1031 Exchange and Investment Information
1031 Exchange Property Investments
1031 Exchange and Investment Overview
Whenever you sell business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale. IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.
1031 investments can include like-kind property exclusively or it can include like-kind property along with cash, liabilities and property that are not like-kind. If you receive cash, relief from debt, or property that is not like-kind, however, you may trigger some taxable gain in the year of the exchange. There can be both deferred and recognized gain in the same transaction when a taxpayer exchanges for like-kind property of lesser value.
1031 Exchange Guidelines
Who qualifies for the Section 1031 exchange?
Owners of investment and business property may qualify for a Section 1031 deferral. Individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts and any other taxpaying entity may set up an exchange of business or investment properties for business or investment properties under Section 1031.
What are the different structures of a Section 1031 Exchange?
To accomplish a Section 1031 exchange, there must be an exchange of properties. The simplest type of Section 1031 exchange is a simultaneous swap of one property for another.
Deferred exchanges are more complex but allow flexibility. They allow you to dispose of property and subsequently acquire one or more other like-kind replacement properties.
To qualify as a Section 1031 exchange, a deferred exchange must be distinguished from the case of a taxpayer simply selling one property and using the proceeds to purchase another property (which is a taxable transaction). Rather, in a deferred exchange, the disposition of the relinquished property and acquisition of the replacement property must be mutually dependent parts of an integrated transaction constituting an exchange of property. Taxpayers engaging in deferred exchanges generally use exchange facilitators under exchange agreements pursuant to rules provided in the Income Tax Regulations.
A reverse exchange is somewhat more complex than a deferred exchange. It involves the acquisition of replacement property through an exchange accommodation titleholder, with whom it is parked for no more than 180 days. During this parking period the taxpayer disposes of its relinquished property to close the exchange.
What property qualifies for a Like-Kind Exchange?
Both the relinquished property you sell and the replacement property you buy must meet certain requirements.
Both properties must be held for use in a trade or business or for investment. Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment.
Both properties must be similar enough to qualify as “like-kind.” Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Also, improvements that are conveyed without land are not of like kind to land.
Real property and personal property can both qualify as exchange properties under Section 1031; but real property can never be like-kind to personal property. In personal property exchanges, the rules pertaining to what qualifies as like-kind are more restrictive than the rules pertaining to real property. As an example, cars are not like-kind to trucks.
Finally, certain types of property are specifically excluded from Section 1031 treatment. Section 1031 does not apply to exchanges of:
- Inventory or stock in trade
- Stocks, bonds, or notes
- Other securities or debt
- Partnership interests
- Certificates of trust
What are the time limits to complete a Section 1031 Deferred Like-Kind Exchange?
While a like-kind exchange does not have to be a simultaneous swap of properties, you must meet two time limits or the entire gain will be taxable. These limits cannot be extended for any circumstance or hardship except in the case of presidentially declared disasters.
The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary. However, notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient.
Replacement properties must be clearly described in the written identification. In the case of real estate, this means a legal description, street address or distinguishable name. Follow the IRS guidelines for the maximum number and value of properties that can be identified.
The second limit is that the replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier. The replacement property received must be substantially the same as property identified within the 45-day limit described above.
Are there restrictions for deferred and reverse exchanges?
It is important to know that taking control of cash or other proceeds before the exchange is complete may disqualify the entire transaction from like-kind exchange treatment and make ALL gain immediately taxable.
If cash or other proceeds that are not like-kind property are received at the conclusion of the exchange, the transaction will still qualify as a like-kind exchange. Gain may be taxable, but only to the extent of the proceeds that are not like-kind property.
One way to avoid premature receipt of cash or other proceeds is to use a qualified intermediary or other exchange facilitator to hold those proceeds until the exchange is complete.
You cannot act as your own facilitator. In addition, your agent (including your real estate agent or broker, investment banker or broker, accountant, attorney, employee or anyone who has worked for you in those capacities within the previous two years) cannot act as your facilitator.
Be careful in your selection of a qualified intermediary as there have been recent incidents of intermediaries declaring bankruptcy or otherwise being unable to meet their contractual obligations to the taxpayer. These situations have resulted in taxpayers not meeting the strict timelines set for a deferred or reverse exchange, thereby disqualifying the transaction from Section 1031 deferral of gain. The gain may be taxable in the current year while any losses the taxpayer suffered would be considered under separate code sections.
How do you compute the basis in the new property?
It is critical that you and your tax representative adjust and track basis correctly to comply with Section 1031 regulations.
Gain is deferred, but not forgiven, in a like-kind exchange. You must calculate and keep track of your basis in the new property you acquired in the exchange.
The basis of property acquired in a Section 1031 exchange is the basis of the property given up with some adjustments. This transfer of basis from the relinquished to the replacement property preserves the deferred gain for later recognition. A collateral affect is that the resulting depreciable basis is generally lower than what would otherwise be available if the replacement property were acquired in a taxable transaction.
When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.
How do you report Section 1031 Like-Kind Exchanges to the IRS?
You must report an exchange to the IRS on Form 8824, Like-Kind Exchanges and file it with your tax return for the year in which the exchange occurred.
