Here is 1031 Exchange Topic 1 in its entirety from our 1031 Exchange Exchange Knowledge Base. Watch future blog posts for all of the 1031 Exchange topics covered.
The sale of real estate is generally a taxable event and can produce a taxable gain or loss. [i] The entire gain (or loss) is recognized for federal income tax purposes in the year of sale. However, there are some important exceptions to this rule.
Selling your primary residence under §121. The sale of property classified as your primary residence at time of sale cannot qualify for section 1031 treatment. Topic 8 discusses the tax classification for your personal residence,
Installment sale method of tax reporting under §453. This method permits gain to be reported ratably over the period deferred payments are received. Many §1031 exchanges involve installment sale notes. Topic 7 covers this vital topic.
Involuntary exchanges under §1033. An involuntary exchange occurs when your property is destroyed, stolen, condemned, or disposed of under the threat of condemnation, and you receive other property or money in payment. This subject is not covered in this edition.
Exchanging your property under the §1031 deferred exchange rules. If your transaction meets the requirements of §1031, no gain or loss will be recognized in the year of sale. However, see Topic 3 for discussion of gain recognized from that part of the exchange that does not qualify for §1031 treatment. It’s called net boot received. This book focuses on the §1031 exchange of real estate under the deferred exchange regulations.
The real estate exchange is an alternative to a sale and purchase. If you want to sell one piece of real estate and buy another, you should compare the tax results of sale and purchase with the tax results of exchanging. If your property has appreciated in value,an exchange could result in substantial tax savings because gain would not be recognized on the transfer. If, on the other hand, your property has decreased in value, it must be sold rather than exchanged if you want to deduct the loss.
Without the special provision of §1031 in the Internal Revenue Code and the related regulations, transfer of one property in exchange for another produces the same result as an outright sale. The fair market value of the property received after deducting expenses of sale is treated as the amount realized. The difference between this amount and your adjusted basis of the property given up is recognized gain or loss.
Code Section 1031 says: “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.”
Caution: The nonrecognition of the gain or loss provision of §1031 is mandatory and must be applied. There is no election on your part. If your real estate transaction meets the requirements of §1031, gain is not taxed and loss cannot be deducted. In other words, even if you realize a gain or loss on the exchange, it will not be recognized for tax purposes.
Do You Really Want to Make an Exchange?
Before getting started planning an exchange for your property to save taxes, take a closer look. You might find an exchange is unnecessary or because there would be a loss or very small gain recognized if you sell the property outright. Or, after a lot of work and expense, discover one of the properties does not qualify.
Here’s a real life experience of a taxpayer who went to great lengths and difficulties to make an exchange that converted lower tax rate capital gains into higher tax rate ordinary income.
Taxpayer owned an apartment house subject to capital gains tax if he sold the property. Instead, he exchanged it for a large parcel of investment land and rolled the lower basis of the apartment house into the land under the substituted basis rules. He was planning to subdivide the land two or three years later and build homes for sale. By careful planning and lots of work, here is what he accomplished:
The large gain from the sale of the apartment house was deferred for tax purposes by rolling over into the investment land, thus lowering the basis of the land by the amount of the gain.
Later when he reclassified the land from investment property (capital gains) to dealer property (ordinary income), his profit (ordinary income) from the sale of each home and lot was increased by the amount of deferred gain resulting from the exchange.
Here is a question from one of our readers illustrating this very important point:
I have a prospect that purchased a condo here in Vegas. The intention of the purchase was to rent it out. They purchased the property with an owner occupied loan—planed on living in it for a few months then renting it out and buying their dream home. The first month, they met some folks in the association who informed them that the CC&R’s will not allow owners to rent their properties! Neither the agent who sold them the home or the sellers informed them of this dilemma.
If they were to sell the condo…could they use a 1031 exchange, since they purchased it with the ‘intent’ to rent?
