Guide to 1031 Exchanges
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Basic Requirements for 1031
If you are considering a Section 1031 Exchange or just want to find out more about how an exchange works, this is a good place to start learning. By no means is this information complete and in all cases you will want to consult with a professional tax adviser before you start an exchange.
Section 1031 of the IRC code has many provisions that must be followed to execute a successful exchange. The following topics represent a subset of those provisions. We present them here to create a starting point in understanding the basic requirements of successfully executing a 1031 exchange and to present possible problems that could delay or disqualify an otherwise acceptable exchange scenario. As always, seek council early with your accountant and/or tax advisers.
Qualifying Property
The property that you are giving up (the “Relinquished Property”) must be used in your trade/business or held for investment, and not for personal use.
The property which you plan to acquire (the “Replacement Property”) must also be used in your trade/business or held for investment, and not acquired for personal use.
The Relinquished Property and the Replacement Property must not be inventory, or other property which is held primarily for resale in the ordinary course of business (“dealer property”).
Tax Deferral
In order for the exchange to be 100% tax-deferred, the purchase price of the Replacement Property must equal or exceed the selling price of the Relinquished Property, and you must not receive cash at the closing of the Relinquished Property. Any cash or other “unlike-kind” property received in the exchange is named “boot” and may result in a taxable gain. “Old” debt must be replaced with “new” debt or “new” cash. Boot received may not be fully taxable if the amount of boot received is less than the gain realized on the transaction or if some law otherwise exempts the gain from taxation.
Seller Financing
While possible in some cases for a minimal period of time, seller financing makes the transaction more complicated and in many cases impossible.
Sale Proceeds
The sales proceeds of the Relinquished Property must not be actually or constructively received by you before the purchase of the Replacement Property. The Intermediary must hold these funds to avoid “constructive receipt” issues.
Real Property vs. Personal Property
Furniture, equipment, some livestock and other personal property transferred with the Relinquished Property or the Replacement Property is not “like kind” to real property, and will be treated as boot unless your Replacement Property also includes “like kind” furniture, equipment, or other personal property. If it is treated as boot, then you must pay tax on its value.
Name Changes and Intent to Hold
Title to the Replacement Property must be taken by the identical owner of the Relinquished Property. For example, if John Smith sells Relinquished Property in the exchange, then John Smith must take title to the Replacement Property, rather than his partnership, corporation, trust, or his son/daughter. The replacement property should be acquired with the intent to hold. A disposition within a year or two after receipt may call into question the intent to hold.
Tax and Legal Advice
The Texas 1031 Exchange Company serves as the Intermediary in the exchange, and does not practice accounting or law. You must rely on the advice and counsel of your tax adviser and/or attorney for this exchange transaction.
Identifying and Purchasing Replacement Property
You must write a letter which identifies all of the potential replacement properties to The Texas 1031 Exchange Company or a suitable party to the transaction within 45 days following the transfer of the Relinquished Property.
Purchase of the Replacement Property must be completed within 180 days following the transfer of the Relinquished Property. The law allows few extensions (disaster or combat zone service). Any property acquired as Replacement Property needs to be included in the 45 day identification letter discussed above.
If you identify Replacement Property within the 45 – day identification period and then purchase some but not all of the property that you have identified without restrictions, then you must not withdraw any remaining funds from your exchange account until the 180-day exchange period is completed. Inappropriate withdrawal from the exchange account destroys the transaction. Thus, to be safe, the funds must not be withdrawn until the expiration of the replacement period or until all eligible properties have been purchased.
Improvement to Replacement Property
Repairs or improvements made to the Replacement Property after you receive title do not count as part of the cost of the Replacement Property for exchange purposes. If extensive repairs or improvements are necessary, and if you need the cost reflected as the Replacement Property, then the Replacement Property must be initially deeded to the Qualified Exchange Accommodation Title Holder until the repairs are completed. To be included in the exchange improvements must have been completed by the 180th day of the exchange. Prepaid materials or labor costs do not qualify. There are additional fees when improvements are made as part of the exchange.
Like-Kind Property
In regard to real property, “like-kind property” is defined as land and anything which is permanently attached to the land. For example, a ranch can be exchanged for a motel, office building, or shopping center. The fair market value of the furniture in the office building you receive is not “like-kind”, but rather is considered “boot” received. You will pay tax on the fair market value of the furniture received unless you also do a separate Personal Property exchange by purchasing “like-kind” furniture.
IRS Reporting Deadline
You must report a tax-deferred exchange to the Internal Revenue Service using IRS Form 8824 (Like-Kind Exchanges), with your Federal income tax return for the tax year in which you sell the Relinquished Property. You must acquire your Replacement Property before you file this income tax return. Therefore, if you have not acquired your Replacement Property by the filing date for that tax year (March 15 or April 15 for calendar year taxpayers), then you must apply for an extension to file for the tax year in which you sold the Relinquished Property.