Form 8824 asks for:
- Descriptions of the properties exchanged
- Dates that properties were identified and transferred
- Any relationship between the parties to the exchange
- Value of the like-kind and other property received
- Gain or loss on sale of other (non-like-kind) property given up
- Cash received or paid; liabilities relieved or assumed
- Adjusted basis of like-kind property given up; realized gain
If you do not specifically follow the rules for like-kind exchanges, you may be held liable for taxes, penalties, and interest on your transactions.
Beware of schemes
Taxpayers should be wary of individuals promoting improper use of like-kind exchanges. Typically they are not tax professionals. Sales pitches may encourage taxpayers to exchange non-qualifying vacation or second homes. Many promoters of like-kind exchanges refer to them as “tax-free” exchanges not “tax-deferred” exchanges. Taxpayers may also be advised to claim an exchange despite the fact that they have taken possession of cash proceeds from the sale.
Corcapa 1031 Advisors is committed to conducting due diligence on sponsors and offerings it provides to investor clients.
Due Diligence is conducted on multiple levels by the sponsors, broker dealer Primex Prime and our branch Corcapa 1031 Advisors. We review third party property reports on the property: Appraisal, Property Condition Report and Environmental Reports. If there are any concerns raised from these reports follow up reports are requested. The Private Placement Memorandum or Prospectus is reviewed in detail at the Corcapa Branch level.
Primex Prime and Corcapa 1031 Advisors also reviews required independent third party reports which contain subject and competitive property information as well as an understanding of risks associated with each investment.
Should these offerings pass our due diligence review, they are approved and may then be shown to investors for consideration. Of course, even the most advanced due diligence process cannot guarantee success and investors must review offering materials in detail to understand all the risks and benefits of a program.
All real estate has risks, including if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions (or rent). If a property fails, there is a possibility the investor could face depreciation recapture and resulting tax.
Consult a tax professional or refer to IRS publications listed below for additional assistance with IRC Section 1031 Like-Kind Exchanges.
1031 Exchange FAQs
Potential Advantages of 1031 TICs*
Generally, 1031 exchanges and TICs are attractive in that they allow:
- Greater investment
Because capital gains taxes are deferred, the investor has a higher adjusted basis, creating greater leverage, than if the tax liability was paid on a current basis. This may increase the investor’s available equity for reinvestment.
One large property can be exchanged into many TIC properties, offering additional asset and geographical diversification.
- Compounding Effect
A property owner who conducts multiple 1031 exchanges and makes unrealized gains on each exchange will be able to reinvest the deferred capital gains on each subsequent exchange. A property owner who holds exchanged property until death avoids the deferred tax liability and his or her heirs inherit the property with a “stepped-up” tax basis.
- Pricing Flexibility
An investor can experience greater pricing flexibility because the sale price of the relinquished property will not need to be inflated to cover capital gains taxes. This enables the seller to have increased flexibility with the selling price on the relinquished property without requiring the investor to contribute additional cash to defer capital gains taxes.
- Property Life
An investor can exchange property that has reached a plateau for one that is on an upswing; an unproductive property can be exchanged for an income-producing property; a property that has been depreciated can be exchanged for a more expensive property which has more room for additional depreciation.
- Institutional-Grade Properties
An investor can access ownership in larger commercial properties that have traditionally been accessible only to very wealthy individuals, pension funds, insurance companies, and other institutional investors. TICs may allow a client access to ownership in commercial properties that they may not otherwise be able to afford.
- Access to Pre-packaged Choices
Bridge Equities, Inc. has relations with sponsors who are offering properties for which they have generally already arranged financing, completed initial due diligence, and commissioned appraisals and environmental reports, prior to the property being presented to investors.
Potential Risks of 1031 DSTs & TICs*
As with any investment, 1031 exchanges and DSTs & TICs have certain risks:
- Fees and Expenses
The cost to acquire a DST or TIC interest may be more than purchasing a property outright because of additional expenses of making the property available to multiple co-owners and marketing it in the form of a private security offering, including brokerage fees, which may outweigh the benefits of tax deferral.
- Past Performance
Past performance does not ensure or indicate future earnings, and property appreciation is not guaranteed. Principal reduction or loss may occur depending on the performance of the underlying real estate.
- Tax Status
The 1031 exchange program through a TIC is a structured investment based on Rev Rul 2004-86 or Rev-Proc 2002-22; current applicable laws may not remain in effect. If laws are changed, or if the IRS determines that the requirements of Section 1031 have not been met, there is a possibility of other ramifications such as back pay under different tax provisions, and immediate tax liabilities, including tax penalties.
- Real Estate Risks
DSTs and TICs interests are investments in real estate and are subject to all risks of owning, operating and disposing of real estate. Results from investing in real estate vary through cyclical economic times.
- Reliance Upon Others
An investor purchasing DST or TIC interests relies upon the sponsor and property manager to make day-to-day decisions related to the property including potentially the sale, refinance and leasing decisions. Certain decisions may require unanimous approval from co-tenants in a TIC structure, such as sale, refinance ect.
A TIC interest is an investment in real estate, subject to a tenants-in-common agreement, and is an illiquid investment. There is currently no established secondary market for the resale of TIC interests.
TIC investments may not be suitable for all 1031 exchange investors.
- Conflicts of Interest
Conflicts of interest may exist that could adversely affect the investment.
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