1031 Exchange FAQs
What is Internal Revenue Code Section 1031?
Since 1921, Federal tax law under Internal Revenue Code (IRC) section 1031 has permitted a taxpayer to exchange business-use or investment assets for other like-kind business use or investment assets without recognizing taxable gain on the sale of the old assets. The taxes, which otherwise would have been due from the sale, are thus deferred. Most 1031 Exchanges involve separate buyers and sellers and are not simple swaps between two parties. Under these circumstances, the use of an independent third party Qualified Intermediary (QI) is necessary to satisfy the “exchange” requirement. The QI holds the sale proceeds for the benefit of the taxpayer during the exchange, disbursing funds for purchase of like-kind replacement property, and returning any unused funds to the taxpayer at the end of the exchange. 1031 Exchanges must be completed within 180 days. Taxpayers recognize gain and pay tax on any unused funds or when they ultimately “cash out” of their property. In 2018, section 1031 was amended to provide that only real estate is eligible for a 1031 Exchange.
What are 1031 Like-Kind Exchanges?
Like Kind Exchanges, also known as tax-deferred exchanges, are defined by IRC section 1031. Since 1921, section 1031 has permitted a taxpayer to exchange business-use or investment assets for other like-kind business use or investment assets without recognizing taxable gain on the sale of the old assets. The taxes which otherwise would have been due from the sale are thus deferred. Section 1031 transactions range from 2-party “swaps” to more complex non-simultaneous 1031 Exchanges involving separate buyers and sellers. Qualifying assets include commercial, agricultural and rental real estate. Tax rules for non-simultaneous exchanges require the use of an independent third party Qualified Intermediary (QI). The QI holds the sale proceeds for the benefit of the taxpayer during the exchange, disbursing funds for purchase of like-kind replacement property, and returning any unused funds to the taxpayer at the end of the exchange. Section 1031 Exchanges must be completed within 180 days. Taxpayers recognize gain and pay tax on any unused funds or when they ultimately “cash out” of their property.
Who uses 1031 Exchanges?
All businesses, manufacturers, real estate investors, companies in the construction, trucking, rail, marine and equipment leasing industries, farmers, ranchers, individuals and more make good use of like-kind exchanges. 1031 Like-Kind Exchanges are one of the few incentives available to and used by taxpayers of all sizes. A recent industry survey showed that 60% of exchanges involve properties worth less than $1 million, and more than a third are worth less than $500,000. Qualified Intermediaries (QI) facilitate non-simultaneous tax-deferred exchanges of investment and business use properties for taxpayers of all sizes, from individuals of modest means to high net worth taxpayers and from small businesses to large entities.
What are the benefits of 1031 Like-Kind Exchanges?
Following a like-kind exchange, the owner of business use or investment real estate (“investor”) has more capital to acquire replacement real estate. This may result in increasing cash flow and/or increasing appreciation potential of the asset. In addition, the economy benefits because the investor cannot receive full tax deferral without fully reinvesting into the replacement property. The transactions generate taxable income in the form of title and escrow fees, real estate commissions, legal fees, and accounting fees as well as the purchase of goods and services if the replacement property is being improved. Local and state governments also benefit from fees and taxes which are generated by the real estate transactions. Since real estate located in foreign countries are not like-kind to real estate in the United States, section 1031 promotes reinvestment and job growth within our US borders.
Does the tax ever go away?
- upon sale of the replacement asset;
- incrementally, through increased income tax due to foregone depreciation; or
- by inclusion in a decedent’s taxable estate, at which time the value of the replacement asset could be subject to estate tax at a rate more than double the capital gains tax rate.
What are the tax policies upon which 1031 Exchanges are based?
- Section 1031 is consistent with goals of efficiency, neutrality, fairness, and simplicity within the tax system.
- Section 1031 promotes business decisions that stimulate US job creation and growth of the US economy.
- Section 1031 promotes efficient use of productive capital and operating cash flow.
- Section 1031 exchanges facilitated by Qualified Intermediaries are neither abusive nor administratively difficult for either the IRS or taxpayers.
- Section 1031 benefits and is widely used by a broad spectrum of taxpayers at all levels, in all lines of business, including individuals, partnerships, limited liability companies, and corporations
Having nothing at all to do with footwear, “Boot” is a term that refers to the items of personal property and/or cash that are necessary to even out an exchange. Boot is property that is received in an exchange but is not “like-kind” as to other property acquired in an exchange transaction. Boot is defined as the “fair market value” of the non-qualified property received in an exchange. Read more….
