Since 1921, federal tax law under section 1031 of the Internal Revenue Code (IRC) has allowed a taxpayer to exchange assets or real estate for other similar assets or real estate without recognizing taxable profits from the sale of the old assets. Taxes that would otherwise have been due from the sale are therefore deferred. Most 1031 exchanges involve separate buyers and sellers and are not simply exchanges between two parties. In these circumstances, the use of a Qualified Intermediary (QI) independent of a third party is required to fulfill the “exchange” requirement. The QI retains the proceeds of the sale for the benefit of the taxpayer during the exchange, pays the funds for the purchase of replacement properties of the same type, and returns the unused funds to the taxpayer upon completion of the exchange. 1031 The exchange must be completed within 180 days. Taxpayers record profits and taxes on unused funds or when they eventually “pay off” their property. In 2018, section 1031 was changed to include only properties for a 1031 exchange.

Tax-deferred exchanges are defined in IRC section 1031. Since 1921, Section 1031 has allowed a taxpayer to exchange assets or fixed assets for other similar assets or fixed assets without recognizing taxable income on the sale of old goods. Taxes that would otherwise have been due from the sale are therefore deferred. Transactions in section 1031 range from two-party exchanges to more complex non-simultaneous 1031 exchanges involving separate buyers and sellers. Eligible assets include commercial, agricultural and rental properties. Non-simultaneous foreign exchange taxation rules require the use of an independent qualified intermediary (QI). The QI retains the proceeds of the sale for the benefit of the taxpayer during the exchange, pays the funds for the purchase of replacement properties of the same type, and returns the unused funds to the taxpayer upon completion of the exchange. § 1031 The exchange must be completed within 180 days. Taxpayers record profits and taxes on unused funds or when they eventually “pay off” their property.

All corporations, manufacturers, real estate investors, farmers, individuals and more use 1031 exchanges. 1031 grants of the same type are one of the few incentives available and used by taxpayers of all sizes. A recent industry survey found that 60% of trades are in real estate under $ 1 million and more than a third are worth less than $ 500,000. Qualified Intermediaries (QIs) allow taxpayers of all sizes, from people with modest means to wealthy taxpayers and from small businesses to large corporations, non-simultaneous trading with tax deferral of investments and commercial real estate.

After a similar exchange, the owner of a commercial or investment property (“investor”) will have more capital to purchase a replacement property. This can lead to an increase in cash flow and / or a greater potential for asset appreciation. Additionally, the economy benefits from the fact that the investor cannot get a full tax deferral without fully investing in the replacement property. Transactions generate taxable income in the form of real estate and fiduciary fees, real estate fees, legal and accounting fees, and the purchase of goods and services when the replacement property is restructured. State and local governments also benefit from fees and taxes incurred for real estate transactions. Because real estate abroad is not like real estate in the United States, Section 1031 encourages reinvestment and job growth within our US borders.

A “reverse” exchange occurs if the taxpayer acquires the replacement property prior to the transfer of the assigned property. A “pure” reverse exchange is not allowed, where the taxpayer simultaneously owns both the transferred property and the replacement property. The IRS has provided guidance on how to structure a reverse exchange and provides a safe haven under Procedure Rev. 2000-37. An Exchange Accommodation Owner (EAT) acquires and maintains the destination property (the parked property) in a separate special purpose vehicle, generally an individual member of the LLC (EAT and LLC are collectively referred to as “EAT”). To complete a reverse exchange, the EAT assumes ownership of the transferred property or the replacement property as part of a “Qualified Accommodation Exchange Agreement” (QEAA).

“Boot” has nothing to do with shoes and refers to personal items and / or cash needed to make up for an exchange. The boot is property received in an exchange, but not like any other property acquired in an exchange transaction. The boot is defined as the “fair market value” of an unqualified property that is obtained in a trade-in. While receiving the boot does not disqualify the trade, an exchanger who receives the boot in an exchange transaction will generally recognize a payout equal to the value of the boot received.

There is a double test for real estate to qualify for IRC tax deferral §1031.

1. Both abandoned and replacement properties must be held by the exchanger for investment or productive use in a business or enterprise. The purpose and intention of the exchanger to retain ownership is the critical test. The use of the property by other parties involved in the exchange (buyers of abandoned properties or sellers of replacement properties) is irrelevant.
2. The “Abandoned” and “Replace” properties must also be “similar”. The term “like” refers to the type or character of the property, ignoring any quality or difference in quality. For example, a property that has not improved is considered equivalent to an improved property because the lack of improvement is a distinction between quality or quality. The basic real estate character of both properties is the same. Fiance. Reg. §1.1031 (a) -1 (b). In essence, all real estate in the United States is “like” any other residential property.

The seller cannot receive or control the net sales proceeds – the proceeds must be deposited with a qualified intermediary.

The replacement property MUST be:

1) “like-kind” to Assigned Property – Both the assigned and replacement property must have been held for investment purposes or for productive use in a business or business.

2) identified within 45 days of the sale of the original property

3) Purchased within 180 days of the sale of the original property

The money invested in the replacement property must be at least equal to the money received from the sale of the assigned property.

The debt placed or assumed on the replacement property must be equal to or greater than the debt received by the transferred property.

This is a summary of some of the key guidelines for a Section 1031 transaction, but it is not an exhaustive list. The costs associated with an exchange under Section 1031 can affect the performance and outweigh the tax benefits of the transaction. Each prospective investor should consult their own tax adviser regarding the qualifications of a particular transaction under Section 1031.