The term "1031 exchange" relates to a very powerful tax strategy for re-deploying real estate while avoiding a significant tax consequence generally associated with selling investment real estate and other eligible assets.
"1031" is the section of the tax code that provides this benefit. Section 1031 provides generally that if a taxpayer relinquishes investment property and acquires property of a like kind in replacement of the relinquished property, then current tax is avoided.
You may also hear about "Starker" exchange, tax deferred exchanges, and like kind exchanges. "Starker" is the name of the taxpayers who first had a popular type of exchange approved by the federal court. A "Starker" exchange involves a disposition of one property followed by an acquisition of a qualifying like kind replacement property at a later time. This concept extends the notion of "exchange" to taxpayers' great advantage. Prior to Starker, exchanges generally consisted of a direct simultaneous swap between two taxpayers owning property desired by the other.
After Starker, the buyer of an exchanging taxpayer's relinquished property need not be the same person as the seller of the exchanging taxpayer's replacement property. The two transactions in practice need have no relationship to each other, except that the exchanging taxpayer is involved in both.
Statutes, regulations, and rulings adopted after Starker now give a taxpayer up to 180 days from the sale of a relinquished property to purchase of a qualifying replacement property, provided that the taxpayer complies with the exhaustive deferred exchange regulations finalized by IRS in 1991.
It is important to understand that a taxpayer cannot simply sell one property then buy another as a "re-investment." An exchanging taxpayer should engage a "qualified intermediary," or "QI", which is an independent party to "accommunityodate" the sale and purchase transactions. According to the deferred exchange regulations, the taxpayer hires the QI to hold the sale proceeds of the relinquished property in trust pending the purchase of the replacement property. Those proceeds held in trust are later used as part or full payment for the acquisition of the replacement property.
Replacement property must be "like-kind" to the relinquished property to qualify for Section 1031 tax avoidance. The term "like-kind" is very broad. Improved property is like to raw land, an apartment building is like to a communityercial property (e.g., an office building), and so on. This gives an exchanging taxpayer tremendous flexibility in re-deploying real estate investments from one category to another.
This is a very complicated strategy. The statutes, regulations and rulings in this area are voluminous, detailed and evolving. Anyone interested in this strategy must seek competent tax advice before taking action.
But, is it taxable?
If the acquisition of the replacement property closes (after the taxpayer owns the title to the replacement property) with money held back for repairs subsequent to closing, the money so held back will be considered taxable boot.
If the money is retained by the intermediary and used to make the capital improvements after the closing (after the taxpayer owns the title to the replacement property), then the funds held back will still be taxable boot. This is true whether or not the funds held back are used within the 180 day exchange period, i.e. the period ending 180 days after the closing of the relinquished property.
The way to do this properly is for the exchange intermediary to take actual title to the property, have the exchange intermediary make the improvements, and have the exchange intermediary convey the property to the taxpayer after the improvements are made. In this way, only qualifying real estate is conveyed to the taxpayer.
Please refer to the "construction exchange" regulations ("property to be produced") at Reg. 1.1031(k)-1 et seq.
It is possible to make some of the improvements after the 180 day period ends, but the property title must have been transferred to the taxpayer by the end of the 180-day period.
Also, be careful that the required identification of the property (within 45 days after the closing of the relinquished property) includes a description of the improvements, and that the improvements ultimately made are in substantial conformity with the identification.
G. Scott Haislet, CPA, Esq. is a qualified intermediary with the Lafayette Exchange Corporation. He can be reached at (925) 283-1031.
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