A legal definition of a 1031 exchange is a real estate transaction to sell properties for investments or to acquire replacements. Under the Internal Revenue Code Section 1031, various regulations and rules govern the different types of 1031-exchanges. It provides that if the property is a holding for use in a trade, business, or investment, there is no gain or loss recognized when exchanged for like-kind property. Of the 1939 Revenue Act, Code Section 202(c) is the first federal tax code provision that permits no gain recognition in an exchange transaction. For example, like-kind properties, such as an apartment building exchanged for another apartment building regardless of quality or grade, are a 1031 exchange transaction.
Who Qualifies for 1031 Exchanges?
- Individuals
- Tax-paying Business Property & Investment Owners
- Corporations (C-corps and S-corps)
- Partnerships (General and Limited)
- Limited Liability Companies (LLCs)
- Trusts
How 1031 Exchange Works
In 1991, the Internal Revenue Service enacted regulations and rules permitting the deferred exchange structure type for taxpayers to sell relinquished properties for replacement properties. For the exchange to efficiently work for you, there are three 1031 exchange steps to follow:
- As a buyer and seller, identify the like-kind property.
- Choose a Qualified Intermediary or an Exchange Facilitator to hold funds in an escrow account.
- Report your exchange transaction to the IRS using Form 8824 with your IRS federal income tax return.
You will need a qualified intermediary or an exchange facilitator to hold the proceeds from the real estate transaction, sell your property, and purchase the replacement real estate. Working with an accounting & tax professional and a qualified intermediary helps prepare legal documents and ensure you comply with IRS rules and regulations. You will have access to a team of experts knowledgeable about what’s 1031 exchange and the entire process. Selecting the right qualified intermediary helps you avoid losing money, missing required deadlines, and paying unnecessary taxes. On Form 8824, the Internal Revenue Service requires you to describe the relinquished and replacement properties and provide the timeline, involved parties, and any cash involvement.
Four Types of 1031 Exchanges
- Simultaneous Swap of Relinquished and Replacement Properties
- Deferred
- Reverse
- Multi-Asset
Of all the four 1031 exchange types, the simultaneous swap to exchange a relinquished property with a replacement property is the simplest. A deferred exchange is most common and flexible but complex because of Internal Revenue Code tax regulations using exchange facilitators to engage in transactions. Another complex exchange type is reverse which involves replacement property acquisition through an exchange accommodation titleholder to park up to 180 days. During this timeline, you can dispose of the relinquished property and acquire the replacement real estate to close the exchange transaction. Multiasset is an exchange type involving the receipt of two or more groups of like-kind properties and transfer or the receipt and transfer of multiple properties with only one like-kind group, according to IRS.
What Are the Best Practices When Entering Into a 1031-Exchange Agreement
Under the Tax Cuts and Jobs Act, it is essential to consider new rules to Section 1031, which now applies only to exchanges of real property and not personal or intangible property exchanges. While a real property you hold for sales continues to not qualify as a like-exchange, there is a new law with a transitional rule. The section applies to a qualifying intangible or personal property exchange if you disposed of it or received the replacement on or before December 31, 2017. As of January 1, 2018, machinery, equipment, vehicles, artworks, patents, and other intangible assets no longer qualify for gain or loss non-recognition as like-kind exchanges.
Benefits of 1031-Exchange
Utilizing a 1031 exchange is a strategic way to invest in a property with the potential to receive a better profitable return on your investment than the property you want to relinquish. Other ways to use real estate structures include real-estate consolidation, selling your investment property and investing in more than one property, or turning your real estate into rental properties. Allowing the resetting of the property’s depreciation is a huge benefit of the exchanges and is helpful when it is time to file your federal income tax return.
Tax Implications of a 1031-Exchange
It is important to remember that a 1031-exchange is not tax-free but tax-deferred, meaning that you will carry over the tax basis in your relinquished property to the replacement real estate. If you do not exchange when you sell the replacement property, you will need to recognize the gain realized in the real estate transaction. In the set of 1031 exchange rules, the replacement basis increases any gain recognized on the relinquished property sale or capital improvements completed after purchase. It increases by the amount of money you spend over the exchange value when acquiring the replacement property.
Taxpayers may have capital gains for leftover cash, known as boot, following the exchange or be taxed on replacement properties if the mortgages are lower than the relinquished real estate. Gross selling of the relinquishable property after deducting sale costs and including the amount of the payoff mortgage is the exchange value. With a 1031 exchange, you can not deduct transfer costs; however, the broker’s commission, attorney fees, accommodator fees, improvement expenses when sold, and escrow and title fees are deductible with a sale.
Individuals, corporations, and partnerships can receive outsourced accounting and tax services to help with the applying processes for a 1031-exchange.
At Fusion CPA we can assist you in finding a qualified intermediary after our accounting team evaluates your business.
This blog article is not intended to be the rendering of legal, accounting, tax advice or other professional services. Articles are based on current or proposed tax rules at the time they are written and older posts are not updated for tax rule changes. We expressly disclaim all liability in regard to actions taken or not taken based on the contents of this blog as well as the use or interpretation of this information. Information provided on this website is not all-inclusive and such information should not be relied upon as being all-inclusive.