The Role of the Qualified Intermediary
The use of a Qualified Intermediary is essential to completing a successful IRC §1031 tax deferred exchange. Investment Property Exchange Services, Inc. (IPX1031), as a professional Qualified Intermediary, performs several vital functions in an exchange and operates under the “safe harbor” set out in Treas. Reg. 1.1031(k)-1(g)(4). Although the process of completing an exchange is relatively simple, the rules are complicated and filled with potential pitfalls. Read more…
Safety & Security for Exchangers
When selecting a Qualified Intermediary, the Exchanger must feel confident that their Qualified Intermediary is a professional company with the competence and commitment to provide high quality service and security for exchange funds. Read more…
What is a Reverse 1031 Exchange?
A “reverse” exchange occurs when the taxpayer acquires the replacement property before transferring the relinquished property. A “pure” reverse exchange, where the taxpayer owns both the relinquished and replacement properties at the same time, is not permitted. Read more…
For an exchange to satisfy IRC §1031, the taxpayer that will hold the title to the Replacement Property must be the same taxpayer that held title to the Relinquished Property. However, business considerations, liability issues, and lender requirements may make it difficult for the Exchanger to keep the same vesting on the Replacement Property. Exchangers must anticipate these vesting issues as part of their advanced planning for the exchange. Read more…
Since 1984, IRC §1031 has specifically excluded exchanges of partnership interests from non-recognition treatment. Thus, §1031 does not apply to an exchange of interests in a partnership regardless of whether the interests exchanged are general or limited partnership interests or are interests in the same partnership or in different partnerships, even if both partnerships own the same kind of real property. Read more…
Qualified “Like-Kind” Property
There is a two-pronged test for properties to qualify for IRC §1031 tax-deferral treatment. Read more…
The Tax Deferred Exchange
The tax deferred exchange, as defined in §1031 of the Internal Revenue Code, offers taxpayers one of the last great opportunities to build wealth and save taxes. By completing an exchange, the Taxpayer (Exchanger) can dispose of investment or business-use assets, acquire Replacement Property and defer the tax that would ordinarily be due upon the sale. Read more…
Planning Ahead for a Successful Exchange
A successful IRC §1031 exchange transaction requires planning, expertise and support. Investment Property Exchange Services, Inc. (IPX1031) assists our clients by explaining the various types of exchanges, discussing the options that may minimize or eliminate any negative tax impact, providing exchange documents, and safeguarding the exchange funds. Laying the proper groundwork before entering into an exchange will avoid unnecessary obstacles and lead to a smooth transaction. Read more…
Section 1031 and the Economy
How do 1031 Like-Kind Exchanges stimulate the economy?
Like-kind exchanges contribute to the velocity of the economy and promote job growth within the United States. §1031 stimulates the economy by encouraging real estate transactions. Transactional activity results in taxable income, job growth, manufacturing, financial services, construction, improved neighborhoods and tax revenue to states and local communities. Ultimately, this economic stimulus spills over to create jobs in factories, restaurants, recreational, hospitality, tourism and other local small businesses that generate revenue from the after tax dollars of employed workers.
How can 1031 Exchanges benefit businesses, and ranchers and farmers?
Farmers and ranchers use 1031 Exchanges to combine acreage or acquire higher grade land or otherwise improve the quality of the operation. Retiring farmers are able to exchange their most valuable asset, their farm or ranch, for other real estate without diminishing the value of their life savings.
How can like kind exchanges be used for conservation and environmental policies?
How does depreciation impact exchanges to make section 1031 revenue neutral?
When depreciated real estate is exchanged under section 1031, the gain due to depreciation and any depreciation recapture is not recognized, but rather is rolled into the newly acquired real estate. Depreciation is only allowable for any remaining tax basis and for value representing additional capital investment into a like-kind asset.
For example, let’s assume an investment property has a fair market value of $10x, but it is fully depreciated and has a tax basis of $0. If it was exchanged for replacement property with a value of $10x, that replacement property would have the same tax basis and no further depreciation would be allowed. If the replacement property has a value of $25x, then only $15x, representing the additional investment, would be available for additional depreciation over a new depreciation period. If the relinquished property was not fully depreciated, but had a remaining tax basis of $2x, and the replacement property had a value of $25,000, then the maximum depreciation allowed on the replacement vehicle would be $17x (remaining tax basis plus the additional investment).
The total depreciation expense allowed over the life of property which participates in a 1031 Exchange is no greater than the depreciation expense of property that does not participate in a 1031 Exchange. Section 1031 benefits the taxpayer by permitting immediate reinvestment of the entire amount of sale proceeds into replacement property, rather than just reinvesting the “after tax” proceeds.