Under Section 1031 of the United States Internal Revenue Code (26 U.S.C. § 1031), the exchange of certain types of property may defer the recognition of capital gains or losses due upon sale, and hence defer any capital gains taxes otherwise due.
To qualify for Section 1031 of the Internal Revenue Code, the properties exchanged must be held for productive use in a trade or business or for investment. Stocks, bonds, and other properties are listed as expressly excluded by Section 1031 of the Internal Revenue Code, though securitized properties are not excluded. The properties exchanged must be “like-kind”, i.e., of the same nature or character, even if they differ in grade or quality. Personal properties of a like class are like-kind properties. Personal property used predominantly in the United States and personal property used predominantly elsewhere are not like-kind properties.
Real properties generally are of like-kind, regardless of whether the properties are improved or unimproved. However, real property in the United States and real property outside the United States are not like-kind properties.
Taxpayers may wonder whether items such as equipment used on a property are included in the lump-sum sale of the property, and if they are able to be deferred. Under Treasury regulation §1.1031(k)-1(c)(5)(i), property that is transferred together with the larger item of value that does not exceed 15% of the fair market value of the larger property does not need to be identified within the 45 day identification period but still needs to be exchanged for like kind property to defer gain.
Cash to equalize a transaction cannot be deferred under Code Section 1031 because it is not like-kind. This cash is called “boot” and is taxed at a normal capital gains rate.
If liabilities assumed by the buyer exceed those of the seller (taxpayer), the realized gain of the seller will be not only be realized, but recognized as well. If however, the seller assumes a greater liability than the buyer, the realized loss cannot offset any realized and recognized gain of receiving boot such as cash or other personal property considered boot.
Originally, 1031 cases needed to be simultaneous transfers of ownership. But since Starker vs. U.S. (602 F.2d 1341), a contract to exchange properties in the future is practically the same as a simultaneous transfer. It is under this case, decided in 1979, that the rules for election of a delayed 1031 originated. To elect the 1031 recognition, a taxpayer must identify the property for exchange before closing, identify the replacement property within 45 days of closing, and acquire the replacement property within 180 days of closing. A Qualified Intermediary must also be used to facilitate the transaction.
The following sequence represents the order of steps in a typical 1031 exchange:
Step 1. Retain the services of tax counsel/CPA. Become advised by same.
Step 2. Sell the property, including the Cooperation Clause in the sales agreement. “Buyer is aware that the seller’s intention is to complete a 1031 Exchange through this transaction and hereby agrees to cooperate with seller to accomplish same, at no additional cost or liability to buyer.” Make sure your escrow officer/closing agent contacts the Qualified Intermediary to order the exchange documents.
Step 3. Enter into a 1031 exchange agreement with your Qualified Intermediary, in which the Qualified Intermediary is named as principal in the sale of your relinquished property and the subsequent purchase of your replacement property. The 1031 Exchange Agreement must meet with IRS Requirements, especially pertaining to the proceeds. Along with said agreement, an amendment to escrow is signed which so names the Qualified Intermediary as seller. Normally the deed is still prepared for recording from the taxpayer to the true buyer. This is called direct deeding. It is not necessary to have the replacement property identified at this time.
Step 4. The relinquished escrow closes, and the closing statement reflects that the Qualified Intermediary was the seller, and the proceeds go to your Qualified Intermediary. The funds should be placed in a separate, completely segregated money market account to insure liquidity and safety. The closing date of the relinquished property escrow is Day 0 of the exchange, and that’s when the exchange clock begins to tick. Written identification of the address of the replacement property must be sent within 45 days and the identified replacement property must be acquired by the taxpayer within 180 days.
Step 5. The taxpayer sends written identification of the address or legal description of the replacement property to the Qualified Intermediary, on or before Day 45 of the exchange. It must be signed by everyone who signed the exchange agreement, and it may be faxed, hand delivered, or mailed either to the Qualified Intermediary, the seller of the replacement property or his agent, or to a totally unrelated attorney. Send it via certified mail, return receipt requested. You will then have proof of receipt from a government agency.
Step 6. Taxpayer enters into an agreement to purchase replacement property, again including the Cooperation Clause. “Seller is aware that the buyer’s intention is to complete a 1031 Exchange through this transaction and hereby agrees to cooperate with buyer to accomplish same, at no additional cost or liability to seller.” An amendment is signed naming the Qualified Intermediary as buyer, but again the deeding is from the true seller to the taxpayer.
Step 7. When conditions are satisfied and escrow is prepared to close and certainly prior to the 180th day, per the 1031 Exchange Agreement, the Qualified Intermediary forwards the exchange funds and growth proceeds to escrow, and the closing statement reflects the Qualified Intermediary as the buyer. A final accounting is sent by the Qualified Intermediary to the taxpayer, showing the funds coming in from one escrow, and going out to the other, all without constructive receipt by the taxpayer.
Step 8. Taxpayer files form 8824 with the IRS when taxes are filed, and whatever similar document your particular state requires.