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The Basics of 1031 Exchange
You are here:   Real Estate Sales and Auctions  »  Real Estate Services  »  The Basics of 1031 Exchange

Most individuals have heard the terminology "like kind exchange" or 1031 exchange.  These two phrases are used interchangeably.  Whether someone calls the transaction a "like kind exchange" or a 1031 exchange, this form of transaction can be very beneficial to a taxpayer.  Therefore, it is important to understand 1031 exchanges.

The name 1031 exchange comes from the Internal Revenue Code Section which allows for like kind exchanges and the deferral of gains. 1031 of the Internal Revenue Code is titled "Exchange of property held for productive use or investment."

So, what exactly is a 1031 exchange? In the simplest terms a 1031 exchange is a transaction in which one investment is exchanged for another investment.  The most attractive part of a 1031 exchange is the deferral of the gain on the transaction. However, there are many requirements to meet for a transaction to qualify as a 1031 exchange.
 

  

Requirements
The first requirement is the property being exchanged must be held for "productive use in a trade or business or for investment."  For example, if a taxpayer owned a vacation property used for personal use, the vacation property would not qualify for a like kind exchange. The property must be used for business. Therefore, a rental property would qualify since it is used for a business/investment purpose.  Therefore, it is important to understand how the property in question is used.

The next requirement for a successful like kind exchange is the property must be exchanged for like kind property. This does not mean if the property is an apartment building used as a rental the new property has to be an apartment building used as a rental property. The properties involved in the exchange must be of the same nature or character. Therefore, real property must be exchanged for other real property. Likewise, personal property must be exchanged for other personal property.   

Generally, it is fairly easy to exchange personal property and for it to meet the requirements of 1031. For example, a taxpayer has a piece of equipment he would like to upgrade. The taxpayer is able to take the piece of equipment to an equipment dealer and trade in the piece of property for another piece of property. The taxpayer will most likely pay additional cash or take out a loan for the difference between the value of the property received and the property given up since he is upgrading the equipment. However, if the value of the property received is less than the value of the property given up and the taxpayer receives cash for the difference a gain will be recognized by the taxpayer.   

Anytime a taxpayer receives cash in a 1031 transaction, he is required to recognize a gain. Also, if the taxpayer receives unlike property, gain will be recognized. A common term used when dealing 1031 exchanges is "boot". Boot means cash or any non-like-kind property. Therefore, when boot is received by the taxpayer, he will recognize a gain.  

1031 exchanges become more complicated when the taxpayer is not able to easily trade or swap one piece of property for another. A taxpayer may decide he would like to exchange a piece of farm land for another piece of farm land. However, he is unable to find anyone who would be interested in completing an exchange with him. He has found someone interested in purchasing the land he currently owns. It is still possible for the taxpayer to complete a deferred exchange under 1031.  

The Internal Revenue Code provides guidelines on how a transaction or series of transactions will qualify as a like kind exchange under 1031. If the taxpayer has a purchaser for his farm land, the first consideration he must take into account is the fact that if he receives cash then a gain is recognized. Furthermore, if the taxpayer receives the proceeds for the farm land he has given up in the transaction, the transaction no longer qualifies as a 1031 exchange. In fact, the transaction is now considered a sale and the entire gain must be recognized by the taxpayer.  Therefore, it is important that the taxpayer does not receive money from the transfer of the property.  

1031(k)-1(g) provides safe harbors that "the use of which will result in a determination that the taxpayer is not in actual or constructive receipt of money or other property for purposes of section 1031." Therefore, it is critical the taxpayer meets the safe harbors in order for the transaction to qualify as a like kind exchange und 1031. One of the common used safe harbors is hiring a qualified intermediary. The qualified intermediary has many duties. One of the duties is holding the cash received on the transfer of the taxpayer's original property until the replacement property is transferred. This takes the question of whether or not the taxpayer actually or constructively received money or other property out of the equation.

1031 also provides specific timing requirements for like kind exchanges to qualify. The taxpayer must identify the like kind property to be received within 45 days of transferring the original property. The identified property must be received the earlier of 180 days after transferring the original property or the due date including extensions of the taxpayer's federal income tax return. The taxpayer and his advisors must pay careful attention to the timing of the identification and transfer of the replacement property.  Missing one of these deadlines by even one day causes the transactions to not qualify as a 1031 exchange. Therefore, instead of having a tax deferred exchange the taxpayer now has a gain to recognize and tax to pay on the gain.

Another option available to the taxpayer is a reverse exchange.  A reverse exchange occurs when the taxpayer finds a replacement property and takes title prior to relinquishing the original property.  The IRS has issued Revenue Procedures 2000-37 and 2004-51 for guidance on reverse exchanges including safe harbor requirements which allow reverse exchanges to be treated as like kind exchanges.

Like-kind exchanges are reported to the IRS on Form 8824 and attached to the taxpayer's income tax return. On Form 8824 the taxpayer includes descriptions of the property given up and received, dates of acquisition, transfer, identification and receipt of property, related party exchange information, and calculations of realized gain or loss, recognized gain, deferred gain or loss and basis of like-kind property received.
 

  

Benefits for Taxpayer
A like-kind exchange has many benefits for a taxpayer. The first has already been mentioned, which is deferral of gain recognition. This of course also defers the payment of tax on the transaction. The gain will be recognized when the replacement property is sold or the taxpayer could engage in another like-kind exchange and defer the gain further. There is even the possibility of the gain not being recognized at all. If the taxpayer passes away and the property is part of his estate, the property will qualify for a step up in basis and pass to the heirs with the fair market value at the taxpayer's date of death as the heirs' basis in the property.

The deferral of taxes does provide an additional benefit. It allows the taxpayer to have more equity in the new property. Instead of paying the tax on the gain and reducing what is left over to invest in new property the money that would be used for taxes remains as part of the investment.
 

  

Conclusion
There are many requirements to meet in order to have a successful like kind exchange.  It is important to know the requirements of 1031 of the Internal Revenue Code.  Imagine a taxpayer planning on a successful 1031 exchange occurring; yet, the transaction does not qualify because one of the requirements was not met. Instead, he would recognize the gain on the transaction and pay taxes related to the gain on the transaction. Most likely, this taxpayer would be disappointed or even angry that he did not receive the benefits of deferring the gain on the transaction. Therefore, it is important to know the requirements to assist a client through the 1031 process.
 

  

Checklist
Use the following checklist to determine if a 1031 exchange would be ideal for a particular situation. If any of the questions are "No" then an exchange is not a viable option. 
 

Question  

Yes 

No  

Does the individual own property he would be interested in disposing of or selling? 

  

  

Is the property used for a business purpose? 

  

  

Does the individual wish to continue in a trade or business? 

  

  

Would the individual be interested in owning a different property of the same nature or character? 

  

  

Would the individual be interested in utilizing the different property in a trade or business? 

  

  

The individual does not need cash from the sale of his property? 

  

  

  

Questions and Contact 

If you have any questions, please contact Randy Dickhut, Senior Vice President of Real Estate Operations, at (402) 496-3276. 

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