What’s 1031 exchange? That is the first question that hovers one’s mind. A 1031 exchange means that an investor has reinvested the sale proceeds in a new like-kind property to defer all capital gain taxes. This is a “popular term ” for signifying the capital gains tax exemption law enshrined under 1031 of the Internal Revenue Code . IRC Section 1031 (a)(1) states as under :
“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment, if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment.”
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1. What are the requirements full tax deferral in a 1031 exchange
Well, for complete tax deferral, a person will have to acquire the property of equal or greater value and spending the entire net equity in the acquisition.This is also an answer to a very common question “How much to reinvest under 1031 exchange?”. In other words,if a taxpayer intends to avail a 1031 exchange for fully defer the capital gains tax on the sold property, two conditions must be fulfilled :
- Reinvest the entire net sale proceeds in one or more “like-kind” replacement properties; and
- Acquire one or more “like-kind” properties with the same or a greater amount of debt.
2. What is a like-kind property?
Or you may ask “What is the 1031 exchange property?”. The answer is simple. Like-kind properties are real estate properties situated with USA territory and must be similar to the property that you sold and claiming 1031 exchange benefit. Further, the like-kind properties must be held for business or investment purposes but do not need to be similar in grade or quality. As per IRC, the quality of property does not decide if the property is like-kind or not. If the property is of the same nature or character as the one being replaced, even if the quality is different. The IRS considers real estate property to be like-kind regardless of how the real estate is improved. So, you can exchange a small flat in a building for a larger apartment elsewhere or for an office suite, or for vacant land.
The Tax Cuts and Jobs Act of 2017 eliminated personal and intangible property from being included in tax-deferred exchanges. That includes items such as machinery, equipment, artwork, collectables, patents and intellectual property. Also , securities, stocks, bonds, partnership interests, and other financial assets do not fall within the like-kind properties definition.
3.Can 1031 exchange be used for a primary residence?
You can not use your primary residence or property for 1031 exchange. That’s because the property that you live in isn’t being used as an investment property or being held for business purposes. However, there are some exceptions to this rule. IRC Section 121 of the Internal Revenue Code gives some situations where you can conduct a 1031 exchange converting your primary residence under section 121 to section 1031 rental investment property.
4. Who can claim 1031 exchange tax deferral?
Anyone who is the owner of investment and business property.So , individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts and any other taxpaying entity are eligible for the benefit of tax deferral under Section 1031.
5. How often can I do a 1031 exchange?
There is no fixed rule about number of times one can avail the benefit of section 1031 exchange. So, you can avail of 1031 exchange scheme as many time as you want.
6. What are the type of 1031 Exchanges?
The most common types of 1031 exchanges are :
- Delayed exchange-It means you dispose of one property by selling or relinquishing and replacement property is purchased during the allowed time.
- Simultaneous exchange-As the term suggests, you buy the replacement property at the same time , you sell the property.
- Delayed reverse exchange-In this type of 1031 exchange , you first buy the replacement property then sells or relinquish the current property.
- Delayed build-to-suit exchange with the current property replaced with a new property built-to-suit the need of the investor.
- Delayed/simultaneous build-to-suit exchange with the built-to-suit property purchased before the current property is sold.
7. Is there a timeline for 1031 exchange?
Yes, the timeline rules for 1031 exchange states that
- The replacement property must be identified within 45 days.
- The replacement property must be purchased within 180 days.
Just remember that the 1031 exchange of properties must be completed in 180 days, not 225 days (45 days +180 days).
8. How to identify replacement property?
As per 1031 exchange timeline rule , you are allowed a strict 45 days to identify a replacement property. For the purpose of identification ,a legal description or replacement property address or even a submitted purchase agreement is sufficient identification.
However, if you wish to purchase multiple properties, you may follow one of the following guidelines for identification of properties :
- Identify up to 3 properties of any value with the intent of purchasing at least one.
- Identify more than 3 properties with an aggregate value that does not exceed 200% of the market value of the relinquished property.
