1031 Exchange Definition
1031 exchanges are IRS-sanctioned processes involving the exchange of like-kind property with no immediate tax liability to the exchanger (the owner of the property being exchanged). These types of exchanges are used primarily for real estate operations but some assets, either depreciable or non-depreciable, could be eligible for an exchange as well. The IRS necessitates the presence of a neutral third party to facilitate the exchange. This third party is commonly referred to as accommodator, qualified intermediary or facilitator.
Advantage of a 1031 Exchange
If you own a business or some property, then a 1031 exchange could prove to be a powerful investment tool. Property, which are transferred or sold for gain can be taxed and those taxes can accumulate quickly. As the property seller, you may be accountable for taxes that tote up to 40% or more. On the other hand, in a 1031 exchange, the exchanger can keep all the equity of the property for re-investment. This allows the exchanger to get a replacement property with less management, a better location, and better flow of cash.
What Can Qualify?
Like-kind is the description of the property’s nature. Only like-kind property can be exchanged. Like-kind property widely refers to any real property located in the United States and in some of its terrains. Property, which is used for investment or business purposes, may also be considered like-kind property. In contrast, personal property is not like-kind to real property. Personal property therefore, can only be exchanged with another personal property deemed eligible.
What Cannot Qualify?
In 1986, the IRC 1031 was amended to exclude certain properties from being exchanged. One of these is property held primarily for sale such as property sold right away after completion of improvements or after acquisition, business inventory such as cars for a car dealership, and developed lots. Also excluded are personal residences. However, the portion of a personal residence utilized for business or investment use may be eligible. Example of this is a home office. Other exclusions are stocks, bonds, notes, partnership interests, and other verifications of indebtedness.
What are the Cornerstones of a 1031 Exchange?
1. When a property is transferred, it must not be a sale. It must be an exchange, which means that the exchanger relinquishes a property but must receive replacement property in return.
2. The property being exchanged must be of like-kind, meaning, they must be of similar classes of property. Like-kind describes the nature and character of the property.
3. For an exchange to be completely deferred from tax, the napkin test, which is basically comparing the values of the relinquished and replacement property, must be satisfied.
4. The party renouncing the relinquished must receive the replacement property.
Timeline Requirements
Yes. The exchanger has exactly 45 days gauged from the date when the relinquished property would close, to propose the potential replacement properties and 180 days to obtain the replacement property. Note that the exchange must be completed within 180 days, not 45 + 180 days.
What are the Rules for Identification?
The exchanger must provide in writing a clear description of the potential replacement property prior to midnight of the 45th day, gauged from the day the relinquished property closed. A legal description of the replacement property would suffice. Apart from that, a submitted purchase contract is also considered enough identification. Moreover, property purchased and close within the 45 days can also qualify as identification.
Are There Exceptions?
It has been mentioned earlier that personal residences are excluded from being exchanged. However, vacation homes and other second homes may be eligible for 1031 exchanges depending on certain conditions defined by the Internal Revenue Service on February of 2008.