Your Ultimate Guide to 1031 Exchanges
1031 Exchange Definition
A 1031 exchange is a legitimate process sanctioned by the Internal Revenue Service where like-kind property is exchanged wherein the property owner, referred to as exchanger, is not liable for immediate taxation. 1031 exchanges are basically carried out for real estate transactions although other tangible and intangible properties could also qualify. The IRS requires an unbiased third party to facilitate the exchange. This party is called facilitator, qualified intermediary (QI) or accommodator.
Benefits of an Exchange
If you happen to have some property or business, then a 1031 exchange is an advantageous investment tool. You are probably aware that property sold or transferred for gain is not exempt from taxation and the taxes could pile up quickly. Being the property seller, the taxes you would have to pay in the end could add up to 40% or more whereas in a 1031 exchange, the exchanger is allowed to preserve for re-investment all equity of the property. This makes it possible for the exchanger to get hold of a replacement property that has a better location, offers superior cash flow, and requires less management.
Eligibility for an Exchange
Like-kind property is generally defined as any real property within the USA or some of its territories. Property that is possessed for productive use in a business or for investment may be qualified to be exchanged as like-kind property. For example, a duplex can be exchanged for a raw land. Personal property on the other hand, is not like-kind real property. An industrial building cannot be exchanged for a private jet for instance. Personal property is evaluated based upon its General Asset Class, its NAICS categorization and its character and nature.
Properties Ineligible for Exchange
Some properties are not eligible for a 1031 exchange. This was determined by the IRS when they modified the IRC 1031 in 1986. Examples of excluded properties include personal residences, stocks, notes, bonds, securities, enterprise gains, amity of a company, and other evidences of indebtedness. Also prohibited from being exchanged are properties held chiefly for sale. However, the portion of a personal residence, which is dedicated to business or investment use, may be eligible for an exchange. A home office is one example.
1031 Exchange Cornerstones
1. An exchange must be carried out, not a sale. One party has to give up a property, referred to as relinquished property, and receive another property in return, which is referred to as the replacement property.
2. The property being exchanged must be of like-kind, meaning, they must be of similar classes of property. Like-kind describes the nature and character of the property.
3. The napkin test must be satisfied in order for an exchange to be completely not liable for taxation. This means that the value of the replacement property should be greater than or equal to the value of the relinquished property (the property given up by the exchanger).
4. The side, which relinquished a property, must obtain the corresponding replacement property.
Timeline Requirements
Calculated from the closing day of the relinquished property, the exchanger has 45 days to nominate the possible replacement properties and acquire the final replacement property in 180 days. The whole exchange must be finished in 180 days, not 225.
Conditions for Identification
The exchanger must provide in writing a clear description of the potential replacement property prior to midnight of the 45th day, gauged from the day the relinquished property closed. A legal description of the replacement property would suffice. Apart from that, a submitted purchase contract is also considered enough identification. Moreover, property purchased and close within the 45 days can also qualify as identification.
Are There Exceptions?
Despite the exclusion of personal residences from 1031 exchanges, vacation homes and other second homes may be eligible if they meet certain conditions defined by the IRS on February 2008 in the IRC 1031.
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