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The 1031 Exchange: How to Max Your Tax Deferral

by | Feb 14, 2020 | Real Estate Law |

“Tax-deferred like-kind exchange.” Commonly known as the 1031 exchange. Unlike other four-digit numbers from the IRS that cause distress, a 1031 exchange can provide you with many benefits. Although riddled with requirements, Ohnstad Twichell is here to help with your 1031 needs. A brief primer on the issue can help decide if a 1031 can benefit you.

A 1031 exchange, named after Section 1031 of the Internal Revenue Code as amended in 1954,[1] allows you to defer capital gains tax when you sell real property.  By completing a 1031 exchange, you will have immediate savings in the year of the sale by avoiding the otherwise-due capital gains tax on sales proceeds.  Further, you may be able to pay reduced taxes by deferring the taxes until a year where you are in a lower tax bracket.  Finally, you may be able to completely eliminate the capital gains tax. If you are able to defer until your death, where a step-up in basis is given, the property can be sold for fair market value without any capital gains tax due. An old proverb of the 1031 exchange industry is to “defer, defer, defer, and then die.” A 1031 exchange is the vital component to start and continue, the deferral process.

To qualify for a 1031, the IRS requires that the real property you sell be held for “productive use in a trade or business or for investment.”[2] In short, you must have owned the property to turn a profit.  For example, the house you live in will not qualify for a 1031, as your primary use of the house is as your residence. However, property that is held to produce an income, such as farmland that you farm yourself or cash rent to tenants, or an apartment house that you lease to others, both qualify for 1031 exchanges.

Normally, upon your sale of these properties, you would pay capital gains tax on the difference between the sale price and your “basis”[3] in the property. If you have owned the property for a long time, the sales price may be tens or hundreds of thousands more than your original purchase price of the property: the IRS would take up to 20% of this amount via the capital gains tax.  By completing a 1031, you are able to delay the payment of these taxes by rolling over your sales proceeds into a new “like-kind” property.[4] “Like-kind” property is a broad term that includes all properties of the same nature or character.[5] Generally, any property that can be once again held for business use, that is, to turn a profit, will qualify.

There are two main types of 1031 exchanges you can utilize to defer the tax payment: the simultaneous exchange (otherwise known as a “swap”) and the delayed exchange.   In a simultaneous/“swap” exchange, both parties exchange their property at the same time.  So long as no cash is exchanged between the parties, there is no capital gains tax due. In short, as neither party ever “touched” any funds or had the benefit of accessing any sales proceeds, there are no capital gains to recognize. The basis in the new property of each party would remain the same as the basis in their old property.

The second type is the most common type of exchange: the delayed exchange.  In this exchange, a party (the “Exchanger”) works with a Qualified Intermediary, otherwise known as a “QI,” to complete the sale of the Exchanger’s property.  An agreement is put in place that requires the Exchanger and the QI to comply with the IRS requirements. In short, the QI agrees to step into the shoes of the Exchanger and complete the sale of the property. Most importantly, the parties agree that the sale proceeds will be held by the QI, and the Exchanger is denied access to them.  The IRS requires this vital step to classify this sale as a tax-deferred exchange, rather than a sale. By the QI serving as the middle-man and holding the cash proceeds, the Exchanger never “touches” the funds. If the Exchanger were to hold the funds themselves or have any form of access to them, the 1031 would fail and the IRS would classify it as a sale.  As a result, capital gains tax would be due on the full sales proceeds.

After the sale is completed and the QI is holding the sale funds, the QI steps into the shoes of the Exchanger once more and completes the purchase on their behalf.  To purchase the new property, the QI uses the held sales proceeds, directly transferring them to the seller.  Once again, the Exchanger cannot have direct access to the funds, which is accomplished by the use of the QI.  At the end of the transaction, the Exchanger is the owner of new property that was purchased using their original sales proceeds.  As the Exchanger never “touched” the sales proceeds, via the use of the QI, the IRS allows for the deferral of the capital gains tax.  The basis of the Exchanger’s original property is thus transferred to their new property, and the capital gains tax is delayed until a future sale.

A third type of 1031 exchange, the reverse exchange, is also possible. In this exchange, the new property is purchased before the old property is sold.  Once again, an Exchanger works with a QI who steps into their shoes for each transaction.  Through the use of temporary title holders, the Exchanger is able to purchase a new property without ever holding title to both the old and new properties at the same time. Once again the sale proceeds are rolled over into the new property. Due to the complexity of this type of 1031 exchange, it is less commonly used.

In addition to the qualifications for the property to be sold and the “like-kind” property to be purchased, there are numerous other requirements set forth by Section 1031.  Using the most common delayed exchange as an example, upon the sale of the Exchanger’s original property, the Exchanger has 45 days to identify what new property will be purchased. In addition, the Exchanger has 180 days after the sale to complete the purchase of their new property.

There are other requirements too numerous to mention concerning all of the aspects of a 1031 exchange.  The planning and execution of a 1031 exchange is crucial to ensure that you defer the most tax and maximize your gain. Ohnstad Twichell, P.C. has specialized and dedicated experts available to assist you with your 1031 exchange from start to finish.  Please contact us to schedule an appointment to start deferring your taxes today.

*Disclaimer: This article’s content is for general information purposes only. Readers should not rely on this article as legal or tax advice. Laws, regulations, and information change frequently, and the article’s content may not be current. This law firm makes no warranties, guarantees, or representations about the content of his article.  Readers should consult with a licensed attorney in his or her state concerning his or her own situation with regard to the reader’s specific legal or tax questions.

[1] 26 U.S.C. § 1031

[2] 26 U.S.C. § 1031(a)(1)

[3] Generally, your basis is the purchase price of the property, plus any improvements, less any depreciation.

[4] 26 U.S.C. § 1031(a)(1)

[5] Treas. Reg. § 1.1031(a)-1(b).