment.
Glossary
To assist you in understanding the concepts being discussed in the text, we have presented a brief glossary of
the terms used in exchanging. This glossary is not intended to be an exhaustive discussion of these terms; it
is presented merely to provide nutshell definitions.
Adjusted Basis:
The basis of the property adjusted for any capital improvements or depreciation. To calculate the adjusted basis,
take the basis (the cost of the property) and add the cost of any capital improvements made to the property during
the taxpayer's ownership, and subtract any depreciation taken on the property during the same time period. Once the
adjusted basis is known, gain or loss can be computed on a transaction. See Basis.
Basis:
The starting point for determining gain or loss in any transaction. In general, basis is the cost of the taxpayer's
property.
Basis in the Replacement Property:
In an exchange, the deferral of the tax on the gain is accomplished by requiring the taxpayer to carry-over
(substitute) the basis of the relinquished property to the replacement property with appropriate adjustments
in the event additional consideration is paid. See Deferral.
Boot:
In an exchange of real property, any consideration received other than real property is "boot." The amount of gain recognized
is always limited to the gain realized or boot, whichever is the smaller amount. Therefore, for a transaction to result in no
recognized gain, the taxpayer must receive property with an equal or greater market value and debt than the property relinquished,
and receive no boot.
In exchanges, there are two types of boot: cash boot and mortgage boot. Cash boot is cash or anything else of
value received. Mortgage boot is any liabilities assumed or taken subject to in the exchange.
Buyer:
The person who wants to acquire the exchangor's property. In a three- or four-party exchange, the buyer usually
has cash.
Deferral:
The tax on an exchange transaction is not paid at the time of the transaction. Rather it is paid at the time
the replacement property is ultimately sold. Deferral is accomplished by substituting, or carrying over the basis
of the taxpayer's relinquished property to the replacement property making any necessary adjustments for additional
consideration paid.
Depreciation Recapture:
Exchanges of like-kind property ordinarily do not trigger any depreciation recapture (that is, deductions taken
in excess of straight-line depreciation under Section 1250 I.R.C.).
Where there is an exchange into a property of lower value, or where the exchange consists partly of cash and
property not of a like-kind, consideration must be given to the depreciation recapture provisions of Section 1250.
Exchangor:
Same as Taxpayer.
Gain:
The amount obtained for a property minus the property's adjusted basis. No matter what the adjusted basis of a
property is, there is no gain until the property is transferred. There are two types of gain: "realized gain" and
"recognized gain." Realized gain is the difference between the total consideration (cash and anything else of value)
received for a piece of property and the adjusted basis. Realized gain is not taxable until it is recognized.
Gain is usually, but not always, recognized in the year in which it is realized. If gain is not recognized in
the year it is realized, it is said to be deferred.
In an exchange under Section 1031, realized gain is recognized in part or in full to the extent that boot is received.
See Boot. Where only like-kind property is received, no gain is recognized at the time of the exchange.
Intermediary:
The party who facilitates a tax-deferred exchange by acquiring and selling property in an exchange. The intermediary
plays a role in almost all exchanges today. He or she neither begins nor ends the transaction with any property.
He or she buys and then resells the properties in return for a fee.
Relinquished Property:
The property that the taxpayer begins the exchange with. This is the property that he or she wishes to dispose of
in the exchange.
Replacement Property:
The property that the taxpayer ends the exchange with. This property, usually owned by the seller, is the property
that the taxpayer acquires in the exchange.
Seller:
In a three- or four-party exchange, the person who owns the property that the taxpayer wants to acquire in the exchange.
Taxpayer:
Also called the exchangor. The taxpayer has property and would like to exchange it for new property. While all parties in an
exchange are theoretically taxpayers, this term applies to the party who expects to receive tax-deferred treatment under
Section 1031.
Transaction Costs:
Any cash paid by way of commission or other expense in an exchange. Transaction costs are deducted in computing the
consideration received.
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