An Introduction to Tax-Free Exchanges
A tax-free exchange under Section 1031 (§1031) of the Internal Revenue Code (IRC) occurs when a person (Exchangor) desires to sell property (Relinquished Property) and replace it with similar, or like-kind, property (Replacement Property) almost immediately.
Why Do It?
People choose to implement the provisions of §1031 in order to defer paying the capital gains tax that would otherwise be payable on the sale of property they intend to replace anyway.
The properties involved in the exchange must be held for business purposes or be income producing.
The properties exchanged must be “Like-Kind.” This means that real estate must be traded for real estate, computers for computers, etc.
The benefits of the tax-free exchange may not be used on the following types of properties:
- Stock in trade or other property held primarily for sale
- Stocks, bonds, or notes
- Other securities or evidences of indebtedness or interest
- Interests in a partnership
- Certificates of trust or beneficial interest
- Choses in action
- Primary Residences
Some Notes on Like-Kind Property
- The class of real estate does not affect the like-kind status (i.e. rental property may be exchanged for commercial property, vacant land may be exchanged for farm land, etc.).
- Property in the United States, generally, may not be exchanged for property in foreign countries.
- Livestock of different sexes are not like-kind.
The Qualified Intermediary (QI) is usually a financial institution but also can be an attorney or other such entity. The role of the QI is to hold the proceeds from the sale of the Relinquished Property until the closing on the Replacement Property. Basically, the QI handles the Exchangor’s money throughout and until the completion of the exchange process.
It is important to note here that the Exchangor is not entitled to receive any of the proceeds from the sale of the Relinquished Property until after the closing on the Replacement Property pursuant to the IRC.
A principal, yet often overlooked, aspect of the process is the timeline in which certain actions must be taken. The first important date is when the Relinquished Property is transferred, as it is the start date for all subsequent deadlines.
Within 45 days from the start date, the Exchangor must identify the Replacement Property and submit written notice of such identification to the QI. The Exchangor may identify the Replacement Property in the original exchange agreement, if known at that time.
The closing on the Replacement Property must occur prior to the first of the following:
- 180 days from the start date; or
- the due date of the Exchangor’s income tax return for the year in which the Relinquished Property was transferred
The Reverse Exchange
Occasionally, a potential Exchangor has already identified the Replacement Property but has yet to find a buyer for or determine what shall be used as the Relinquished Property. In order to accommodate this possibility, the Internal Revenue Service updated the IRC to allow for Reverse Exchanges. This type of exchange is usually structured in one of two ways:
- The Exchangor acquires the Replacement Property and transfers the Relinquished Property to an Exchange Accommodation Titleholder (EAT) until such time as the Relinquished Property is sold. This method is typically used when the lender requires the Exchangor to take title to the Replacement Property immediately.
- The EAT acquires title to the Replacement Property and when the Exchangor is ready to proceed, the EAT acts as seller of the Replacement Property and the exchange occurs as normal.
It is important to note that Reverse Exchanges also have deadlines.
- The Relinquished Property must be identified within 45 days from the date of the transfer to the EAT.
- The property may only be held by the EAT for 180 days.
Points to Remember
- The exchanged property must be Like-Kind.
- The QI must hold the money until the process is complete.
- Certain rules apply to who can act as your QI and what property may be exchanged.
- The deadlines must be followed.
- Special language must be included in the contracts relating to the sale/purchase of the Relinquished/Replacement Properties, as well as the preparation of additional, extensive documentation pertaining to the transaction as a whole.
Other restrictions, not listed here, apply to §1031 exchanges and should be carefully reviewed by your accountant and attorney.
Should you wish to discuss the process further, or if you feel a tax-free exchange would work for you, please contact our office to make an appointment with Jim Benckendorf.