Related Party Exchanges
In most cases you cannot purchase Replacement Property from a “related party” (family member or controlled corporation, partnership, or trust) as that term is defined by the Internal Revenue Code. Please contact us or your tax adviser for more information if this term applies to your transaction.
The above information is not tax or legal advice but presented for your information and consideration. Please consult your tax or legal adviser for questions related to completing your 1031 exchange.
[/vc_column][/vc_row][vc_row no_margin=”true” padding_top=”0px” padding_bottom=”20px” border=”none”][vc_column width=”1/1″]Q&A – Terms and Timeline
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Farm and Ranch Exchange
Section 1031 allows investors to defer capital gains on the sale of a qualified property if it is exchanged for like-kind property. In general, there are very flexible IRS rules to accomplish the 1031 exchange.
The typical exchange occurs for many reasons. It can be a wealth building strategy by deferring taxes or defeating taxes. It is a huge benefit for those re-locating operations. Also significant is its use in diversification, estate planning and generational transitions. Step-up in basis rules make your tax deferral under § 1031 permanent.
Many ranch exchanges are multiple asset exchanges consisting of both real property and personal property. Allocation of cost between the different asset types becomes critical. The property may also include a principal residence which could fall under the § 121 exclusion rules. Maximizing this benefit is an-other key element in a good ranch transaction.
Real property exchanges have more flexibility in determining what is like-kind. Examples that are interchangeable include: land, buildings, commercial, residential, conservation easements, perpetual water rights, perpetual easements, mineral rights, long term leases, royalty interests, pipeline easements.
Personal property exchanges are hugely beneficial whenever largely depreciated assets such as equipment, livestock, wildlife or vehicles are including as part of a ranch sale or in conjunction with a sale. Even if a ranching or farming operation is discontinued, a strategy of buying replacement equipment for a leasing business is a great opportunity.
Livestock and wildlife are personal property. Consequently, like-kind requirements are much stricter. Only breeding stock qualifies. Steers and stocker and feeder calves are considered inventory and do not qualify. Males are like-kind only to other males of the species, etc. Replacement identification and timing can become challenging. In drought areas, consider other deferral options under drought relief and livestock sales – Notice 2006-82. (See National Drought Mitigation Center)
Agriculture exchanges could include irrigation equipment (is a fixed pivot real property or personal property?), cattle feeders, farm and ranch tools, and live-stock handling equipment. A complex classification system requires close planning with your accountant to determine like-kind categories. Use NAICS classifications as a guide. The sale of equipment with high cash value but low or zero cost basis creates opportunity for tax deferral. It may be advisable to create a bill of sale for personal property rather than include them in a real estate contract. The allocation of values could create tension between parties.
Reverse exchanges allow flexible purchase strategies but by nature are more complex and expensive. If cash is not available, financing of replacement property requires knowledgeable lenders. Possible operational issues include farm program payments and eligibility, and limitations on use of entities. Closing deadline is still 180 days. Non-safe harbor reverse exchanges (longer than 180 days) are possible but require considerable planning, exposes parties to in-creased risk, and performed by only a very few exchange accommodators.
Interplay of Section 1031 with Section 1033 exchanges. Section 1033(g) uses a “similar in use” standard to qualify replacement property. This requires unimproved land be replaced with unimproved land, the transition to improved property is not similar-in-use. To use the “like-kind” standards for real property, one must substitute 1031 rules for 1033 rules, thus the taxpayer is limited to a 180 replacement period rather than the “up to” 3 year period under 1033.
[/vc_column][/vc_row][vc_row no_margin=”true” padding_top=”0px” padding_bottom=”20px” border=”none”][vc_column width=”1/1″]Livestock and Wildlife Exchanges
Livestock and wildlife are considered “personal property” as opposed to “real property” and as such fall under much more restrictive like-kind rules than real estate exchanges. Consequently, personal property cannot be exchanged with real property.
To qualify for 1031 exchange treatment, cattle or other livestock/wildlife must be held with the intent to be used for breeding.
Only same-sex livestock or wildlife are “like–kind”. One can only exchange a male or males for other males or males and likewise breeding cows or does for other breeding females.
Cattle raised “primarily for sale” in the ordinary course of business and other stocker or feeder cattle are inventory and thus do not qualify under the exchange rules. By extension, it is presumed wildlife held and managed to be harvested, do not qualify. This likely would include bulls and heifers raised for sale even if they are breeding animals.
Herd sires or replacement females raised with the intention of using for breeding will likely qualify.
