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1031 Exchange

 

The Tax Deferred or 1031 Exchange

by Paul T. Schemel, MBA; JD

Section 1031 of the Internal Revenue Code offers the individual or corporate taxpayer an opportunity to defer capital gain taxes on the sale of investment property so long as the taxpayer reinvests their equity in the property sold into new investment property. This is commonly referred to as a 1031 Exchange and if you own investment property, whether it be real estate or personal property, you should be considering the potential of this tax-saving devise.

A 1031 Exchange works by allowing the taxpayer to roll the proceeds of a sale of investment property into new investment property. By utilizing the 1031, the taxpayer does not pay capital gain on the sale, rather they defer the capital gain. The deferral is an assignment of the tax basis in the property sold or "relinquished" property over into the new property or "replacement" property. For example, if you purchased property in 1992 for $100,000, sell the relinquished property in 2004 for $175,000 and with the proceeds of the sale purchase replacement property for $175,000, your tax basis in the replacement property will be $100,000 not the $175,000 which you paid for the property.

Although retaining the low basis in the replacement property may initially sound undesirable, in the short term you save the significant capital gain taxation on the appreciation of the property. In the example that I provided above, the amount that would be subject to capital gain taxation would be $75,000. Aside from just savings on capital gain taxation, 1031 exchanges also give the taxpayer the opportunity to exchange fully depreciated property for property that can be depreciated or to either consolidate or diversify their property holdings.

For those instances when you have to purchase the replacement property before you have sold the relinquished property, you can take advantage of a reverse exchange. In a reverse exchange the replacement property is temporarily titled or "parked" in an intermediary while the relinquished property is sold. Reverse exchanges are more complicated than regular or "forward" exchanges but they offer the same deferral of capital gains.

1031 Exchanges can apply to most investment property, so long as the replacement property is of a "like kind" to the relinquished property. Fortunately, the IRS has applied a liberal standard of evaluation to the "like kind" nature of real estate. For example, a vacant lot can be exchanged for an improved lot or a farm can be exchanged for an apartment building. In general, any investment real estate can be exchanged for other investment real estate. You can also exchange one relinquished property for multiple replacement properties. Unfortunately, the exchange of personal property is more restrictive. A cow cannot be exchanged for a bull and a machine press cannot be exchanged for a threading machine. Typically, 1031 exchanges are for real estate because equipment and inventory tends to depreciate rather than appreciate in value.

In order to avail yourself of the 1031 exchange provisions, certain requirements set out in the Code must be carefully followed. For example, you cannot receive any funds from the sale of the relinquished property, all proceeds of the sale are escrowed with an intermediary who will ultimately pay the funds over directly to the settlement agent for the purchase of the replacement property. Also, once the relinquished property is sold, replacement property must be formally identified within 45 days and final settlement must be held within 180 days. Various written documents must be prepared to properly evidence the exchange. The IRS will scrutinize exchanges carefully and any departure from the Code will invalidate the exchange.

If you believe that you could benefit from a 1031 exchange, or would just like to learn more about them please give us a call and consult with your accountant. This tax-saving devise could save you significant and unnecessary taxes and provide you with flexibility that you may have never known you have.

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