Section 1031 Exchanges enable the owners of real property and other assets that are ‘used in a trade or business, or held for investment,’ to sell their owned assets (the ‘Relinquished Property’) and acquire new ‘like-kind’ assets (the ‘Replacement Property’) without incurring a capital gains tax on their disposition. 

Ordinarily, whenever an asset such as investment real property or an aircraft is sold for a gain, the result is a capital gains tax liability.  Because this liability may include depreciation recapture, the gains tax can be significant.  Section 1031 Exchanges allow for the deferral of this tax, which means that capital is preserved and efficiently redeployed.  Exchanges provide taxpayers with the ability to trade up to a newer or larger property without having to divert equity to satisfy a capital gains tax liability.

Note that Section 1031 Exchanges are not ‘tax free exchanges,’ they are tax deferred exchanges.  If and when you sell your Replacement Property, you may at that time be liable for the capital gains tax, including depreciation recapture, which you deferred at the time of your exchange. 

Qualifying Property

Section 1031 exchanges often are associated with investment real estate, and certainly real estate is the most common asset for a Section 1031 Exchange.  Note, however, that many other assets may qualify, including:

      (i)  Tangible personal property such as aircraft and vessels, fleet vehicles, construction and communication equipment, and musical instruments, livestock, artwork and collectables; and

     (ii)  Intangible personal property such as licenses, franchises, patents, distributorships, and trademarks, and contracts.

The ‘Like-kind’ Requirement

In addition to meeting the ‘trade, business, or investment’ qualification, the second major rule to qualify for a Section 1031 Exchange is that the relinquished assets and the replacement assets must meet the ‘like-kind’ test established by IRS regulations.  Real property must be exchanged for real property.    

The like-kind test is fairly easily met for real property; however the test is somewhat more restrictive for personal property.  Please visit our ‘Like-kind Requirement’ page for more information on this important matter.

Excluded Property

The following assets generally do not qualify for a Section 1031 Exchange: stocks, bonds, and notes; personal use property, goodwill, property that is ‘held for sale or acquired for resale,’ partnership interests, multi-member LLC interests and some trust interests.  Several of these determinations are based on your particular facts and circumstances, so we invite you to call us regarding your specific situation.

 

Boot

 

Boot is the term that refers to anything the taxpayer receives in a Section 1031 exchange other than qualifying, like-kind property.  Boot generally takes the form of cash, net debt reduction, or non like-kind property received by the taxpayer in addition to the replacement property.   The value of Boot received is subject to capital gains tax, which means the taxpayer will not receive the full benefit of his or her Section 1031 Exchange. 

Boot is most commonly incurred by taxpayers who:

 

1.  Trade down in value from the sale price of his Relinquished property (adjusted for selling costs) to the purchase price of his Replacement property; or

 

2.  Take cash out of the exchange by not reinvesting all of the equity from their sale into ‘qualifying, like-kind property.’ 

 

It is important to review the facts of your exchange with a knowledgeable qualified intermediary prior to your sale or purchase.  A small amount of Boot is often acceptable if significant tax deferral is achieved.  In other instances, and exchange may not make sense unless the taxpayer decides to acquire a second replacement property. 

 

 

Options Available to You

 

There are significant rules, requirements, and timelines that the taxpayer must meet in order to successfully complete a Section 1031 Exchange.  Nevertheless, the Code provides significant flexibility to enable you to do so.  Please note:

 

1.  Most Taxpayers will first close on the sale of their Relinquished property, then close on the purchase of their Replacement within 180-days.  This is referred to as a Forward exchange.  Please visit our Section 1031 Library  for a summary of the basic 1031 Exchange rules.

 

2.  Taxpayers also have the option of first acquiring their replacement property, then later closing on the sale of their Relinquished property via a Reverse Exchange.  Please see Rev. Proc. 2002-37 for the Reverse Exchange safe harbor guidelines.

  

3.  Taxpayers can designate a property that requires significant construction or modification before it is acquired as Replacement property to complete the exchange.  This is referred to as a ‘Construction,' 'Build-to-Suit,' or 'Improvement' exchange. 

 

4.  Different quantities of properties can be exchanged, for example, taxpayers can diversify by selling one relinquished property and acquiring two or more replacement properties, or taxpayers can consolidate their holdings by selling two or more relinquished properties and acquiring one replacement property.

 

5. Real Estate investors often use 1031 Exchanges to modify their portfolio; for example, exchanging land for a rental property that produces monthly income; or exchanging a management intensive asset such as an apartment building for a commercial property that is subject to a long term lease with an investment grade tenant.

 

6. The like-kind requirement for Real Estate provides substantial flexibility; for example, a property owner can sell land and acquire an apartment building, or sell a retail property and acquire an office property.  In many states, it is possible to grant an easement or sell perpetual air rights, and acquire a fee interest in a ‘business or investment’ property.

  

Planning is essential.  While it is important to know the rules and understand the constraints, it is equally important to understand in advance the many options that may be available to you.   

Please visit our Library for more information on Section 1031 Exchange regulations and related topics.

We invite you to contact the experienced professionals of Beacon Exchange Company to review your contemplated Section 1031 Exchange with us.