1031 Exchange Information
If you sell investment or business property and you have a gain, you generally have to pay taxes on the gain. Section 1031 of the Internal Revenue Code permits you to defer capital gains tax if you exchange the property sold for another like-kind asset. The tax that would normally be due on the sale can be deferred or delayed until a later date.
Tax deferred exchanges are best known for their application to real estate exchanges, which is why 1031 exchanges are often referred to as “tax free exchanges”. Generally, most personal and real property can be exchanged. This includes investment grade art, stamp and coin collections, antique automobiles, and antique furniture. In addition to business assets like trucks, airplanes, and fishing boats, tax deferred exchanges can also be made for businesses.
For Section 1031 to qualify for tax deferral, three requirements must be met: (1) the exchange must be like-kind; (2) like-kind properties must be exchanged; and (3) the properties transferred and the properties received must be held either for productive use in a trade or business or for investment.
Tax deferred exchanges are both practical and easy to accomplish. The IRS guidelines (April, 1991) state that you have 180 days to purchase a replacement property after selling your property. Using a Qualified Intermediary is a relatively simple, hassle-free, and safe way to defer the tax due on a sale. Section 1031 does, however, contain strict rules.
Frequently Asked Questions about 1031 Exchange
1. Is vacation property eligible for a 1031 exchange?
In 1031 exchanges, like kind properties must be exchanged, and both properties transferred and received must be used for productive purposes in a business or trade. But that's what the written definition says. Therefore, it makes sense to ask if vacation property is eligible.
In Private Letter Rulings, the IRS has allowed Section 1031 when the taxpayer intends to acquire property for personal enjoyment as well as investment. The house and lot acquired in this trade will be used for the same purposes as the properties exchange: to provide personal enjoyment as well as to invest in real estate. We can read that personal enjoyment of vacation property is not a reason not to be eligible for Section 1031's benefits.
2. In a 1031 exchange, can I live in the property I purchased for investment?
The property can be used for personal use if it is used for an investment for a period of time. The specific initial investment use period is not expressly referred to in the code, but a holding period of 2-3 years is generally accepted, after which a property for investment under 1031 may be used as the owner wishes.
3. Is it possible to replace my farmland with a rental condo at the beach or in the mountains if I sell some of my farmland?
Under this arrangement, it is important that you use the condo as investment property, which means limiting your personal use to 14 days per year.
4. How much replacement property can I purchase with $100,000 from the sale of my relinquished property?
If you use the entire $100,000 of relinquished funds, you can purchase as much property as you can leverage. For example, you could buy $1,000,000 in replacement property with 10% ($100,000) down.
5. Is a Qualified Intermediary required?
As a result of IRS regulations and court decisions, a third party must hold the proceeds of the sale of the relinquished property during a delayed exchange. Qualified Intermediaries cannot act on behalf of either the seller or the buyer of the property. Most of the time, Qualified Intermediaries are accommodators who specialize in this type of transaction.
6. Could the money be left in escrow with instructions not to disburse until a replacement property is found?
The escrow is not an independent third party. It is a bilateral agency where all parties give instructions to the agent. Instructing the escrow to keep the money disqualifies the exchange.
7. Can anyone serve as a Qualified Intermediary?
Individuals who are not disqualified have the option to act as the accommodator (Qualified Intermediary) for the exchange. The guidelines prevent related parties (such as close family members and controlled business entities) and agents like real estate brokers, attorneys, and accountants from fulfilling this role. Eligible individuals or companies include those who are unrelated, someone else's attorney or accountant, and accommodator companies. Before making a decision, the Exchangor should assess their requirements and consider potential risks.