The Basics of the IRC§1031 Tax-Free Exchange

by

A.J. Cataldo, Ph.D., CPA, CMA

Northeastern University - Boston

Introduction

This article provides a very brief and introductory framework or primer on the Internal Revenue Code Section 1031 (IRC§1031) exchange.  Complex transactions may require a careful reading of Treasury Regulations, Internal Revenue Service (IRS) Revenue Rulings and Revenue Procedures, as well as well-written and researched professional and academic journal articles, properly and accurately providing illustrations and interpreting these sources and authorities.

The IRS provides some broad instructions on the IRC§1031 exchange in its Publication 544 – Sales and Other Dispositions of Assets.  This publication is updated every year and is provided to the public, for free, by calling the IRS tax forms 1-800 telephone number or by downloading the publication from the Internet at www.irs.gov .  IRC§1031 exchanges are reported on Form 8824, Like-Kind Exchanges.

Why pursue an IRC§1031 exchange?

The IRC§1031 exchange is the result of an intentional desire, by Congress, to allow any taxpayer meeting the requirements, to exchange one property for another and avoid paying taxes on this (otherwise taxable) transaction.  The exchange is “tax deferred.”  If properly structured, the “realized” gain will not be “recognized” (i.e., taxed).  In summary, the amount that the taxpayer might have otherwise paid in capital gains tax may, instead, be used for reinvestment.  This benefit, arising from tax deferral, is often referred to as “leverage,” as the taxpayer retains all of his or her equity.  Table 1 summarizes the long-term capital gains tax rates that would, otherwise, apply, should the taxpayer decide not to pursue an IRC§1031 exchange and simply pay the tax.

Which properties qualify for legitimate application of the IRC§1031 exchange?

The following qualify for legitimate application of the IRC§1031 exchange:

·         Real property held for business use in the taxpayer’s trade or business (e.g., rental or income properties and covered under IRC§1231)

·         Real property held for investment (e.g., unimproved land and covered under IRC§1221)

Which properties do not qualify for legitimate application of the IRC§1031 exchange?

The following do not qualify for legitimate application of the IRC§1031 exchange:

·         Real property held for personal use (e.g., personal residence)

o        Reason: Already covered by IRC§1034 and IRC§121, providing for the exclusion of $250,000 ($500,000) of gain for single (married, filing jointly) taxpayers

·         Real property held primarily for sale or resale (i.e., classified as “inventory” to a “dealer”)

o        Reason: “Dealers” (e.g., realtors with real properties held for the long-term or investment may distinguish these properties from those classified as short-term holdings or inventory, where the latter may not be involved in an IRC§1031 exchange – this is an advanced topical area, but many, experienced Realtors® have probably heard of this distinction)

The 4 basic types or classifications of IRC§1031 exchanges

The 4 basic types or classifications of IRC§1031 exchanges include:

1.        Simultaneous exchanges – closing of relinquished and replacement properties occur on the same day

2.        Delayed exchanges – sequential closings of relinquished and replacement properties, also known as a “Starker” exchange

3.        Reverse exchanges – closing of replacement property occurs before closing of relinquished property

4.        Improvement exchanges – closing for the replacement property occurs after improvements are made

The 2 basic, time-based rules applying to IRC§1031 exchanges

The 2 basic (and very strict), time-based rules applying to IRC§1031 exchanges include:

1.        The 45-day (identification) rule – the taxpayer has 45 days after the sale of the relinquished property to identify up to 3 replacement properties

AND

2.        The 180-day (purchase) rule – the taxpayer has 180 days after the sale of the relinquished property to close on the purchase of the replacement property

3 additional, basic rules for IRC§1031 exchanges

3 additional, basic rules for IRC§1031 exchanges include:

1.        The 3-property rule – the taxpayer may select any 3 qualifying replacement properties as possible replacements for the relinquished property

OR

2.        The 200% rule – the taxpayer may identify any number of qualifying replacement properties as possible replacements for the relinquished property, as long as their aggregate or combined fair market value does not exceed 200 percent of the value of the relinquished property

OR

3.        The 95% exemption – the taxpayer may identify any number of qualifying properties as possible replacements for the relinquished property, as long as they result in the purchase of at least 95 percent of the aggregate or total fair market value of all properties identified

Summary

This very brief article provides you with a framework for further self-education into the topic of IRC§1031 exchanges.  Use the key words contained in this article to search the Internet and continue your education on this very important topic – one of particular relevance to Realtors®.  Also, you may wish to copy or print this very brief article and discuss the contents with your tax accountant.

Feel free to publish or reproduce anywhere, as long as you provide a copy to and/or notify the author <ajcataldo@comcast.net>.