The Internal Revenue Code allows transfers of certain properties to defer the taxes that may be due because of the transfer if the property is exchanged for “like kind” property. The procedures and requirements are outlined in this article.
The Basic Law:
A tax-deferred exchange is simply a method by which a property owner trades property for other like-kind property and has the ability to defer any capital gain or loss which would be realized upon a sale. Section 1031 of the Internal Revenue Code allows up to one hundred percent deferral of the realized gain.
To qualify for Section 1031 of the Internal Revenue Code, the properties exchanged must be held for productive use in a trade or business or for investment. Stocks, bonds, and other properties are listed as expressly excluded by Section 1031 of the Internal Revenue Code. However, securitized properties are not excluded. The properties exchanged must be of the same nature or character.
It is important to note that the tax is deferred, not eliminated. Sooner or later some tax will have to be paid. The true value of the 1031 is that it allows the owner to utilize the tax money saved for years and that, in turn, allows income to be generated. That 2.275 million described above would earn over a hundred thousand dollars a year even if very conservatively invested. In effect, the government allows you to make that money from your tax deferral.
The actual laws is as follows: (Be sure to update the law and not rely on what is reproduced here.)
26 USC § 1031
Title 26 – INTERNAL REVENUE CODE
Chapter 1 – NORMAL TAXES AND SURTAXES
26 USC § 1031. Exchange of property held for productive use or investment
Subtitle A – Income Taxes
Subchapter O – Gain or Loss on Disposition of Property
PART III – COMMON NONTAXABLE EXCHANGES
(a) Nonrecognition of gain or loss from exchanges solely in kind (1) In general - No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment. (2) Exception - This subsection shall not apply to any exchange of -(A) stock in trade or other property held primarily for sale, (B) stocks, bonds, or notes, (C) other securities or evidences of indebtedness or interest, (D) interests in a partnership, (E) certificates of trust or beneficial interests, or (F) choses in action.For purposes of this section, an interest in a partnership which has in effect a valid election under section 761(a) to be excluded from the application of all of subchapter K shall be treated as an interest in each of the assets of such partnership and not as an interest in a partnership. (3) Requirement that property be identified and that exchange be completed not more than 180 days after transfer of exchanged propertyFor purposes of this subsection, any property received by the taxpayer shall be treated as property which is not like-kind property if - (A) such property is not identified as property to be received in the exchange on or before the day which is 45 days after the date on which the taxpayer transfers the property relinquished in the exchange, or (B) such property is received after the earlier of - (i) the day which is 180 days after the date on which the taxpayer transfers the property relinquished in the exchange, or (ii) the due date (determined with regard to extension) for the transferor’s return of the tax imposed by this chapter for the taxable year in which the transfer of the relinquished property occurs.
(b) Gain from exchanges not solely in kindIf an exchange would be within the provisions of subsection (a), of section 1035(a), of section 1036(a), or of section 1037(a), if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain, but also of other property or money, then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property.
(c) Loss from exchanges not solely in kind - If an exchange would be within the provisions of subsection (a), of section 1035(a), of section 1036(a), or of section 1037(a), if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain or loss, but also of other property or money, then no loss from the exchange shall be recognized.
(d) Basis - If property was acquired on an exchange described in this section, section 1035(a), section 1036(a), or section 1037(a), then the basis shall be the same as that of the property exchanged, decreased in the amount of any money received by the taxpayer and increased in the amount of gain or decreased in the amount of loss to the taxpayer that was recognized on such exchange. If the property so acquired consisted in part of the type of property permitted by this section, section 1035(a), section 1036(a), or section 1037(a), to be received without the recognition of gain or loss, and in part of other property, the basis provided in this subsection shall be allocated between the properties (other than money) received, and for the purpose of the allocation there shall be assigned to such other property an amount equivalent to its fair market value at the date of the exchange. For purposes of this section, section 1035(a), and section 1036(a), where as part of the consideration to the taxpayer another party to the exchange assumed (as determined under section 357(d)) a liability of the taxpayer, such assumption shall be considered as money received by the taxpayer on the exchange.
(e) Exchanges of livestock of different sexes - For purposes of this section, livestock of different sexes are not property of a like kind.
