You have probably heard of “like kind” or “tax free” exchanges in reference to real estate transactions. Normally, when an asset is sold, tax must be paid on the difference between the amount received on the sale less the taxpayer’s “basis” in the property (the investment in the property, with some adjustments). Section 1031 of the Internal Revenue Code permits a taxpayer to defer paying tax on this amount if the proceeds are instead applied towards the purchase of property of “like kind.”
The potentially huge tax benefits have given the practice its own nickname – “1031 exchanges.” It is important to plan these 1031 exchange transactions in advance to meet strict requirements. Typically, a qualified intermediary is used to hold the sale proceeds until the replacement property is purchased. Replacement assets must be identified within 45 days, and closing on the purchase must occur within 180 days. The replacement property must be of value that is equal to or greater than the relinquished property, or a portion of the transaction may be taxable.
Did you also know these lesser-known facts about 1031 exchanges?
• Something like an airplane could qualify for a 1031 exchange. When you do a 1031 deal, the replacement property must be of like kind, meaning the same broad category of asset. Investment real estate for investment real estate is the most common. But taxpayers can defer the taxable gain on the sale of most types of capital assets with a few notable exceptions such as stocks, bonds, partnership interests, or notes. In other words, the exchange of a valuable non-real estate asset –such as an airplane – is eligible.
• A taxpayer often has difficulty identifying a property of roughly equivalent value within the time frame specified. One potential solution is to have the taxpayer purchase a fractional interest in the replacement property. This also benefits buyers by allowing them to move from less valuable to more valuable properties. From a seller’s standpoint, it may increase the marketability of a more valuable property by opening up a larger class of buyers.
• “Reverse” 1031 exchanges, though more complicated, are possible. In the standard 1031 exchange, a person sells a property first and invests the proceeds in a replacement property identified later without incurring tax. In a reverse exchange, a buyer acquires the replacement property first and sells the relinquished property later through the use of intermediaries. This structure may be useful, for example, where an investment property comes on the market before the investor is ready to sell the first property.
• Section 1031 exchanges can be done between related parties, with certain important limitations. The rules for determining whether parties are related are fairly complex, but if an exchange is made between related parties, the replacement property must be held for two years before it can be sold or the tax deferred by the 1031 exchange is due. A seller can purchase the replacement property from a related party only if the related party is also initiating a 1031 exchange.
If you are planning to sell a capital asset with a low tax basis in the near future, contact your attorney or accountant to discuss the possibility of a 1031 exchange.
Alex Snyder is a partner in Pennsylvania-based Barley Snyder’s Tax, Business, and Personal Planning groups. Contact him at 717-852-4975 or asnyder@barley.com.