1031 Tax Exchange
Below is a good explanation of the 1031 Tax Exchange.
The 1031 tax exchange is a much-used method for turning a little into a lot. Understanding how it works is critical to making the best use of this important investment tool. Many deer hunters have used this tool to accumulate their dream property.
The 1031 tax exchange is one of the key factors keeping a fire lit under the land boom. It takes its name from the section of the IRS code in which you will find it. Concisely, the 1031 tax exchange allows you to sell one piece of real estate and replace it with another one while deferring capital gains tax and recaptured depreciation to a later date when you choose to cash out of your real estate holdings – if ever.
You want to own your dream hunting land, but you haven’t been able to find it. At the same time, you keep seeing the price of land going up. You fear that the price will grow too high before you find the dream piece and you will no longer be able to afford it. This is a common problem, but thankfully, there is a solution.
The best strategy is to buy a good property in a good neighborhood. Maybe it isn’t your dream piece, but it is good nonetheless. You can improve it and pour your heart into it. When your dream piece does come up on the market, you will have a high quality piece to sell and then you can exchange the capital gain (using the 1031 tax exchange) into the dream piece. Ideally, you can get an option on the farm you wish to buy, giving you some time to sell, or possibly you can get the seller to sign a contract permitting you to sell yours first.
Many deer hunters also use the 1031 exchange to trade up for larger pieces when they have accumulated good equity in their initial piece of land. They then use this equity as the basis for a large down payment in their bigger dream farm. Of course, not having to pay capital gains taxes makes the equity go a lot farther.
Overall, the 1031 is a great tool for deer hunters looking to make the most of their money.
There is a gray area related to the 1031 exchange.. A number of hunting land investors are under the impression that the velocity of their transactions will some day get them in trouble. They fear that because they are buying and selling often, in the event of an audit their 1031 activities will be disqualified.
Different accountants when asked about using the 1031 to buy hunting land have slightly different takes. Here is a portion of the actual language in section 1031 of the actual IRS code:
...no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged solely for property of a like kind to be held either for productive use in a trade or business or for investment.
The problem lies in the interpretation of the word “investment”. Some think that investment carries with it an implied holding period. That may or may not be the case. But to be on the safe side, if you are able to hold the land for at least one year before “trading up” you won’t have any worries. An even bigger issue revolves around the actual taxes triggered when you finally cash out. This confusion stems from the fact that the 1031 is a tax deferral tool. The word defer implies that you will pay them later. When you cash out you will trigger taxes all the way back to the first sale. Some believe that transactions involving properties held for less than a year will be taxed at the short-term rate even though you used the 1031 to move the proceeds into another parcel.
Again, according to a tax accountant, these fears are unfounded. According to him, as long as you hold the final property for at least a year before selling it, you only pay long-term capital gains back to your original basis – the original cost you paid for the first property. Other accountants interpret this differently, as noted. They suggest that you will actually be triggering short-term capital gains on the properties you held for less than a year. You must make a like-kind exchange. Like-kind has a broad interpretation. For example, certain realtors specialize in helping customers from California park the proceeds from the sales of their franchise properties in farmland until they can find a different use for the money.
Some 1031 tax exchange can be tame by comparison. Replacing hunting land with hunting land is very simple. However, any kind of real property is exchangeable with any other kind of real property. However, you can’t exchange the sale of ownership in a subchapter S land corporation with personal property or other shares in a subchapter S. Stock in a limited partnership is not real property.
The 1031 exchange works as long as you never have actual or constructive receipt of the funds from the sale of the relinquished property before those funds are used to purchase the replacement property. In other words, an intermediary has to handle both closings for you and you can’t have any kind of access to the money – even to borrow against it – until the entire process is completed. You empower the intermediary to receive the proceeds from your sale and further instruct the intermediary as to which property you want to purchase as the replacement.
The intermediary then makes the purchase (or purchases) on your behalf and finally signs the purchased property (or properties) over to you after the closing. In exchange for this service, you pay the intermediary a fee. I’m sure it depends on your market and the nature of your transaction, but in my experience the intermediary receives well under $1,000 for a simple exchange Typically, a lawyer handles most of my transactions. He finds another attorney in the area that he is comfortable with to act as the intermediary. There are also hundreds of specialized companies set up to serve as intermediaries throughout the country. The intermediary doesn’t have to be a local entity to handle this service for you.
If you type “1031 tax exchange” into your internet search engine, you will quickly see that you have many options. You must notify your buyer and seller that you are going to perform a 1031 tax exchange because they have to sign off on the exchange. They are effectively acknowledging that you have empowered an intermediary to act on your behalf in these transactions. You typically make this notification in the purchase agreement so the buyer and seller are bound by law to cooperate. If you plan to execute a 1031 exchange, or think you might, be sure to add the appropriate language to any purchase agreement you enter into regarding the relinquished property and the replacement property. You have 45 days starting the day after you close on the sale of your relinquished property to identify its replacement.
If you don’t notify the intermediary of the replacement within this time, the 1031 exchange will fail and you will immediately trigger the transfer of your assets into your name and you will be responsible for any taxes that result from the sale. Further, you have 180 days starting the day after your closing on the relinquished property to close on its replacement. You can identify more than one replacement property. Certain rules apply if you identify more than three, so be sure to consult with your intermediary if you are considering identifying four or more properties. The exchange has to take place within a single tax year. You may be able to play some games with filing dates to make that work, so consult with your tax accountant if you are at risk.
The most common type of 1031 exchange used is the delayed exchange. This is the type that I have discussed so far, where you sell the relinquished property first and then purchase the replacement property.
For an exchange to be a simultaneous exchange, both closings must occur at the same moment – the closing for your sale and the closing for your purchase. Again, this satisfies the requirement that you have no actual or constructive receipt of the funds of the sale of the relinquished property before purchasing the replacement. At one time, this was how all exchanges were done, but today, simultaneous exchanges are rarely used.
Improvement exchange or construction exchange:
Construction exchanges permit you to make improvements on the replacement property before assuming ownership. To do this, the intermediary makes the improvements before signing the property over to you. For example, suppose you sell a parcel of land near the city worth $300,000. Your goal is to use the proceeds to buy a piece of hunting land and put a cabin on it. You can defer all the capital gains taxes on your sale as long as the replacement property, plus the improvements (the cabin), are worth at least $300,000.
Reverse exchanges are the most complex. In this scenario, you buy the replacement property before relinquishing the original property. Again, you can’t hold title to both at the same time. An Exchange Accommodation Titleholder makes the purchase and holds the title of the replacement property on your behalf and this starts the clock ticking. You have 45 days from that closing to identify the relinquished property and 180 days to close the sale of the relinquished property. Obviously, identifying the relinquished property is easy, but closing it in 180 days may not be so easy unless you already have a buyer on the hook.
You don’t have to use every dollar of the proceeds from the sale of your relinquished property to purchase a replacement property. If you use only a portion, the taxable gains are pro-rated accordingly. If you perform a partial exchange, the amount of money remaining after the replacement property is purchased is called cash boot. When performing an exchange where the relinquished property is under mortgage, you still have to replace the entire sale price of the relinquished property (not just your equity) or the IRS will treat it as a partial exchange. You can replace the debt with cash or new debt to defer all capital gains taxes. However, if you don’t, you will have what is called mortgage boot, which will incur a tax liability.
The 1031 tax exchange is a powerful tool for those looking to upgrade to their dream hunting land, which should be a big part of your long-term strategy.Click here to return to our blog