(f) Special rules for exchanges between related persons (1) In general If -(A) a taxpayer exchanges property with a related person, (B) there is nonrecognition of gain or loss to the taxpayer under this section with respect to the exchange of such property (determined without regard to this subsection), and (C) before the date 2 years after the date of the last transfer which was part of such exchange - (i) the related person disposes of such property, or (ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer,there shall be no nonrecognition of gain or loss under this section to the taxpayer with respect to such exchange; except that any gain or loss recognized by the taxpayer by reason of this subsection shall be taken into account as of the date on which the disposition referred to in subparagraph (C) occurs. (2) Certain dispositions not taken into accountFor purposes of paragraph (1)(C), there shall not be taken into account any disposition - (A) after the earlier of the death of the taxpayer or the death of the related person, (B) in a compulsory or involuntary conversion (within the meaning of section 1033) if the exchange occurred before the threat or imminence of such conversion, or (C) with respect to which it is established to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax. (3) Related personFor purposes of this subsection, the term “related person” means any person bearing a relationship to the taxpayer described in section 267(b) or 707(b)(1).(4) Treatment of certain transactionsThis section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection.
(g) Special rule where substantial diminution of risk (1) In generalIf paragraph (2) applies to any property for any period, the running of the period set forth in subsection (f)(1)(C) with respect to such property shall be suspended during such period.(2) Property to which subsection appliesThis paragraph shall apply to any property for any period during which the holder’s risk of loss with respect to the property is substantially diminished by -(A) the holding of a put with respect to such property,(B) the holding by another person of a right to acquire such property, or(C) a short sale or any other transaction.
(h) Special rules for foreign real and personal property For purposes of this section -(1) Real property - Real property located in the United States and real property located outside the United States are not property of a like kind. (2) Personal property (A) In general - Personal property used predominantly within the United States and personal property used predominantly outside the United States are not property of a like kind. (B) Predominant use - Except as provided in subparagraphs (C) and (D), the predominant use of any property shall be determined based on - (i) in the case of the property relinquished in the exchange, the 2-year period ending on the date of such relinquishment, and (ii) in the case of the property acquired in the exchange, the 2-year period beginning on the date of such acquisition. (C) Property held for less than 2 years - Except in the case of an exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection - (i) only the periods the property was held by the person relinquishing the property (or any related person) shall be taken into account under subparagraph (B)(i), and (ii) only the periods the property was held by the person acquiring the property (or any related person) shall be taken into account under subparagraph (B)(ii). (D) Special rule for certain property - Property described in any subparagraph of section 168(g)(4) shall be treated as used predominantly in the United States.
(Aug. 16, 1954, ch. 736, 68A Stat. 302; Pub. L. 85-866, title I, Sec. 44, Sept. 2, 1958, 72 Stat. 1641; Pub. L. 86-346, title II, Sec. 201(c)-(e), Sept. 22, 1959, 73 Stat. 624; Pub. L. 91-172, title II, Sec. 212(c)(1), Dec. 30, 1969, 83 Stat. 571; Pub. L. 98-369, div. A, title I, Sec. 77(a), July 18, 1984, 98 Stat. 595; Pub. L. 99-514, title XVIII, Sec. 1805(d), Oct. 22, 1986, 100 Stat. 2810; Pub. L. 101-239, title VII, Sec. 7601(a), Dec. 19, 1989, 103 Stat. 2370; Pub. L. 101-508, title XI, Secs. 11701(h), 11703(d)(1), Nov. 5, 1990, 104 Stat. 1388-508, 1388-517; Pub. L. 105-34, title X, Sec. 1052(a), Aug. 5, 1997, 111 Stat. 940; Pub. L. 106-36, title III, Sec. 3001(c)(2), June 25, 1999, 113 Stat. 183; Pub. L. 109-135, title IV, Sec. 412(pp), Dec. 21, 2005, 119 Stat. 2640.)
Amendments
P.L. 110-234
Session Laws
2008 Public Laws
SEC. 15342. ALLOWANCE OF SECTION 1031 TREATMENT FOR EXCHANGES INVOLVING CERTAIN MUTUAL DITCH, RESERVOIR, OR IRRIGATION COMPANY STOCK.
