To Exchange or Not to Exchange - That is the Question
Authored By: Scott W. Dunlap, Esq.
Values of real estate have risen the last several years (thank goodness!). Therefore, we have seen a return to the benefits of accomplishing a tax deferred exchange under Section 1031 of the Internal Revenue Code. As a reminder, a 1031 Exchange is the sale of a property in which the taxable gain on the sale is “rolled” into a property or properties to be acquired. Tax on the gain is, therefore, deferred.
Here are a couple of basics of tax deferred exchanges, to keep in mind:
- The property to be sold (in an exchange, the “relinquished property”), must have been held for productive use in a trade or business, or for investment purposes. In plain English, this means that a taxpayer’s personal residence, whether primary, secondary, or vacation, typically does not work for purposes of the tax deferred exchange.
- The property to be acquired (known as the “replacement property”), must be “like kind.” This does not mean that the uses of the relinquished property and replacement property must be the same; only that the replacement property must also be property held for trade or business or investment. So, a vacant commercial parcel can be exchanged for a shopping center, for example.
- Generally speaking, the taxpayer must exchange up in value, and up in debt, in order to avoid receiving cash or “boot.” Any cash or boot received is presently taxable.
- Time limits apply. For instance, the replacement property must be properly identified within 45 days of closing the sale of the relinquished property; and the replacement property must be acquired by the lesser of 180 days from the date of sale, or the date the taxpayer actually files its tax return for the year of the sale.
- Prior to the sale of the relinquished property, an appropriate agreement needs to be executed with a qualified intermediary, or a “QI.” The QI will hold the exchange proceeds. The taxpayer can’t take possession of the sale/exchange proceeds until the exchange is fully completed or otherwise ended.
- Make sure to coordinate required paperwork with your attorney or QI, as most of the rules must be strictly followed in order for the exchange to work.
If the requirements for an exchange are met, remember that the 1031 Exchange is a tax deferral strategy, not a tax avoidance strategy. Therefore, it is always a good idea to have your tax advisor or CPA run some scenarios as to present and possible future tax ramifications, so that the question of whether to exchange or not to exchange may be answered.
This blog is intended for informational purposes only and it is not intended to be, nor should it be construed as, legal advice or legal opinion. The reader should not consider this information to be an invitation to an attorney/client relationship, should not rely on information presented here for any purpose, and should always seek the legal advice of counsel in the appropriate jurisdiction.