The 1031 Exchange — Sell Business Property Now, Pay Tax Later
Section 1031 of the U.S. Tax Code permits a seller of commercial properties to defer the capital gains obligation if it identifies a replacement property within 45 days of closing the sale. The seller must then close on its new purchase within 180 days of the first closing.
In a typical transaction, the property owner is taxed on any gain realized from the sale. However, through a Section 1031 Exchange, the tax on the gain is deferred until some future date. Section 1031 of the Internal Revenue Code provides 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. A tax-deferred exchange is a method by which a business owner who has outgrown a company-owned building, for example, can defer the tax liability as long as the proceeds are used to buy another building of equal or greater value within a specified period of time.
The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer’s investment is still the same, only the form has changed. Therefore, it would be unfair to force the taxpayer to pay tax on a “paper” gain.
The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.
Key factors to consider for a 1031 Exchange.
1. Investment Intent
Both the Relinquished Property and the Replacement Property must be held for investment or productive use in a trade or business. Personal residences do not qualify. Although there is no specific holding period to establish investment intent, taxpayers who hold their Relinquished Property for two years generally satisfy the requisite intent for a 1031 Exchange. A holding period of over a year has commonly been accepted but may be subject to review by the IRS.
Replacement Property(ies) must be identified within 45 days of the sale of the Relinquished Property and must be purchased within 180 days of the sale of the Relinquished Property.
3. Rules of Identification
The Three Property Rule. The taxpayer may identify up to three properties without regard to their value; or The 200% Rule. The taxpayer may identify more then three properties, provided their combined fair market value does not exceed 200% of value of the property sold; or The 95% Rule. The taxpayer may identify any number of properties, without regard to their value, provided the Exchanger acquires 95% of the fair market value of those properties.
4. Equal or Greater
The taxpayer must buy Replacement Property(ies) of equal or greater value to the property sold in order to defer the applicable capital gains tax, or pay tax on the difference. The taxpayer must use all the cash proceeds from the sale of the purchase in order to completely defer the applicable capital gains tax, or be taxed on the funds withheld.
5. Common Ownership
The party selling the Relinquished Property must be the same party purchasing the Replacement Property or a disregarded entity with respect to the party (such as an LLC or a trust, where a single taxpayer holds 100% of the beneficial interests in that entity). Spouses can be added or removed in community property states.
6. Like Kind
The Replacement Property must be “Like Kind” to the Relinquished Property. Any type of real property is like kind to other real property. Personal Residence. Taxpayers can exchange business or investment property, but not their personal residence(s). Vacation Homes. Vacation Homes treated as a personal residence are generally not eligible for 1031 treatment. Investment property listed on Schedule E is generally eligible for 1031 treatment. Condo Conversion. Recent rulings point to the acceptance of exchanging units on a condo conversion, provided the property was held for investments for a sufficient period of time before the taxpayer even contemplated the conversion. Contract Exchanges. Recent rulings point to the acceptance of exchanging contracts, provided all other 1031 requirements, such as holding period and investment intent, are met. Contracts to purchase Real Estate may be exchange for another contract or other existing real property.
7. Qualified Intermediary
To qualify for sale harbor tax deferral, sale proceeds must be held by a Qualified Intermediary between the sale of the Relinquished Property and the purchase of the Replacement Property. A Qualified Intermediary must remain completely independent and cannot have been the taxpayer’s agent in the past 2 years. A CPA, attorney, or other agent cannot act as a Qualified Intermediary for their clients. More information can be found on the FEA website.