- Land which is under development.
- Inventory Property.
- Construction for resale or Fix n’ Flips.
- Beneficial interest in a partnership.
- Stocks, Bonds, or Notes.
When an Exchanger is exchanging real property, like-kind
is one of the real advantages of §1031 exchanges. All real property is like-kind with all other real property. Like-kind refers to how the property is held by the investor, not the type or character of property. The Exchanger must have held the relinquished property
for investment or for productive use in their trade or business and intend to do the same with the replacement property. The following are examples of like-kind properties:
- Residential relinquished property for commercial replacement property.
- Bank building as relinquished property for swamp land as replacement property.
- Bare land as relinquished property for residential rental as replacement property.
- Fee simple interest in your relinquished property for 30-year leasehold in your replacement property.
- Single family rental as relinquished property for multi-family rental as replacement property.
- Non-income producing relinquished property for income producing replacement property.
- Rental house at the river relinquished property for a medical office in which the exchanger intends to practice as replacement property.
If the Exchanger is exchanging personal property the rules are far more restrictive. Definitions of what is considered real property and personal property can vary from state to state. It is essential to consult with a tax advisor when structuring personal property exchanges because one transaction may have multiple exchanges, involving tax deferral on both the personal and real property. Personal property is considered like-kind only if it appears in the same General Asset Class or Product Class. Therefore the Exchanger may exchange:
- Cement truck for a cement truck.
- Vending routes for vending routes.
- Cotton candy equipment for cotton candy equipment.
Not allowed are transfers of certain property inventory or other property held primarily for sale, such as subdivided lots held for sale, and interests in partnerships or real estate investment trusts.
The Exchanger must have held the relinquished property for investment or for productive use in their trade or business and intend to do the same with the replacement property. A vacation home may qualify, if you've rented it out and have used it less that 14 days last year. Both rentals and vacant lots are investment property
, and are eligible for an exchange so long as you select a replacement property to hold as an investment.
While no formal rule exists, your exchange could be challenged if you sell the replacement property shortly after the exchange. No specific time frame is defined, but many CPAs say you should hold replacement property for a year.
In order to defer all the capital gains taxes, You must buy 1031 replacement property of equal or greater value, with equal or greater debt, unless you bring in cash equal to the debt being paid off pertaining to the relinquished property. The equity must match. Both the value and net equity of the taxpayer's replacement property must equal or be greater than the value and net equity of the relinquished property at the time of the exchange. Before you enter into any exchange of real estate, you must first figure your adjusted basis.
Start with the price you paid for your property, add any capital improvements, and subtract any depreciation. This figure is your adjusted basis. Subtract the adjusted basis and the new costs of sale from the new sales price and the remaining figure is your gain.
If the value of the replacement property is less or the net equity is less, you would be taxed on the greater of the trade down in value or equity, limited to the gain you would have recognized if the property simply had been sold for its fair market value. For real property assets, basis is the term given to the price that was originally paid for the property, plus any capital improvements, less depreciation.
Do not confuse capital gain with equity. The two terms cannot be compared with each other. Equity is the amount of money you have left over after you have sold the property and paid off all related liabilities and mortgages. As an example lets say you bought a property for $200,000 five years ago, it has a mortgage of $130,000 and has a basis of $166,667. If you sold that property today for $400,000, and paid out $30,000 in closing costs and commissions, you have equity of $240,000 (the amount of cash you would get out of the closing). However your capital gain on this property would be the difference between your basis: $166,667 and your adjusted sales price of $370,000 (Price: 400k – Costs: 30k = 370k), in this case $203,333. If this sale is not turned into 1031 Exchange, there will be capital gains tax owed on the entire gain. At the base federal rate of 15%, that’s $30,499.95 due in federal taxes alone. Be careful here if you have refinanced since your original purchase, it is in this area you want to be very cautious not to trap yourself. In a situation like this you are almost obligated to exchange unless you have the additional funds to pay the taxes. For example, a taxpayer buys property for $100,000 with a mortgage of $70,000. Later its value increases to $210,000 and the taxpayer refinances with a new mortgage of $140,000.If the taxpayer sells this property for $210,000 and does not use a 1031 Exchange, the gain of $110,000 will require the payment of $16,500 in federal taxes alone. (Sale price: 210,000 - Basis: 100,000 = Gain: 110,000 x Federal Cap Gains tax: 15% = Taxes due 16,500) The larger the transactions and the more money and leveraging involved the greater tax burden of cashing out. The advice of your tax advisor is priceless in this instance.
The catalyst which transforms the ordinary purchase and sale of property into an exchange, the Qualified Intermediary is a crucial component of a valid and successful 1031 Exchange. In order for a 1031 Exchange to qualify under the “safe harbor“ Regulations, there must be a written agreement between the taxpayer and the intermediary stating the seller’s intent to exchange and expressly limiting the taxpayer's rights to receive, pledge, borrow or otherwise obtain the benefits of the money or property held by the intermediary. The intermediary can act with respect to the property as the agent of any party to the transaction and further, an intermediary is treated as entering into an agreement if the rights of a party to the agreement are assigned to the intermediary and all parties to the agreement are notified in writing of the assignment on or before the date of the relevant transfer of property. This provision allows a taxpayer to enter into an agreement for the transfer of the relinquished property (i.e., a contract of sale on the property) and thereafter to assign his rights in that agreement to the intermediary. Providing all parties to the agreement are notified in writing of the assignment on or before the date of the transfer of the relinquished property, the intermediary is treated as having entered into the agreement and, upon completion of the transfer, as having acquired and transferred the relinquished property. The Qualified Intermediary does not provide legal counsel or offer specific tax advice to the exchanger, but will usually perform the following services:
- Coordinates with the exchangers and their advisors, to structure a successful exchange.
- Prepares the documentation for the Relinquished Property and the Replacement Property.
- Furnishes escrow with instructions and documents to effect the exchange.
- Secures the funds in an insured bank account until the exchange is completed.
- Provides documents to transfer Replacement Property to the exchanger, and disburse exchange proceeds to the closing.
- Holds the document of Identification of Replacement Properties sent by the Taxpayer.
- Submits a full accounting of the Exchange for the taxpayer’s records.
- Submits a 1099 to the taxpayer and the IRS for any growth proceeds/interest earned by exchange funds and paid to the taxpayer.
The Basic Rules of a 1031 Exchange
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to watch the 1031 Basics Presentation.