Tax Deferred Exchanges
Normally, during the sale of property, the owner is taxed on recognized gains from the sale of their property. However, the Internal Revenue Code, Section 1031, authorizes exchanges of property that allows the tax to be deferred until a future time. This is called a tax deferred exchange, or 1031 exchange because of its IRC section number. In these exchanges, the property owner purchases a new property, of equal or greater value to completely defer taxes, with the funds from the sale of the initial property. While it is not a requirement for the replacement property to be of equal or greater value, any amount from the sale of the initial property not invested in the replacement property will be taxed.
Arranging and orchestrating an exchange can become complicated and a lot to manage. Generally, four parties will be involved with the exchange: the taxpayer who is exchanging one property for another; the buyer for the property the taxpayer is selling (relinquished property); the seller of the property the taxpayer wishes to acquire (replacement property); and a Qualified Intermediary (QI) that handles the exchange of funds. In the standard deferred exchange, the taxpayer transfer the relinquished property title to the buyer, who pays cash to the QI. The QI then pays the seller and the seller transfers the title to the property to the taxpayer.
The exchange of properties does not have to occur on a 1:1 basis. When identifying an exchange property or properties, up to three properties can be identified or more than three with the value not to exceed 200% of the total fair market value of the combined properties to be relinquished.
In order to qualify for a tax deferred exchange, certain conditions and requirements must be met:
- Generally, most tax deferred exchanges and are for real estate, and a tenancy in common may qualify.
- Both properties in the exchange must be used for commercial or investment purpose and not for primary residence or simple resale. Vacations homes and rental properties can qualify under specific conditions.
- The replacement property must be of “like-kind” to the relinquished one. All types of real properties are considered “like-kind”, but it cannot be “like-kind” to personal property.
- If the exchange is not happening simultaneously, the person exchanging properties must identify the replacement property on or before midnight on the 45th day after the relinquished property was transferred. Then, the replacement property must be acquired on or before 180 days OR the due date of their federal tax return for the year, whichever is sooner.
In the event that a replacement property needs to close prior to the sale of the relinquished property, a Reverse Exchange can be done. A fifth party is needed for this type of exchange, an Exchange Accommodation Titleholder (EAT) that holds the relinquished property until the buy closes on it. EATs can also be used to construct improvements on properties as part of the tax deferment.
Regardless of the type of exchange, IRC 1031 exchanges can be confusing and complicated. In the event an IRC 1031 exchange is not done properly, it can lead to tax liabilities. We have years of experience helping clients identify these opportunities and managing the process to be legal and profitable. Often, we can serve as your trusted Qualified Intermediate to make the process cost effective and simple for you. Call attorney David J. Franks today at 563-362-3288 ext. 1 today to start planning.