(a) In General.–Section 1031 {{NOTE:26 USC 1031.}} (relating to exchange of property held for productive use or investment) is amended by adding at the end the following new subsection: “(i) Special Rules for Mutual Ditch, Reservoir, or Irrigation Company Stock.–For purposes of subsection (a)(2)(B), the term `stocks’ shall not include shares in a mutual ditch, reservoir, or irrigation company if at the time of the exchange– “(1) the mutual ditch, reservoir, or irrigation company is an organization described in section 501(c)(12)(A) (determined without regard to the percentage of its income that is collected from its members for the purpose of meeting losses and expenses), and “(2) the shares in such company have been recognized by the highest court of the State in which such company was organized or by applicable State statute as constituting or representing real property or an interest in real property.”.
(b) {{NOTE: 26 USC 1031 note.}} Effective Date.–The amendment made by this section shall apply to exchanges completed after the date of the enactment of this Act.
NOTE THE LAW IS SUBJECT TO REVENUE RULINGS AND CHANGES AND SHOULD BE UPDATED BEFORE RELYING UPON IT.
The Usual Questions:
What is a tax-deferred property exchange?
A tax-deferred exchange is simply a method by which a property owner trades property for other like-kind property and has the ability to defer any capital gain or loss which would be realized upon a sale. Section 1031 of the Internal Revenue Code allows up to 100 percent deferral of the realized gain.
What types of properties are eligible for tax-deferred exchanges?
In general, tax-deferred exchanges are structured either as a real property or a personal property exchange. Real property exchanges include single-family rental property, apartments, office buildings, commercial and industrial properties, and undeveloped land. Personal property exchanges encompass virtually all other types of property that are held for use in a trade or business or for investment.
To be eligible for the favorable tax treatment afforded by an exchange, the property or business asset to be exchanged must be of “like-kind”, to the property received. “Like-kind” is defined under Section 1031 as property that has been held by the client for productive use in a trade or business, or for investment purposes
To determine if your property qualifies as “like-kind” under §1031, ask yourself the following question: Has the property been used in a trade or business or held for investment?
If your answer is yes, you may proceed to answer the next qualifying question: What is/are the intention(s) of the party(ies) going forward? To be eligible, the property received must also be used for business, trade or investment purposes.
Who should consider a tax-deferred property exchange?
The primary advantage is the ability to dispose of property and defer the capital gain that would otherwise result from a sale. This capital gain can then be reinvested for the benefit of the taxpayer, which will generate a greater return versus the amount available net of the tax liability.
Tax-deferred property exchanges can be a very useful strategy in estate planning. They can also be employed to expand business operations or to maximize capital.
There are a number of issues that should be considered when approaching an exchange. The first step for anyone considering a tax-deferred exchange is to consult a knowledgeable tax advisor. Only your tax advisor has access to all of the factors that influence your tax planning strategy. The state of the real estate market, your own personal tax rate and the likelihood that capital gains rates may increase in the relatively near future, the expense and trouble of arranging the exchange, all these are factors to be considered before opting for the 1031 exchange.
Your tax advisor can determine the anticipated capital gain from the sale of your property and then determine whether there are capital losses available to offset any potential gain, or whether capital losses can be created by the liquidation of other capital assets.
How does it work?
Each 1031 tax and property situation is unique. Some exchanges can be fairly simple while some, involving numerous parties, the existence of trusts or probate, etc. can become complex, based on all the factors involved. In general however, most exchange are structured using the “Safe Harbor Regulations” enacted by the Department of the Treasury in 1991. The Safe Harbor Regulations created a framework for transacting exchanges that added clarity and predictability to the process.
The basic requirements that must be met in order to qualify the exchange are:
- Intent – there must be intent to conduct an exchange.
- Like-kind – both the property exchanged and received must be of like kind to each other.
- Timeliness – the exchange must be completed within the statutory period of 180 days or the due date for the taxpayer’s return, whichever comes first.
In most cases, an exchange is accomplished with the help of a qualified intermediary who specialize in facilitating the process. While such an intermediary will have the necessary forms and methodology, the wise property owner also has their own CPA and attorney intimately involved in the transaction.
The monetary consequences of failure to achieve the 1031 can be substantial, creating unnecessary and potentially devastating results.
Conclusion:
1031 exchanges are among the most useful tax deferral tools available to business and those fortunate enough to have capital gains to defer. The complexity of utilizing them and meeting the requirements is well worth it in many situations as illustrated in the above examples. Along with interest deductions and depreciations, it constitutes one of the vital tax advantages available to owning income property and should be considered as a possible alternative whenever liquidation of real property is at issue.