A 1031 Exchange- What Is It? Updated for 2016
IRC Section 1031 is a 1031 exchange that is properly structured in order to permit an investor to sell a particular property; in turn, they may also turn around and re-invest any profits made from said sale into a new property and all capital gain
taxes may be deferred. This is stated within the confines of IRC Section 1031 (a)(1), which clearly states:
"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."
A 1031 exchange offers significant protection for any investor; please note how such protection can work for those who possess a thorough understanding of it in the examples below:
- An investor has a tax liability of approximately $140,000 in the wake of a $400,000 capital gain ; this liability is made up of combined taxes such as federal and state capital gain taxes as well as depreciation recapture, procured at the time of the sale. As a result, the investor will only have $260,000 left to use for reinvestment in a new property.
- The Seller would only be able to buy a new property for $1,040,000 if they had placed a 25 percent down payment and a 75 percent loan-to-value ratio.
- Taking identical down payment and loan-to-value ratios into consideration, the same investor could instead chose to exchange and, as a result, have the ability to purchase $1,600,000 in real estate by reinvesting the total $400,000 in equity.
This example illustrates strong return on the investment, as well as impressive portfolio expansion; in addition, it protects an investor or investors from capital gain taxes. However, to make the most of these benefits, an extensive knowledge of the exchange process and the IRC is a must. An investor’s primary resource to procure solid and vitally useful is found in Asset Preservation, and to achieve that one must have a complete understanding of any terminology used in the real estate field.
Rules and Requirements for 1031 Exchange
Rules and requirements for the main 1031 exchange are comprised of:
- The taxpayer who is the seller of the property must also be the same taxpayer who buys the property.
- Within 45 calendar days after the closing on the first property, property identification must be made.
- The replacement property must be bought within 180 calendar days.
- The taxpayer must be certain that previous property has a value that is equal to or lesser than the replacement property.
- Intent to hold for investment must be supported by adequate hold time.
- Transaction regulations must be adhered to by all participating individuals.
1. Same Taxpayer: The name of the person who buys the property must be one in the same in regards to the names on the individual tax returns and titles of the property. A single member limited liability company (SMLLC), which can be utilized as a go-between, can be used to sell the property and allow the seller to purchase it using their actual name.
2. Property Identification: The individual who is exchanging has 45 calendar days after closing on the property to note the location of the new property or its accommodator ; in contrast, the individual who is exchanging has 45 calendar days to produce a comprehensive documentation of any properties either bought or up for sale.
o Three Property Rule: Any three properties can be identified, despite the final value
o Two Hundred Percent Rule: Four or greater properties can be identified provided the value of said properties does not rise above 200 percent of any property sold
o 95-Percent Exception Rule: 95 percent of anything that has been identified has to be bought, provided the value rises above 200 percent
3. Replacement: The property in question must be bought within 180 calendar days of either the closing of the initial property od the extension of the tax return of the individual exchanging the property.
4. Trading Up: In order to defer 100 percent of the tax on a sale, both the equity and net market value of the property being sold must be equal to or greater than the replacement property. If this is not the case, tax must be paid on the part of the Exchangor. In addition, the equity and debt of the relinquished property must be equal to or greater than the equity and debt in regards to the relinquished property; while debt can be offset by additional equity, additional equity does not offset debt.
5. Hold Time: The concept of hold time does not exist in the 1031 code; however, the Internal Revenue Service (IRS) will attempt to ascertain if the property in question was acquired immediately prior to the exchange, and if said property was bought in order to upgrade and sell for a profit or held by means of productive use or as an investment in order to increase its value. The amount of time between acquisition and sale can be a determining factor to the IRS; if the property is held for a significant duration, the intent can be established as to the intent of its use. The IRS may also look into other factors, such as the possible rental of the property or its potential use as a second home by the owner, as established by the itemization of said property Schedule E or Schedule A; investment properties are listed on Schedule E.
