Internal Revenue Code Section 1031 Exchanges are a method by which the recognition of taxable gain or loss realized upon the sale or exchange or property may be deferred until a later date. Most real estate and tax lawyers are generally familiar with Section 1031 tax deferred exchanges. In fact, the most widely used form of real estate contract in Florida, the FAR/BAR Residential Contract for Sale and Purchase, includes a boilerplate provision requiring the parties to cooperate with one another in the event either party desires to utilize the subject transaction as part of a Section 1031 Exchange.
Utilization of Section 1031 Exchanges has been extremely limited over the past 5 or 6 years for the obvious reason – very few transactions involving the sale or exchange of property have resulted in gain. As real estate values gradually improve and some of the early fortunate or opportunistic investors begin to take profits, properties are now being sold at gains sufficient to justify utilizing tax deferred exchanges.
To be clear, a 1031 Exchange is not “tax free” – however, it defers the recognition of gain and hence, the obligation to pay tax until the subsequent sale of the exchange property. A few benefits of Section 1031 Exchanges are:
– In addition to saving the 15% federal capital gains tax, assets held for a considerable number of years may trigger depreciation recapture tax and a large capital gain will generally trigger alternative minimum tax.
– Subject to compliance with strict rules regarding timing, the types of property which may be used as exchange or replacement property, the use of a qualified intermediary and some additional record keeping, there is quite a bit of flexibility in terms of the exchange property or properties. Assuming the values can be matched up, one or more property(ies) may be exchanged for one or more other property(ies).
– Following the prior example, 1031 Exchanges may be used as an estate planning tool. For example, if an individual owns an income producing property- say a rental property with significant appreciation, upon his death, the estate receives a stepped up basis resulting in no gain upon the taxpayer’s death. If the taxpayer’s beneficiaries do not wish to continue to own the specific property but the taxpayer sells the property, there will be at least a 15% gain on the appreciation. Alternatively, after consultation with his beneficiaries, the taxpayer could sell the property in a tax deferred exchange for separate properties each designated for a specific beneficiary. In that manner, each beneficiary will receive his or her separate property upon the taxpayer’s death with a stepped up basis and will be free to hold or sell the property without reference to the other beneficiaries.
– 1031 Exchanges of property do not need to be simultaneous. In fact, many 1031 Exchanges are delayed. In order to resolve uncertainties after the 1979 9th Circuit Case, Starker vs. U.S., the Tax Reform Act of 1984 amended Section 1031(a) to permit non-simultaneous exchanges under certain circumstances. In general, the property to be received in exchange for the exchanged property must be identified with 45 days after the exchanged property is transferred and the exchange property must be received within 180 days after the initial transfer. There are other limitations beyond the scope of this discussion, however, the transactions do not need to close simultaneously.
– Further, a tax deferred non-simultaneous exchange may occur in reverse – one or more properties may be purchased as the first leg of the transaction with the sale/exchange of existing property owned by the taxpayer subsequently sold, subject to similar timing requirements. Non-simultaneous exchanges to be sure are somewhat more complicated as it is necessary to involve a Qualified Intermediary – a person or entity independent of the exchanging parties to hold title to the property prior to completion of both exchanges.
While the use of Section 1031 Exchanges can be complicated, there are qualified professionals who specialize in and are able to assist with these transactions. If tax deferral makes sense, it may be worth the additional cost involved.
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