We answered: If the clients sold the condo right now, would the amount realized from the sale (sales price minus all selling expenses including commissions, etc.) be more than their cost of the condo including closing costs? This is often the case on quick sales like this. If there is no gain, the question of exchange is moot. If there is a gain, the property should qualify for §1031 treatment since the need and decision to sell are considered an unrelated event to the purchase.
Special attention must also be given to the exchange of depreciable property that has appreciated in value. Since the basis of the old property is “substituted” into the new property, your depreciation deductions may be affected. On the other hand, a sale and purchase could result in a higher cost basis in the new property and higher depreciation deductions.
What is a Like-Kind Exchange?
To understand §1031, you must look to its legislative design. Congress intended non-recognizable taxable gain or loss if the Replacement Property received is merely a continuation of your old property investment. To qualify, you must structure and complete your exchange transaction in accordance with the requirements of §1031. Your intent doesn’t count — what you actually do is what determines if you qualify or not. However, if the transaction is ambiguous, the Courts may look to intent of the parties. See Step Transactions and Substance over Form Doctrines—for more discussion on this matter.
Section 1031 provides for nonrecognition of gain or loss if three conditions are met:
1.Only property held for investment or use in your trade or business qualifies for §1031 exchanges. Both the property exchanged by you and the property received by you must be qualified. Personal use property such as your personal residence does not qualify. Nor does “dealer” property.
2.The properties must be of like-kind. They do not have to be identical. This is a very broad definition. All qualified real estate is of like-kind with all other qualified real estate.
3.There must be an actual exchange of properties. There can be a transfer of money with the qualified property. This will not disqualify the exchange. Taxpayers lose most tax cases involving exchanges because their transaction fails to meet the requirements of §1031 for a reciprocal transfer of property.
There Must Be an Actual Exchange of Properties
Structuring and executing an exchange of real estate must be done correctly. If not, the transaction is treated as a sale. The Internal Revenue Code and related regulations all refer to the transaction as a “sale or exchange” and the rules for distinguishing between the two are steadfast and unwavering. You will not get §1031 treatment merely if you intend to exchange—you must actually make an exchange of your property.
Parallel Point 1-1
You find a choice apartment house property for sale. You know of a buyer who would be willing to pay top dollar for the property. You decide to acquire the property and sell the buyer a two-year option to buy the property. In the meantime you will operate it as a rental income property. You currently own a commercial property you want to sell now but your accountant advises you need another capital gain this year like you need a hole in your head.
You enter into an exchange agreement to sell your commercial property and acquire the choice apartment house with the plan of selling the option, operating the property until the option is exercised, and taking your total gain in that taxable year.
The exchange will be disallowed and treated as a sale. Not only does the step transaction doctrine apply and collapse the exchange but also the act of selling the option at time of acquisition reclassifies the rental property as real estate held for sale in the ordinary course of business.
The deferred exchange is designed to solve this dilemma. It permits you to “sell” your property now and use the proceeds to buy the Replacement Property later. As long as it’s done following the rules with a Qualified Intermediary, you get §1031 treatment.
A deferred exchange is an exchange in which you transfer qualified property called the “Relinquished Property” and subsequently receive qualified property as consideration. The property received is called Replacement Property.
The IRS regulation explaining how to put together the §1031 deferred real estate exchange is one of the most powerful tools for selling appreciated business, farm, and investment real estate without recognition of gain for income tax purposes. It spells everything out—step by step. Just follow the rules and you can sell your appreciated property, use the cash proceeds to buy your Replacement Property and qualify for the full benefits of nonrecognition of gain under Section 1031. The regulation has the weight of law and all parties must follow it—even the IRS.
One of the outstanding features of the deferred exchange regulation is it establishes and defines the Qualified Intermediary (QI) as your vehicle to qualify for the safe harbor procedures you must follow to get non-recognition of gain treatment on your deferred exchange.
After the transaction is completed, you and your QI settle up. Your tax reporting of the exchange is easy to figure. You simply measure what you put into the exchange—Relinquished Property and boot—against what you take out after your settlement with the QI§—Replacement Property and boot.