FAQ:

What is a Section 1031 exchange?  

A section 1031 exchange is essentially a tax deferred exchange. In a typical transaction which generates capital gains, tax is payable when the gain is realized. However, in an exchange tax can be deferred until a future date when the gain is realized.

The taxpayer sells the property and correspondingly purchases a like-kind property. The proceeds of the sale do not go the taxpayer directly. These proceeds are used to a purchase replacement property. When the replacement property is sold for cash, the original gain plus the additional gain realized since it was purchased is subject to tax.   

What is the theory behind a 1031 exchange?  

An exchange does not generate cash. To ask the taxpayer to pay tax on a gain in respect of which he or she has not received cash would be unfair as the gain is essentially a “paper gain” and generally the tax liability on capital gains can be large. The investment is the same, only the form changes. Tax liability arises when the replacement property is sold for cash.

What is a like-kind property?  

For the properties to qualify as like-kind properties in an exchange, they should be the same with respect to their nature. They need not necessarily be of the same quality nor is it necessary that they should be similar. For example land can be exchanged for a building as both are real properties.

Do properties used for personal purposes qualify for a 1031 exchange?

Properties used for personal purposes do not qualify. To qualify for a 1031 exchange, both the property transferred and the property received must be held either –

(a)    for productive use in trade or business.

(b)   for investment.  

Investment property can be exchanged for a business or trade property or vice versa.

Are there any assets to which section 1031 does not apply?

Yes. These assets are:

1)      Inventory held for sale

2)      Stocks, bonds, or notes

3)      Other securities or evidences of indebtedness or interest

4)      Interest in a partnership

5)      Certificate of trust or beneficial interests

6)      Choses in action.

What are the different types of exchanges?

·         Simultaneous exchange: In this type of exchange, both the relinquished and the replacement properties are exchanged at the same time.

·         Delayed exchange: In a delayed exchange, there is a time gap between the transfer of the relinquished property and the completion of acquisition of the replacement property. This is the most common form of exchange.

·         Reverse Exchange: In a reverse exchange, the replacement property is acquired before the relinquished property is transferred.

·         Improvement or Construction Exchange: This type of exchange permits the taxpayer to make improvements to the replacement property or to build on it. The exchange proceeds can be used for this purpose. The task of making improvements or building should be done by the intermediary as it is the intermediary who receives the exchange proceeds. However, the taxpayer can act a construction manager and make improvements or build on the replacement property. 

What are the time restrictions on delayed exchanges?

The 45-Day rule: The replacement property must be identified within 45 days from the date the relinquished property is sold. The taxpayer should be sent an identification notice to the intermediary clearly providing the details of the property.

The 180-Day rule: The exchange transaction should be completed within 180 days from the date the relinquished property is sold or on or before the due date for filing the return, whichever is earlier.

What are the time restrictions on reverse exchanges?

The 5 Day rule: The taxpayer must enter into an agreement with a qualified intermediary within five business days after the title to the replacement property is transferred to the qualified intermediary.

The 45 Day rule: The relinquished property should be identified within 45 days.

The 180 Day rule: The reverse exchange must be completed within 180 days from the date the title to the replacement property is transferred to the qualified intermediary.

Is there any limit to the number of properties that can be identified?

Yes. At least one of the following conditions must be met:

The 3-property rule: Any three properties can be identified regardless of their value.

The 200% rule: Any number properties can be identified provided the fair market value of the properties together does not exceed 200% of the fair market value of the relinquished property.

The 95% rule: Any number of properties can be purchased before the exchange period ends provided the aggregate fair market value of the properties is not less than 95% of the aggregate fair market value of the properties identified.

What happens to that part of the relinquished property proceeds that is not used for the purchase of the replacement property?

This portion of the proceeds is known as boot and is subject to capital gains tax.  To avoid boot the purchase value of the replacement property should be either equal to or exceed the sale proceeds of the relinquished property. Boot can be reduced by the amount of exchange expenses paid.  

Is it necessary to exchange a property with the same person for availing the benefits of Section 1031?

No. You can sell the property to one person and purchase another from an unrelated person. A third person comes into play in such a transaction. This person is the qualified intermediary (QI). The proceeds of the relinquished property are vested with the QI along with the title to the property. These proceeds are used to purchase the replacement property with the exchange being completed on transfer of the title to the taxpayer by the QI.

Does the qualified intermediary actually take title to the property?

In majority of the situations, the qualified intermediary does not take title to the property in the true sense. The regulations allow the property to be deeded by which the taxpayer assigns his or her rights to the property to the qualified intermediary.