Breeding stock purchased with the intention of holding for breeding but later sold will likely qualify. The regulations do not impose a specific holding period for either the relinquished animals or replacements. The key issue is the “intent to hold” at the time of placement into the herd or time of purchase.
It is likely that a commercial beef cow is like-kind to a registered beef cow. A beef animal is probably not like-kind to a dairy animal because they are entirely different types of livestock.
As in all IRC 1031 Exchanges, the replacement property must be identified within 45 days of closing on the relinquished property. In the case of livestock, the exchanger may be best served by actually purchasing the replacement cattle before the end of the 45 day identification period. The IRC rules do not specifically state how the replacement livestock are to be identified so that all ambiguities are eliminated. If the livestock cannot be purchased before the end of the 45 days, the identification should presumably be as specific as possible. One scenario may be to identify the herd of origin and specific animals in that herd. Under the 200% rule, the total value of the identified livestock could not be more than twice the value of the livestock sold.
This information is not to be taken as legal or tax advice. Please consult your tax advisor before engaging in a 1031 exchange in order to effectively construct an effective plan. Texas 1031 is always available to you as a resource for you and your tax and real estate professionals.
[/vc_column][/vc_row][vc_row no_margin=”true” padding_top=”0px” padding_bottom=”20px” border=”none”][vc_column width=”1/1″]Real Property vs. Personal Property
Generally speaking, real property for most people means real estate, as you might have guessed. For the purposes of Section 1031 exchanges, real property can mean land, buildings, perpetual easements, conservation easements, water rights, oil and gas interests and even pipelines. That doesn’t mean that they automatically qualify for 1031 treatment however. For instance, property owned for personal use or held “primarily for sale” is excluded in I.R.C. § 1031(a)(2). Section 1031(a)(1) requires that the relinquished property (property to be sold) and the replacement property be held for productive use or in a business or trade or for investment. The effect of 1031(a)(1) is that property that is purchased to rehab and/or “flip” is disqualified for 1031 treatment. This would include property held as inventory by developers and even those as a “work in progress”. Consult with your tax advisor about the status of your property if questionable.
Real property that is owned by a partnership or corporation is generally exchangeable but the interest in a partnership, limited liability company, REIT, or stock is not. The nature of this ownership makes is extremely important to execute long term planning if it is likely the ownership will break up with some owners executing exchanges and others cashing out their interest. The longer the planning period the more likely a successful low risk exchange can be implemented.
It appears that under Rev. Rul. 92-105, 1992-2 C.B. 204, interest in a land trust (only in some states) will be considered interest in the real property. A beneficial interest in a Delaware statutory trust (DST) may be considered an interest in the real property held by the DST.
Personal property like airplane, heavy equipment, farm equipment, vehicles, computers, truck and trailers, office and motel furniture and equipment are common personal property items and may qualify for non-recognition treatment (eligible for 1031 exchange). Other personal property exchanges permitted include breeding livestock, gold coins, gold bullion, major league sports contracts, permits, environmental credits and investment collectibles.
Personal property is divided into two categories under like-kind regulations. These two are (1) depreciable intangible personal property and (2) intangible personal property and nondepreciable personal property. Determining if two properties are like-kind is more narrowly defined. This may be determined by General Asset Class, Product Class, nature or character of the rights involved and nature or character of underlying properties. In some cases there is little guidance in the Regulations. Obviously, the guidance of a qualified tax advisor is highly recommended.
This article is for informational purposes only and does not constitute tax, legal or accounting advice. You are advised to seek appropriate professional advice regarding your facts and circumstances.
[/vc_column][/vc_row][vc_row no_margin=”true” padding_top=”0px” padding_bottom=”20px” border=”none”][vc_column width=”1/1″]Advanced Exchanges
In this context, “Advanced Exchanges” are merely those that go beyond the typical, sell first and buy second, scenario. The fact of the matter is there are many ways to accomplish a 1031 exchange even if at first it isn’t evident. The following list briefly describes a few of the many types of exchanges. Click on the links to go to a more detailed description or follow the original menu choices under “Advanced Exchanges”.
Reverse Exchanges: These are implemented by purchasing the replacement property first and selling the relinquished property within 180 days. These are more complicated and more costly to execute but can be cost effective in many ways.
Construction Exchange: These are usually implemented when the cost of the replacement property is less than value of relinquished sale. The cost of improvements can be rolled into the exchange to increase overall value if structured correctly.
Reverse + Construction: Improvements may be constructed on the property purchased as the replacement just as in the construction exchanges but the premium exchange fee typically covers both the reverse and construction aspects of the exchange.
Combination Forward + Reverse: A boon to those who may be selling and/or buying multiple properties with unequal values.
Personal Property Exchanges involving equipment, livestock, wildlife, collectibles and other investment items. Although not difficult to execute, they often require more planning and a better understanding of the complex personal property like-kind rules.
