Section 1031 of the Internal Revenue Code provides for tax deferred exchanges. IRS rules allow owners of certain Real and Personal property to sell and buy like-kind property deferring Capital Gains Tax. The rules dictate that the "Exchanger" have a third party hold the funds during the exchange process. This party is a “Qualified Intermediary”.
Deferring capital gains conserves real estate wealth. The IRS allows property owners to exchange property for other property, making possible the shift of profits gained from one property into another while deferring tax.
A seller transfers property called the "Relinquished Property" and later obtains other property known as "Replacement Property.” A real property owner may "sell" his Relinquished Property now and purchase Replacement Property later. If the rules are observed and a Qualified Intermediary employed, the property owner qualifies for tax deferral.
Three requirements must be met to achieve deferment of gain under §1031: The properties involved must qualify. There must be a true exchange, not an assignment of property involving money only. Time periods must be exactly observed.
The exchange will not be recognized by the IRS and taxed as a sale if the Relinquished Property and Replacement Property properties do not qualify. Then taxes will be due on any gains.
Property Categories
For income tax purposes, real estate has four categories:
- Held for business use
- Held for investment
- Held personal use
- Held primarily for sale
The first two categories qualify for potential tax deferment. The other two do not. Classifications can be mixed: an office building (business property) can be exchanged for two vacant lots (investment property).
The property owned is used in the owner's trade or business. Examples are an office owned to conduct business or a warehouse used to store inventory.
When an owner rents his property to a third party, that action qualifies it as property used in a trade or business. Investment real estate is held primarily for increases in worth. Real estate held for investment qualifies for tax deferred treatment when exchanged for investment real estate or for real estate used in a trade or business.
“Like-kind” is a tax term describing the property as used by the owner. “Like-Kind” is real estate discussed above as “Qualified.” Qualified real estate in the 50 United States is like-kind when exchanged for other qualified real estate located in the 50 United States and the U.S. Virgin Islands. A vacation or second home which is not rental property is real estate held for personal use and does not qualify for §1031 treatment.
Time Limitations on Completing Real Estate Exchanges for Tax Deferral
An exchange must comply with two time limitations on deferred real estate exchanges. In a §1031 exchange, any Replacement Property received will not be treated as like-kind property to the Relinquished Property if: the Replacement Property is not "identified" before end of the "identification period", which is 45 days from the original sale, or it is not bought during the “exchange period”, during which begins when the Relinquished Property is sold and ends 180 days after the transfer or the due date (including extensions) for the exchanger’s tax return for the taxable year in which the transfer of the Relinquished Property occurs, whichever date is earlier.
The Qualified Intermediary is a critical legal element of the transaction. For tax deferral, there must be an exchange, and not a sale for money. The Qualified Intermediary acts to facilitate this. When an exchanger sells his property he must not receive the funds. The Qualified Intermediary receives the funds, and holds them for the purchase of the Replacement Property. The exchanger never comes into possession of the money.
A Qualified Intermediary agrees to a contract with the seller for the exchange of properties. The Qualified Intermediary does not provide legal or tax advice to the exchanger, but usually renders these services:
- Cooperates with the Exchangers and their counselors.
- Protects the funds in an insured bank account until the exchange is consummated.
- Provides the documentation for the Relinquished Property and the Replacement Property.
- Furnishes escrow instructions to execute the exchange.
Real Estate Wealth Preservation without Capital Gains Taxes
The preservation of real estate wealth without taxation can be achieved through the use of the 1031 exchange. It can be done over and over with properties of ever increasing value with tax deferral. When the property owner dies, the property is valued in his/her estate as of the date of the death. In that case, neither the property owner, nor the heirs ever pay tax on the appreciated values.
David J. Shestokas - Mr. Shestokas is a former prosecutor & writes on the Constitution & legal issues for the Save America Foundation & Suite 101.
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