1031 Tax Deferred Exchange – The Exchange Connection
Washington State Law, RCW 19.310.040, requires an exchange facilitator to either maintain a fidelity bond, in an amount of not less than $1M, that protects clients against losses caused by criminal acts of the exchange facilitator or hold all client funds in a qualified escrow account or qualified trust. RCW 19.310.040(1)(B) AS AMENDED
Section 1031 Tax Free Exchanges of Real Property at a Glance
The main tenet of a section 1031 like-kind exchange states:
The relinquished property, that is property disposed of by the taxpayer, must have been held for productive use in trade or business, or for investment. The property must be exchanged solely for like-kind property, to be held either for productive use in trade or business, or for investment (I.R.C. & 1031 (a) (i)).
If the taxpayer receives money, or other non-like-kind property, in the exchange, or is relieved of a liability as part of the exchange, the exchange will not qualify for complete nonrecognition of gain but may still qualify for partial nonrecognition treatment.
Common 1031 Tax Exchange Misconceptions
Navigating the complex system set up for a 1031 tax free exchange of real property can be challenging. An experienced tax-deferred exchange lawyer can help you traverse the system. At the Gourley Law Group, we have witnessed our clients coming into the exchange process with several misunderstandings of how the code is meant to work.
MISCONCEPTION: You must find someone who has property you want and who wants your property in order to complete an exchange.
TRUTH: While the above scenario would certainly qualify as an exchange, it is truly a rare occurrence. Today’s exchange is typically accomplished with a qualified intermediary who accepts the relinquished property, sells it to a waiting buyer, and uses the proceeds to purchase the replacement property. This must be accomplished in strict compliance with the rules and regulations governing 1031 exchanges.
MISCONCEPTION: The requirement that property be like-kind limits the taxpayer’s investment options.
TRUTH: The term like-kind simply means that real property must be exchanged for real property. Some examples of differing properties that still qualify as like-kind exchanges include,
- improved land for unimproved land,
- single property for multiple properties,
- duplex for a fourplex,
- single family residence for a condominium,
- vacant land for an office building, or
- farmland for a shopping center.
Even leases are exchangeable. There is a limitation that real property may not be exchanged for personal property however.
MISCONCEPTION: Title to the relinquished property must pass simultaneously with the receipt of the title to the replacement property.
TRUTH: By far the most common exchange today is the deferred like-kind exchange. Section 1031 provides that the taxpayer has 180 days from the transfer, or disposal, of the relinquished property to acquire the replacement property. This extended time period allows for the realities of real estate transactions; which, depending on the nature of the acquisition and the number of parties involved, are likely to experience delays in closing.
MISCONCEPTION: Only real estate is eligible for exchange treatment under section 1031.
TRUTH: Section 1031 applies to all assets used in trade or business or investment purposes. The definition of “like-kind” is more restricted for personal property but farm equipment, oil and gas equipment, fishing boats, mill equipment, barges, ships, trucks, bulldozers, and planes are but a few examples. Even the furniture and fixtures in business sales are exchangeable.
MISCONCEPTION: I can personally set up a special account to transfer the sale proceeds to.
TRUTH: Even if you never touch the money, by failing to have a qualified intermediary controlling the process, you would be committing an act of dominion and control over the proceeds; disqualifying the exchange. The control of the proceeds must, at all times, be in the hands of an unrelated third party.
Advantages and Disadvantages of an Exchange
Saving tax dollars is a strong incentive for considering a like-kind exchange, but some non-tax reasons for considering an exchange are
- consolidation or diversification of investments,
- exchange of the asset for an asset with greater appreciation or cash flow,
- geographic relocation of assets or elimination of management problems, and
- transferring tax basis between properties and estate planning.
In weighing the advantages, you must also consider the disadvantages of an exchange, such as the relinquished property basis carrying over to the replacement property, resulting in a lower depreciable basis in the replacement property than if it were purchased outright. There are also increased transactional costs to be conscious of.
Section 1031 Exchange Technical Requirements
Section 1031 (a) (1) mandatory provision states that:
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
Property not exchangeable is referred to as stock in trade or property held primarily for sale. Examples of stock in trade are
- stocks, bonds, or notes,
- partnership interests,
- certificates of trust or beneficial interest, and
- choses in action.
Stock in trade is property considered as inventory to a dealer of that type of property. Real property, held as inventory, does not qualify for exchange under section 1031 (a). Nothing, however, prevents a dealer from holding specific assets either for productive use in trade or business or for investment.
Factors to be considered in identifying stock in trade include,
- purpose for which the property was initially acquired and subsequently held,
- extent improvements were made to the property,
- frequency, number and continuity of sales,
- extent and nature of the transaction involved,
- business of the taxpayer,
- extent of advertising used in soliciting buyers,
- listing of the property, and
- purpose for which the property was held at the time of sale.
Experienced Tax-Deferred Exchange Lawyers
Navigating section 1031 tax free exchanges of real property can be complicated. It is important to have a skilled tax-deferred exchange lawyer to guide you through the process. Contact the Gourley Law Group today at (360) 323-2885.
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