The Internal Revenue Code (IRC), 1031 Exchange is a tax-management tool that applies to commercial investment property. Often it is referred to as tax free....the truth is, it is not tax-free but tax deferred. The rules for an exchange are complicated and if you elect to use this tool consult a qualified real estate or tax professional.
As an example let's look at Don's situation. He has a warehouse, in Port Charlotte, Florida that his friend Frank would like to purchase for $280,000. Don would like to sell this asset but given his current tax situation it would not be prudent to sell the property at this time according to his accountant.
Don paid $120,000 for the property 8 years ago. If he sells the property for $280,000 he would have significant taxable gain. Frank suggests that Don consider a 101 Exchange.
How does a 1031 Exchange work?
The seller exchanges his commercial property for other commercial property using specific (IRC) guidelines. The properties exchanged must be of like-kind, i.e. of the same nature of character even if they differ in grade or quality.
Sellers should view tax-deferred exchanges as a viable tax-planning tool. Property structured tax deferred exchanges can defer significant gain and the corresponding tax liabilities.
Sellers do not need to enter into a simultaneous exchange, which, more often than not, is nearly impossible to effectuate. Tax deferred exchanges under Section 1031 of the IRS code allow taxpayers a reasonable period of time in which to complete a tax-deferred transaction.
To elect a 1031 recognition a taxpayer must identify the property for exchange, which, more often than not, is nearly impossible to effectuate. Tax deferred exchanges under Section 1031 of the IRS code allow taxpayers a reasonable period of time in which to complete a tax deferred transaction.
Cash to equalize a transaction cannot be deferred under Code Section because it is not of like. This cash is call "boot", and is taxed at normal capital gains rate.
When seeking replacement property, it is advantageous to identify more than one property in the event that the primary property cannot be acquired. The regulations provide that the seller must meet any one of the following three alternatives for property identification:
- One to three properties without regard to the fair market value.
- Any number of properties, provided that the aggregate fair market value does not exceed 200 percent of the relinquished property.
- Any number of properties as long as the acquisition of the replacement property represents 95 percent of the identified properties. (e.g., If you identify 2,000,000 in replacement property and purchase $1,900,000.)
Of the three alternatives, the "three property rule" is the one most sellers choose.
For more information on 1031 Exchanges, consult your qualified Real Estate Professional or visit; http://www.law.cornell.edu/uscode/text/26/1031