Tax Deferred Exchange

Section 1031 of the Internal Revenue Code allows certain types of property to be exchanged and the result of an exchange is an non-recognition of gain for income tax purposes. The essence of an exchange is a reciprocal transfer of property for property, as distinguished from a sale and reinvestment. The property exchanged must be “like kind” property and the determination of like-kind property is not always a simple proposition. If the criteria of Section 1031 are met, the non-recognition of gain is mandatory.

Statutory Requirements

1. Both the property surrendered and the property received must be either for productive use in a trade or business, or for investment.

2. The property surrendered and the property received must be of “like-kind.”

3. The exchange must be reciprocal transfers of properties as distinguished from a sale and repurchase.

Excluded Property

Section 1031 denies non-recognition treatment of a transfer or receipt of the following categories of property:

1. Stock in trade or other property held primarily for sale (dealer property).

2. Stocks, bonds, or notes.

3. Interests in partnerships or limited liability companies.

4. Other securities or evidence of indebtedness or interest.

Time Requirements

There are a number of time requirements that apply to Section 1031. The first time requirement concerns the length of time the property to be exchanged is held for productive use in a trade or business. Although there is no specified number of years or months the property must be held before attempting a Section 1031 exchange, it is recommended the property be held for productive use or investment purposes for at least two taxable years. Transfers to corporations or partnerships in close proximity to attempting a Section 1031 exchange are suspect and are subjected to strict scrutiny by the IRS.

There are also time requirements associated with the completion of the exchange. Through the use of a qualified intermediary, tax-free exchanges do not have to be simultaneous. A given property may be sold, the proceeds deposited with a qualified intermediary, and replacement property or properties acquired as late as 180 days after the sale of the relinquished property. Generally, the following rules apply:

1. A limited number of properties must be designated as replacement property or properties within 45 days from the date the taxpayer surrenders control of the relinquished property.

2. Replacement property or properties must actually be acquired within 180 days of the date the taxpayer surrenders control of the relinquished property.

Like-Kind Property

Generally, “like-kind” refers to the nature or character of the property, and not to its quality. Real property may be exchanged for other real property and the determination of what constitutes real property is governed by state law. For example, if state law defines water rights as real property rights, water rights may be exchanged for a fee interest in land. “Like-kind” does not mean Section 1031 exchanges must be on a one for one basis. As many as three properties may be utilized as replacement properties in exchange for the original relinquished property. However, to the extent cash or property not qualifying as “like-kind” is received in the exchange there will be taxable gain.

Tax Basis in the Relinquished Property

The tax basis in the relinquished property will be transferred to the replacement property. If more than one property is acquired in the exchange, the basis will be proportional as to the replacement properties. If there is cash received from the exchange, the cash received will have attributed to it a proportional amount of the basis of the relinquished property.

Conclusion

Tax-deferred exchanges are an excellent tool to allow property owners to change the nature of their investments as well as the location without paying tax on the gain which has accrued over time. However, the rules and regulations are complex and the variations which might apply to a given exchange can be extremely difficult to implement and understand. Existing mortgages and assumed debt related to an exchange transaction present a number of issues which almost always requires professional advice. Moreover, Section 1031 is mandatory in application and, if a transaction has been structured to qualify for Section 1031, it will be difficult or impossible to make a last minute change to permit recognition of gain or loss. Because of these complexities, an experienced advisor is essential to most tax-free exchanges.