- Identify more than 3 properties with an aggregate value exceeding 200% of the relinquished property, knowing that 95% of the market value of all properties identified must be acquired.
9. How much does the 1031 exchange cost?
The cost for a standard 1031 exchange hovers between $650 and $1,200. This cost is paid to your qualified intermediary Certain as fee . The cost of a reverse 1031 exchange which is a bit complex procedure , is higher, in the range between $3,300 to $7,800.
10. How often are 1031 exchanges audited?
Based on the available data on audit cases of 1031 exchange , it looks like there is no fixed formula to find out , how often IRS takes up audit of 1031 exchange .However , data suggests that the partnership 1031 exchange has the highest chance of being audited by IRS. You may note that before IRS may or may not audit your 1031 exchange , auditors will certainly scrutinize exchange thoroughly on following points :
- if the replacement property is like kind, or
- if the property was used in a trade or business or for investment,
- if the identification of a replacement property and exchange were within allowed time,
- if the replacement property was of equal or higher value than the relinquished property, and any “boot” must be reported.
- Whether there is a qualified intermediary involvement in 1031 exchange as defined under Treas. Reg. §1.1031(k)-1(g)(4) .
11. When to report 1031 exchange?
The rule of reporting is that you need to report exchange on the federal and state tax return for the tax year in which you transferred the sold or relinquished property even if the exchange was not completed in that same year. For example, if a taxpayer started an exchange in August of 2019, and completed the exchange in February of 2020, the 1031 exchange will be reported on their 2019 tax return.
12. How to report 1031 exchange ?
Reporting of 1031 exchange is done by filing Form 8824 along with your federal income tax return. If you completed more than one exchange, you need to fill form 8824 for each exchange. Reporting form 8824 is extremely important as IRS will match the information with the form 1099-S filed by your settlement agent.
13. Can 1031 exchange be used for improvements?
The answer is a definite yes .You can improve a replacement property in a 1031 exchange with tax-deferred dollar . This type of exchange is also referred to as a construction or build-to-suit exchange under which you can use the proceeds from the sale of your relinquished property to acquire replacement property and use any excess sale proceeds to improve the acquired property as part of your 1031 Exchange transaction.
14.What is a failed 1031 exchange?
As the term suggests, a failed 1031 exchange is one that fails to satisfy the condition provided under section 1031. Most common reasons for a failed 1031 exchange canbe one of the following:
- You failed to identify replacement property within 45 Days
- The property received is not substantially the same as the property identified.
- You closed the property without a contract with a facilitator
15. What is a reverse 1031 exchange?
In normal exchange , we sell or transfer a property and after that we get the replacement property .But in a reverse 1031 exchange the replacement property is purchased before the relinquished or old property is sold. The timeline of a reverse exchange is same as standard normal 1031 exchange rules.
16. Are 1031 exchange expenses deductible?
Nothing clearly written about the deduction of exchange expense . But ,if you look to IRS Form 8824, that must be filed under 1031 exchange, it provides that exchange expenses are to be deducted from the contract price in the determination of realized gain. So, it looks like one can deduct the exchange expense attributable to sale of the property should be deducted from gross sale value, other selling expenses that may be excluded are transfer taxes, attorney’s fees, recording fees and the cost of the owner’s title insurance policy.
In this regard, please note the Letter Ruling 8328011, Mercantile Trust Co. of Baltimore v. Comm, 32 BTA 82 (1935), Rev. Rul. 72-456, 1972-2 CB 468 that qualified intermediary (QI) fees, escrow closing costs and broker commissions are exchange expense . Exchange expense however does not cover loan-related fees, such as prepaid interest, mortgage insurance fees, appraisal fees and lender’s title insurance relate to the loan used to acquire replacement property [refer Treasury Regulation §1.1031(k)-1(g)(7)] . Loan costs are not included in the cost basis for the replacement property. See Rev. Rul. 70-360, 1970-2 CB 103, S&L Building Corporation, 19 BTA 788 (1930).