I. Property Held for Productive Use in a Trade or Business or Held for Investment
In order to qualify for like-kind exchange treatment, the property must be “held for productive use in a trade or business or for investment.” This requirement excludes property held for sale to customers in the ordinary course of business or owned by a “dealer” whose activities “taint” his property from qualification under this section. The acquired property must also be held for one of these qualified purposes.
II. “Like-Kind” Property
Property of a like-kind does not mean property of the precise same type (e.g., an apartment building exchanged for an apartment building). The only requirement is that the property exchanged must be real property for real property, or personal property (with exclusions of certain types of personal property) for personal property. This rule permits the exchange of improved realty for unimproved realty. A long-term lease of real estate (exceeding 30 years) qualifies as real property for exchange purposes.
What Properties Qualify?
This area can be very confusing. Very simply, any real estate used for business, trade or investment purposes will qualify. Examples include apartments, office buildings, multiplexes, single family or condo rentals, raw land, farms ranches, and commercial and industrial complexes. All of these qualify! A lot adjoining a primary residence can also qualify if it is considered investment property.
Mix and Match
You are not restricted to exchanging for property similar or identical to your present property. The IRS allows you to trade raw land for an apartment building, a commercial mall, or a condo rental property, as long as the transaction is structured as an exchange. Provided you sell or exchange real property used for business, trade or investment purposes, you can buy (exchange it for) any other type of business, trade or investment properties. For example, you can sell your self-operated gas station and buy an apartment building and pay no taxes!
What Properties Don’t Qualify?
Internal Revenue Code Section 1034 concerns your personal residence. The home you live in will not qualify for an exchange because you cannot mix IRC Sections 1031 with 1034. In other words, you cannot sell your home and use the proceeds to buy business or investment property without paying capital gains taxes if the gain exceeds $250,000 ($500,000 for married couples). Nor can you sell business or investment properties and buy a primary residence that you intend to live in shortly after acquiring it without paying capital gains taxes. There is however, nothing to preclude you from buying a home that you intend to use as a principal residence in the future and using it as a Qualified Rental Property now for the purpose of the exchange. Remember, all of the properties you exchange for and exchange into a Tax Deferred exchange must be trade, business or investment related.
Certain properties are specifically excluded from the non-recognition rules of IRC Section 1031. The rules do not apply to an exchange of:
- Stock, in trade or other property held primarily for sale;
- Stocks, bonds or notes;
- Other securities or evidences of indebtedness or interest;
- Interests in a partnership (subject to election under subchapter “K”)
- Certificates of trust or beneficial interest;
- Chooses in action (Lawsuits)
Combine Section 1031 with Homeowner Exemption
III. “Boot” And Depreciation
Any money received in a like-kind exchange is considered “boot” and is recognized and taxed to the extent received. “Boot” is the cash or other consideration including relief from indebtedness that benefits a party to an exchange when the items exchanged do not have equal equities.
If gain is recognized, depreciation will be recaptured (“if applicable”) first to the extent that any gain is recognized until the depreciation is fully recaptured.
IV. Non-Simultaneous Exchanges Or Delayed Exchanges (Previously Called Starker Exchanges)
In many instances a typical three party exchange is not workable because exchange property has not yet been identified. Prior to the decision of the Ninth Circuit Court of Appeals in Starker v. United States, 602 F 2d 1341 (9th Cir. 1979), a method to achieve the same result was to permit the cash buyer the right to use the property with an exchange option, until appropriate exchange property could be identified. The Starker case permitted a more attractive alternative structure. In Starker the taxpayer transferred approximately $1,000,000.00 worth of real property to Crown Zellerbach under an agreement which provided that Crown Zellerbach would credit the taxpayer with approximately $1,000,000.00 on its books and locate suitable exchange property to be transferred to the taxpayer over a period of five years. If suitable exchange property could not be located then the taxpayer would be entitled, at the end of five years, to the remaining cash balance of the bookkeeping account as well as a “growth factor” of six percent per annum. The Ninth Circuit held that the “growth factor” was currently taxable as ordinary income, but the overall exchange deferred the capital gain.
It should be noted that the structure of this transaction studiously avoided any argument of constructive receipt of cash or its equivalent by the taxpayer. The taxpayer was not entitled to receive any funds and could only accept property for a five year period and the funds were not held in trust or otherwise for the taxpayer. A large part of the decision in the Starker case rests in the substantial financial resources of Crown Zellerbach upon which the taxpayer relied in making the tax deferred exchange.
V. Non-Simultaneous Exchanges and the Tax Reform Act Of 1984
The Tax Reform Act of 1984 imposed limits on the length of time Starker type transactions may be open and further requires that the property to be received in the exchange be identified within 45 days of the original transfer. The like-kind property must then actually be received within 180 days of the original transfer or, if earlier, by the due date of the tax return for that year (including extensions).
VI. Reverse Exchanges
In a “reverse exchange,” before the relinquished property is sold, the replacement property is acquired and placed with a Qualified Intermediary who holds it as title holder until the relinquished property is sold to a third party buyer. With this reverse exchange, the taxpayer preserves the 1031 exchange tax benefits by then receiving the replacement property at the same time the relinquished property is sold. During the time period between the purchase and exchange, the replacement property is net-leased to the taxpayer.
Click here to learn more at Wachovia Corporate & Institutional – Reverse Exchanges
There are two types of reverse exchanges:
Safe harbor
In the fall of 2000, the IRS issued a Revenue Procedure (2000-37) which provides a safe harbor for reverse exchanges. This outlines the necessary requirements and procedures to provide taxpayers with a “safe harbor” for the structure of a reverse exchange in limited circumstances. The taxpayer must still be wary of the time limits, and must settle on the relinquished property within 180 days of the time the taxpayer settled on the replacement property.
Non-safe harbor
Transactions which are “non-safe harbor” are significantly more complex, and therefore require additional planning and structuring on behalf of the taxpayer.
VII. The Role of A Facilitator And Qualified Intermediary And The Tax Reform Act Of 1987
The Tax Reform Act of 1987 and the demise of capital gains treatment caused renewed interest in exchanging. However, most two party exchanges are not completed because it is difficult to find target properties with suitable valuations and still comply with the strict time limitations of identification and closing. A need arose for a facilitator that could assure compliance with the statute.
A qualified intermediary is a person who: a) is not the taxpayer or a disqualified person, and b) acts to facilitate the deferred exchange by entering into a written agreement with the taxpayer for the exchange of properties pursuant to which such person 1) acquires the relinquished property from the taxpayer, 2) transfers the relinquished property (either on its own behalf or as an agent of any party to the transaction), 3) acquires the replacement property (either on its own behalf or as the agent of any party of the transaction) and 4) transfers the replacement property (either on its own behalf or as an agent of any party to the transaction) to the taxpayer. The qualified intermediary does not have to take legal title to either the relinquished property or the replacement property.
By using a qualified intermediary, an exchanger can complete the sale of its own property and take advantage of the time provided in the code to complete a tax deferred exchange.
Click here to learn more about a Realty Exchange
VIII. Related Party Transactions
Please refer to the link for up-to-date information on “Related Party Transactions
