At my open house this past weekend, a couple came through who were going through what’s known as a “1031 exchange.” In a nutshell, a 1031 exchange is a swap of one business, property or other investment asset for another. Each party can then change the form of their investment without cashing out. They can also defer their capital gains taxes, so long as the other property, or properties, is held as an investment. “1031” derives from Section 1031 of the Internal Revenue Code, which deals with this matter.
We got into a nice discussion about 1031 exchanges at the open house. Others who came weren’t very familiar with them, so I thought I would share more information with you, as provided by Leonard Spoto from the Asset Exchange Company.
Spoto clarifies that the taxpayer who sells relinquished property must be the same taxpayer who buys replacement property. This usually means that the vesting is the same for both the relinquished and the replacement properties. For example, John Doe’s name is on title to both properties involved in the 1031 exchange. However, there may be times when the party involved in the 1031 would like to make a change in how the replacement property is held. For example, John Doe is on title to the relinquished property, but would like to take title to the replacement property in an LLC.
This is only allowable if the LLC is treated as a pass through entity, disregarded for tax purposes. The tax ID for the LLC will be the taxpayer’s social security number, and there will be no need to file a separate return for the LLC. This not only works for an LLC, but also for a revocable living trust, since living trusts are also pass through entities for tax purposes.
The rule of thumb regarding a 1031 exchange is to maintain the same taxpayer. The taxpayer who sells relinquished property needs to be the same taxpayer who buys replacement property, regardless of the vesting. Strict adherence to the legal requirements of Section 1031 of the Internal Revenue Code is required for a successful exchange. Investors should be aware of four basic requirements when entering into a delayed exchange, and should seek the advice of a tax accountant or attorney to ensure proper adherence to the tax code. The four basic requirements for a successful exchange are:
1. Property Qualifications
The internal revenue code states that the properties involved in an exchange must be held for productive use in trade or business or for investment, and they must be “like-kind.”
The IRS provides a maximum of 180 days to complete an exchange. The timeline begins upon the close of escrow (COE) of the relinquished property. The new property (or properties) must be acquired on or before midnight of the 180th day. No exceptions! In addition, the IRS requires that all potential replacement properties be identified by midnight of the 45th day of the exchange.
Identification of all potential replacement properties is required on day 45 of the exchange. Identification must be in writing, and the description of the properties must be unambiguous. The IRS provides two rules for identifying replacement property:
The 3 Property Rule – The 3 Property Rule allows for identification of any three properties, of any price, anywhere in the United States.
The 200% Rule – The 200% Rule is an option for identifying more than three properties. With the 200% Rule, four or more properties can be identified. However, the combined value of all properties identified cannot exceed 200% of the property sold.
4. Tax Deferral
To defer 100% of the capital gains tax liability, two requirements must be met:
a. Reinvest all the cash. All the cash that was generated from the sale of the relinquished property must be reinvested into the new property or properties.
b. Exchange for a property that is of equal or greater value. The new property (or properties) must be equal or greater in value to the property sold.
If you would like more information about 1031 exchanges, please contact me directly.
America Foy is a top-producing agent with Sotheby’s International Realty at 2 Tunnel Road in Berkeley, 510-473-7775. Follow him on Twitter @americafoy, and for questions or suggestions on topics to discuss, e-mail him at firstname.lastname@example.org