TAX-FREE (ACTUALLY,
TAX-DEFERRED) PROPERTY EXCHANGES
Like-kind property (under
section 1031 of the Internal
Revenue Code) can be exchanged
for other property, and the
taxable gain on the transaction
deferred until the sale of the
replacement property. However
there are numerous rules to
comply with in doing an exchange
and a thoroughly documented
paper trail is required.
Property must be like-kind and
must be held for productive use
in a trade or business
The definition of like-kind
is fairly broad. Property is of
like-kind if it is of the same
nature or character. Property
held for productive use in a
trade or business or for
investment must be exchanged
solely for property of a
like-kind which is to be held
either for productive use in a
trade or business or for
investment.
Examples of like-kind
exchanges would be:
- Seller who rents out
Iowa farmland sells it and
buys a rental house, duplex
or apartment building or
other farmland.
- Business owner sells
building he or she owns and
buys a replacement building
to continue the business.
Examples that are not
considered like-kind:
- Seller who rents out
Iowa farmland buys a second
home they occupy
exclusively.
- Seller who owns farmland
sells it and reinvests in
stocks and mutual funds.
The following classes of
property are not entitled to
tax-deferral treatment:
1. Property held for
resale (inventory)
2. Stocks, bonds and notes
3. Other securities or debt
obligations
4. Interest in a partnership
5. Certificates of trust
Simultaneous transfers of
property
One needs to make sure the
sale and acquisition are not
independent transactions. Both a
sales agreement and a purchase
agreement must include language
setting forth the intent to do a
1031 exchange.
If the taxpayer has actual or
constructive control over cash
proceeds, the expenditure of the
cash on the replacement property
will not be eligible for
tax-deferral treatment.
Non-simultaneous transfers of
property and the use of a
Qualified Intermediary to
complete exchange
The law allows a properly
established Qualified
Intermediary to escrow the sale
money and assist in completing
the exchange. A typical
Qualified Intermediary is a bank
or exchange service that holds
the sale proceeds so the
taxpayer does not have actual or
constructive receipt of the
proceeds. There should be a
written exchange agreement
between the parties.
The sale proceeds can be held
under the seller's social
security number and the seller
may earn interest during the
holding period.
45 day identification period
A seller has 45 days to
identify possible replacement
property, and the period begins
to run on the date a seller
transfers or deeds the
relinquished property.
A person can identify up to
three (3) properties or
properties whose sale price is
up to 200% of the sales price of
the relinquished property.
The identification of
replacement property needs to be
in writing and timely submitted
to the Qualified Intermediary.
180 day exchange period
A taxpayer has the lesser of
180 days or the due date
(including extensions) of the
seller's income tax return to
acquire the replacement
properties. Often property
relinquished late in a
taxpayer's year means they may
need to file an extension of
their income tax return until
the exchange is finalized.
You need not acquire all the
replacement properties you have
identified.
Fractional interest and Partial
replacement property acquisition
A fractional interest may be
exchanged for an entire interest
in other property. For example a
brother and sister may inherit
their parents' Iowa farm. After
renting it out for a few years,
they decide to sell it to the
farm tenant. Sister wants to be
cashed out so she can invest in
the stock market and is willing
to pay the capital gains tax on
the difference between the sale
price and the cost basis at
which she inherited the farm.
Brother wishes to reinvest his
in rental income-producing
property in Phoenix, Arizona,
where he resides and can better
manage a property.
If brother spends all of his
50% share of the farm sale
proceeds on the rental property,
he can avoid any current capital
gain tax by the exchange.
However, if Brother can only
find rental properties with a
purchase price of $200,000 and
his share of the farm sale
proceeds is $300,000 -- then
$200,000 is considered
reinvested and tax deferred, but
he must recognize on his income
tax return the taxable share of
the $100,000 portion not
reinvested.
Not every dollar of sale
proceeds needs to be reinvested
to obtain benefit of the exchange.
Miscellaneous Requirements
The tax deferral benefit does
not apply if one of the
properties is outside the United
States.
If the relinquished property
was encumbered by a mortgage one
needs to remember the
reinvestment deferral is
computed from the sale price and
not the net proceeds. It may be
necessary to borrow a like sum
to receive the non-recognition
of income tax benefit.
Exchanges between related
parties require the property be
held for two (2) years from the
date of the last exchange or any
property transferred is treated
as if the exchange had not
occurred and income tax is
recognized.
A remainder interest in
farmland can be exchanged for
another remainder interest in
farmland (or a fee interest).
Conclusion
This article is intended to
inform readers of some of the
general principals of doing a
tax deferred exchange of
property. It is by no means an
all-inclusive statement of the
code, regulations and case law
on this subject.
-- February 1, 2002
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