Common 1031 exchange questions answered

Cattle Market & Farm Reports, Editorials
Feb 14, 2005
by WLJ
The past several years a growing portion of U.S. ranch transactions have been done utilizing Section 1031 language in the U.S. tax code. Several sources have indicated that nationally between 35-45 percent of ranch purchases have been done via Section 1031 Exchange rules, and several brokers and Realtors have indicated they think that trend could grow even more, perhaps above 50 percent over the next few years.
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 property owner trades one or more relinquished properties for one or more replacement properties of "like-kind," while deferring the payment of federal income taxes and some state taxes on the transaction.
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, the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.
The following are answers to some commonly asked questions that WLJ presented to a couple of property acquisition specialists with the IRS.
Q: What are the benefits of 1031 exchanges?
A: A Section 1031 exchange is one of the few techniques available to postpone or potentially eliminate taxes due on the sale of qualifying properties. By deferring the tax, there is more money available to invest in another property. It’s like receiving an interest-free loan from the federal government, in the amount that would have paid in taxes. Any gain from depreciation recapture is postponed. Finally, properties can be acquired and disposed of to reallocate an investor’s portfolio without paying taxes on any gain.
Q: What are the five types of exchanges allowed?
A: They are:
• Simultaneous Exchange: The exchange of the relinquished property for the replacement property occurs at the same time.
• Delayed Exchange: This is the most common type of exchange. A delayed exchange is when there is a time gap between the transfer of the Relinquished Property and the acquisition of the Replacement Property. It is subject to strict time limits set by the U.S. Department of the Treasury.
• Build-to-Suit Exchange: This technique allows the taxpayer to build on, or make improvements to, the replacement property, using the exchange proceeds.
• Reverse Exchange: When the replacement property is acquired prior to transferring the relinquished property. The IRS has offered a safe harbor for reverse exchanges, which became effective Sept. 15, 2000. These transactions are sometimes referred to as "parking arrangements" and may also be structured in ways that are outside the safe harbor.
• Personal Property Exchange: These are not limited to real property. Personal property can also be exchanged for other personal property of like-kind or like-class.
Q: What makes up a valid exchange?
A: First it must be said that certain types of property are specifically excluded from Section 1031. Among those exclusions are property held primarily for sale; inventories; stocks, bonds or notes; other securities or evidences of indebtedness; interests in a partnership; and certificates of trusts or beneficial interest. If property is not specifically excluded, it can qualify for tax-deferred treatment. Both relinquished and replacement property must be held for productive use in a trade or business or for investment. Taxpayers’ personal residences do not qualify. Replacement property acquired must be "like-kind" to the property being relinquished. In addition, relinquished property must be exchanged for other property, rather than sold for cash and using the proceeds to buy the replacement property.
Q: How can all taxable gain be deferred?
A: According to brokers, the value of the replacement property must be equal to or greater than the value of the relinquished property; equity in the replacement property must be equal to or greater than the equity in the relinquished property; debt on the replacement property must be equal to or greater than the debt on the relinquished property; and all of the net proceeds from the sale of the relinquished property must be used to acquire the replacement property.
Q: Can replacement property be converted to a primary residence or vacation home?
A: Yes, but the holding requirements of Section 1031 must be met prior to changing the primary use of the property. There are no specific regulations on holding periods. However, it’s recommended that taxpayers hold replacement property for a proper use for a period of at least a year.
Q: Are there time restrictions?
A: A taxpayer has 45 days after the date relinquished property is transferred to identify possible replacement properties. The exchange must be completed by the date that is 180 days after the transfer of the relinquished property, or the due date of the taxpayer's federal tax return for the year in which the relinquished property was transferred, whichever is earlier.
Q: What if replacement property isn’t identified within 45 days, or there is failure to close on replacement property before exchange deadline?
A: If taxpayers do not meet time restrictions, the exchange will fail and taxes arising from the sale of relinquished property have to be paid. There are no extensions available!
Q: What’s the limit on identified properties?
A: There are three rules that limit the number of properties that can be identified. Taxpayers must meet the requirements of at least one of these rules. The three-property rule limits buyers to three potential replacement properties without regard to their value. The 200 percent rule allows an unlimited number of properties to be identified but their total value cannot exceed twice the value of relinquished property. The 95 percent rule allows people to identify as many properties as desired, but must also acquire replacement properties with an aggregate fair market value equal to at least 95 percent of all the identified properties.
Q: Are 1031 exchanges limited to real estate?
A: No. Any property that is held for productive use in a trade or business, or for investment, may qualify for tax-deferred treatment under Section 1031. In fact, many exchanges are "multi-asset" exchanges, involving both real property and personal property. — WLJ