Understanding a 1031 Exchange

Understanding a 1031 ExchangeReal and personal property held in a trade, business or for investment when sold and replaced with like kind property is provided an exception in Federal Treasury Regulations Section 1.1031. Commonly referred to as a 1031 Exchange, these transactions defer or put off the tax charge associated with gain as the seller essentially trades one property for another that is similar in nature and character. Eventually, the property will be subject to tax when the taxpayer ends up selling the property completely, even if it is sold at a loss given it was depreciated. Consequently, the tax is deferred, postponed, delayed until the property sold is not replaced. 

Defer Federal and State Capital Gains Tax

The 1031 Exchange under Treasury Regulations is particularly useful because it helps businesses and taxpayers defer federal, state, local capital gains taxes on the selling of the capital asset. Capital assets are not inexpensive. With minimal appreciation on real estate, capital gain taxes can account for upwards of 40 percent of the sale. Why pay the tax when if replacing the asset, the tax can be deferred allowing for the relocation of the asset or exchanging one that provides a better cash flow?

Because of the way 1031 Exchanges are covered in the Treasury Regulations, specific exchange rules must be followed. First, the cost of the replacement property has to be equal to or more than the price of the property sold to defer the entire gain. The property must be “like kind” meaning real estate for real estate while tangible and intangible property must be of the same class or group as the replacement asset. All the equity obtained from the first real or personal property sale and debt retired needs to be replaced in the purchase of the new property. It can’t be for a lesser value otherwise a tax is triggered on the difference. Both the property sold and the property acquired have to be held for the productive use in a trade, business or as an investment, eliminating assets such as property held primarily for personal use, partnership interests, inventory, indebtedness and securities.

Certified Exchange Specialist©

To make things a bit more complicated, the transaction and funds can’t go through the seller or broker. Instead, the Exchange must be managed by a “qualified intermediary,” which is defined by the IRS as a third party that fulfills the role of an Exchange Accommodator. This role can’t just be taken on intermittently; rather the suggestion is to engage a Certified Exchange Specialist© who follows best of breed practices including maintaining an Errors and Omissions Insurance policy, the use of a Qualified Escrow Account requiring dual signatures prior to disbursement and operates in accordance with state laws.

If the Treasury Regulations and Internal Revenue Code Section 1.1031 are not meticulously followed, then the IRS could determine in an audit to invalidate the 1031 exchange resulting in a tax, interest on the tax and a penalty. There is a three year statute of limitations where the IRS may audit the 1031 exchange. Few 1031 exchanges trigger an audit unless they violate the Treasury Regulations 1031 code.

Personal Use Must Be Minimal

Again, a 1031 Exchange should not be confused with a primary residence or property held primarily for personal use. The 1031 Exchange process is specific to business and taxpayer investment in real or personal property and ultimately only defers capital gains taxes; it doesn’t avoid them altogether. Though there are transactions such as converting a rental property to a primary residence, after five years sell and 3/5ths of the gain can be absorbed into the $250,000/$500,000 Section 121 exclusion. Done right, the 1031 Exchange can help a business and individual taxpayers tremendously, but taxpayers should make sure they fully understand the related Treasury Regulations. The federal law authorizing the exemption is U.S. Code Title 26, Section 1031, but the IRS also provides its own manual on the matter in IRS Publication 544.

Learn in a free eBook “Ten Reasons Why a 1031 Exchange Makes Sense” by clicking on the button below.

Ten Reasons Why a 1031 Exchange Makes Sense