last update 12-10-02
IRS Section 1031 Tax Free Exchanges
The Internal Revenue Code 1031 provides investors with one of the
last available tax shelters by allowing them to avoid paying any taxes
when an investment property is exchanged. Why, when and how this happens
are questions that should be answered here.
The general rule is that if property is sold in a typical sale
transaction, gain or loss may be recognized. However, Section 1031 basically
provides an exception to the general rule by providing that gain or loss
will not be recognized on the exchange of business or investment property
if it is exchanged for "like kind" property. The gain is not forgiven but
is simply rolled into the new property and may be recognized later when a
typical sale takes place. The non-recognition in an exchange is not elected
it is mandatory if the conditions are met.
"Like kind" property refers to the nature, character or class of the
property, not to its grade or quality. This definition would include an
exchange of real estate for other real estate. As long as both parcels are
in the U.S., the specific location of the property does not matter.
The non-recognition provisions do not apply to stock in trade (inventory),
stocks, bonds and notes, interests in partnerships, or other securities.
How an Exchange Works
Two property owners rarely want each other's
properties. In reality, most exchanges involve three parties: the taxpayer
who wants to dispose of his property but delay taxation, the buyer for that
property and a seller who has property that the taxpayer wants to acquire.
If the taxpayer sells his property, then re-invests the proceeds into the new
property, he will have to pay taxes on the gain on selling his property and
will not have the full value to invest. By exchanging, he is dealing with
the full property value and not one reduced by taxes.
In concept, the buyer purchases the property that the seller wants to
acquire and then the buyer exchanges it with the seller. The seller disposes
of his property and gets a replacement property without paying taxes, the
buyer parted with his money and got the property that he wanted and the third
party simply sold his property. In reality, all three parties normally have
a closing on the same day in which they come in with the properties that they
have and leave with the properties or cash that they want.
With careful planning and a sharp eye toward timing, the above
transaction can be expanded somewhat. The above example assumes that the 3
parties can come to the same closing table to conclude the transaction.
However, the taxpayer can defer the selection of his new acquisition for 45
days and the actual taking of it for 180 days if he is careful. Thus, if
Taxpayer has a potential buyer ready to deal today but Taxpayer has not yet
found the property that he wants to acquire in the exchange, he can proceed
with a transfer of his own property to Buyer and have the proceeds placed in
an escrow account. He must then select the property that he wants to acquire
within 45 days and must actually take title within 180 days of the disposition
of his own property. This delayed exchange can be tricky and should not be
undertaken without professional advice for the specific facts involved.
Caveat: Be sure that all the requirements are met.
In a Tax Court case, a couple did everything for a
deferred exchange but the seller backed out of the deal the
day that it was set for closing. The taxpayer still claimed
tax free status on the transaction and argued that he had
done everything that he was supposed to do and that the
seller's change of heart was outside his control. The Tax
Court said that the Internal Revenue Code creates no
exceptions to the deadline, so the taxpayer cannot treat it
as a valid tax free exchange. David A Knight, TC Memo
What Is Like-kind Property
Like-kind property refers to the nature, character, or class of the property,
not to its grade or quality. Thus an exchange of real estate for real estate
is a like-kind exchange. It doesn't matter where the property is located or
whether it is improved or unimproved. This means not only exchanging an
apartment building for an apartment building but also exchanging an apartment
building for a farm, vacant land, a cranberry bog or any other real property,
as long as the new property is not the investor's personal residence. The
requirement in the statute that the exchange is only available for "business
or investment property" eliminates an exchange of the Taxpayer's residence
under this section. Further, he must intend to keep the newly acquired
property for at least six months and preferably a year. To sell it sooner
may classify the Taxpayer as a dealer since these provisions only apply to
exchanges of property for productive use in a trade or business or for
"Boot" or Liabilities in Exchanges
If a Taxpayer receives boot (money or other non-exchangeable property) in the
exchange transaction, gain will be recognized to the extent of the boot
received prior to recognizing the tax deferral provisions of the exchange.
Thus, gain will be recognized and taxes will be paid on the cash received.
To avoid this problem, make the exchange so that cash is not received.
Liabilities transferred to the Buyer will be treated as boot received.
If boot is given in the exchange, the amount of the boot simply increases
the Taxpayer's basis or cost in the property acquired. Liabilities assumed will
be treated as boot paid. However, liabilities transferred will be netted
against liabilities assumed to determine the net amount of any boot.
Basis in Exchanges
In tax parlance, basis refers to the net, adjusted cost of a
property. In real estate, it is common to depreciate the improvements in a
property over its useful life. Thus, a parcel that costs $60,000 may be
depreciated down to a current tax basis of $50,000. However, the actual
property could have gone up in value to $200,000 due to location, inflation,
etc. The Taxpayer will be exchanging his property for other property worth
$200,000. In acquiring the new property, his old net depreciated basis of
$50,000 would be transferred to the new property. In essence, the basis for the
old property simply becomes the basis for the new property. Thus, if he later
sold the new property, he would have a gain on the difference between the sales
price of the new property and the $50,000 carryover basis. Future depreciation
on the new property would be limited to the basis figure of $50,000 also.
Exchanges with Related Parties
If an exchange occurs between related parties, and if either party disposes of
the exchanged property within two years of the last transfer of the exchange,
then gain or loss not recognized in the exchange will be recognized and taxed.
The term related parties included a Taxpayer's family, brothers, sisters,
ancestors, lineal descendants and corporations with more than 50% controlled
by related parties.
======================== WARNING =======================
This information is provided for the reader's benefit in
becoming familiar with the legal matters discussed. Your
particular facts may be different from the points above.
You should not rely on the above data without consulting a
attorney to discuss the specific facts of your case
and the law of your state.
If you live in Louisiana and want to talk about your situation, please
call me at:
Marvin E. Owen
3036 Brakley Drive
Baton Rouge, La 70816
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