These are just the major types of exchanges and combinations. Please consult with your tax advisor before making any decision to implement one of these exchanges. The Texas 1031 Exchange Company does not offer tax or legal advice.
[/vc_column][/vc_row][vc_row no_margin=”true” padding_top=”0px” padding_bottom=”20px” border=”none”][vc_column width=”1/1″]Documentation
The Texas 1031 Exchange Company provides the documentation necessary for executing a typical Section 1031 exchange. In some unique cases, the exchanger may need to have his attorney prepare some instruments prior to closing. In all cases, the documentation must be in place before the relinquished (currently owned) property is closed or in the case of a reverse exchange, before the replacement property is purchased. These exchange documents are executed at closing but they will also provide pre-closing guidance to the closing agent. The documents also provide wiring instructions and bank escrow information. Without properly constructed and executed documents, the exchange could be disallowed.
Documentation for forward exchanges can be prepared with relatively little lead-time. We suggest that the title company be made aware of an exchange as soon as possible even if the contract states that potential. (See: Forward Exchange Check List). We can and will do last minute exchange preparation but this is usually not the best approach for either the exchanger or the closing agents.
A reverse exchange and a combination reverse/construction exchange could take weeks of preparation to execute, depending upon source of funds for purchase of the replacement property. See: Reverse Exchange Check List
An exchange involving a partnership split up or dissolution will usually require your attorney’s and accountant’s preparatory work. Ideally, executing a dissolution prior to any intent to sell offers the least risk for a successful exchange.
The above information may not be complete and should only be considered a general guide to the mechanics of completing a 1031 exchange transaction. Please consult with your tax advisor/attorney for all tax and legal advice.
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Livestock and Wildlife Exchanges
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Does My Property Qualify
This are is certainly one in which the “devil is in the details. Whether or not a property qualifies depends upon the facts of each transaction. For best results, always plan ahead and consult with a knowledgeable attorney, CPA, or knowledgeable tax adviser.
Qualifying Property
Real Property: If held as an investment or used in a business or trade, real property will generally qualify regardless of type. This includes farm and ranch land, rent houses, apartment buildings, vacation houses primarily held for rental, vacant land, perpetual easements, perpetual water rights (most states), long term leases (>30 years), mineral rights, and oil & gas interests. This is not a complete list. Real properties that do not qualify are those purchased for personal use (residence or vacation) and property purchased for resale.
Personal Property: The most common personal property exchanges include auto fleets, construction and agriculture equipment, computers, office furniture. Less common items are collectables such as art, gold and silver, livestock, wildlife and collectable autos. While real property is like kind to almost all other real property, “like-kind” rules for personal property are much more restricted. For instance, a sedan is not like kind to a pickup truck, gold bullion is not like kind to gold coins, and a bull is not like kind to a cow!
In both cases, property located outside the United States is not like-kind to property located within the United States.
How long do I have to own the property before it qualifies?
This answer can be simple or complex depending upon the situation. Other than related party exchanges, there are generally no defined holding periods for property. At the time of purchase, the intent must be to hold the property as an investment or use in a business. It is assumed that as long as credible intent to hold was demonstrated, an unsolicited offer does not preclude the owner from selling the property as part of a 1031 exchange even if the time lapse was relatively short. Obviously, the longer the property is held and as long as business or investment use is demonstrated, the more secure the exchange should be.
How do I qualify a second dwelling or vacation home?
This is that exception to the “general” holding period rule, at least under Safe-Harbor guidelines. Under IRC 2008-16, the service created a set of guidelines that when followed, allowed the taxpayer to exchange minimal use second dwellings even if the taxpayer personally used the property periodically. These guidelines are fairly restrictive as to personal use in the previous two 12 month periods before sale or the two 12 month periods following purchase. In short, the taxpayer or related parties cannot use the property for more than 14 days per 12 month period or 10% of the total rental days, whichever is greater. The taxpayer is also allowed maintenance days.
In addition, the taxpayer must have rented the property to unrelated parties for at least 14 days of each twelve month period. For vacation properties that have fallen into disuse, advanced planning can foster a good exchange and create opportunities for reinvestment otherwise lost.
[/vc_column][/vc_row][vc_row no_margin=”true” padding_top=”0px” padding_bottom=”20px” border=”none”][vc_column width=”1/1″]Understanding Basis and Gain
A 1031 Exchange does not require you to replace the full value of the relinquished property, but you cannot do so without tax liability on the portion you did not replace, whether this be debt, depreciation recapture or equity. The intrinsic value of a 1031 exchange is directly related to the amount of deferred gain, thus potential tax, that is offset in the exchange with the purchase of a replacement property. View additional information.
Home Sale Tax Exclusion
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Understanding the impact of Depreciation…
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