6. Related Party: Terms such as “Related person” or “related party” refers to any individual, group, or entity that is related to or has any sort of relationship with the taxpayer as outlined in Section 267(b) or Section 707(b)(1) of the Internal Revenue Code ("IRC"), such as:
o Any and all members of the same family, including siblings, spouse, ancestors, and lineal descendants;
o A corporation where one individual owns over 50 percent of the value of the stock;
o Two (2) corporations that are in the same controlled group (as defined in subsection (f));
o A grantor and a fiduciary of any trust;
o A fiduciary of one trust and the fiduciary and/or beneficiary of another trust where the same person is the grantor for both trusts;
o A fiduciary of a trust and a beneficiary of the same trust;
o Corporation where more than 50 percent of the value of the stock is owned directly or indirectly by or for one particular trust or by or for the grantor or fiduciary of the trust;
o An organization qualified under Section 501 of the Internal Revenue Code (relating to certain educational or charitable non-profit organizations) which is controlled directly or indirectly by a specific person or (if such person is an individual) by members of the family of such individual;
o A corporation and a partnership if the same person or persons own:
§ more than 50 percent in value of the outstanding stock of the corporation, and
§ more than 50 percent of the capital interest, or the profits interest, in the partnership;
o An S corporation and another S corporation or a C corporation if the same person or persons own more than 50 percent in value of the outstanding stock of each corporation;
o A partnership and a person owning, directly or indirectly, more than a 50-percent capital interest or a 50-percent profits interest, in such partnership;
o Two partnerships in which the same person or persons own, directly or indirectly, more than a 50-percent capital interest or a 50-percent profits interest, in both partnerships;
o An executor of an estate and the beneficiaries of the estate.
Trusts do not have the same grantor per Private Letter Ruling 9224008; therefore, an inter vivos generation skipping trust created by a wife, or a testamentary trust created by a husband are unrelated. However, the ownership of the related party may be changed by transferring or eliminating interests in a partnership or shares in a corporation to an unrelated third-party to get the related party's ownership interest below the 50-percent level; this will have the effect of negating any related party transaction issues. Constructive ownership rules under the Internal Revenue Code Section 267(c) does seem to apply when ascertaining profits interest, capital interest, and deciding ownership of stock.
Related Party Transactions
1031 Exchange transactions as pertaining to related parties take place when a relinquished property is sold to a related party, or a like-kind replacement property is purchased from a related party. The Internal Revenue Service allows related party 1031 Exchanges provided the involved parties adhere to their set guidelines and rules on doing so.
Any property must be held for two years if it is to be sold to a related party; otherwise, the tax monies deferred by the 1031 Exchange will be due at the time of the sale. If a related party is utilizing a 1031 Exchange, replacement property may be purchased from them as well.
Examples of related party relationships include but are not limited to: immediate family members, such as brothers, sisters, spouses, ancestors and lineal descendants. If the related parties share any such relationship and said relationship no longer exists prior to the sale of the property in question, related party issues can also be avoided altogether.
In addition, a related party could be considered as any corporation in which a taxpayer owns over 50 percent of stock, membership/partner interests or over 50 percent of profit/capital interests.
Please note that certain relationships do not fall under the “related party” umbrella as it pertains to a 1031 Exchange; these relationships include stepparents, uncles, aunts, in-laws, cousins, nephews, nieces and ex-spouses.
Lineal Descendant pertains to any generational parent/child relationship, up to and including a direct lineal relationship beginning with a person and leading down through their children, grand children, great-grand children, and onwards.
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Disclaimer: 1031 exchange made simple does not guarantee the performance of the QI's in our referral network and we can not be held liable for any misrepresentations or mistakes in regards to a 1031 exchange by one of the QI's that we refer to you. 1031 Exchange made simple does not provide tax advice nor can we make representations regarding the tax consequences of an exchange transaction. 1031 Exchange made simple is a 1031 QI Referral Network. 1031 made simple is not responsible (in any way) for the performance, creditability, and financial condition of any QI in our network. In this new economic environment it is imperative that all potential 1031 exchange customers do their own due diligence and research on any QI that they may use, on a 1031 exchange. Please verify and check the validity of the Bonding and Insurance of your QI. It may be wise to have your 1031 exchange accounts set up as separate, individual customer accounts. Our web site is to be used as a information based web site only. All parties doing a 1031 exchange must consult their tax advisors or attorney for this information.
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