What is a 1031 Exchange?
Internal Revenue Code (IRC) Section 1031 is one of the last remaining tax deferments. It is a powerful tool that allows investors to exchange any investment property for any other investment property. For your exchange to be valid, you must follow specific IRS regulations.
Here is an abbreviated list of the regulations:
◦ The properties being exchanged must be of like kind (but not identical). For example, you may exchange: land for a duplex, a strip mall for an office building or an investment house for land.
◦ You must identify and close on your replacement property within a specific period of time.
◦ 45-Day Identification period: A taxpayer has 45 days within which to identify one or more replacement properties. Identification must be made in writing. The taxpayer may identify three properties without regard to value, or an unlimited number of replacement properties if their aggregate does not exceed 200% of the property transferred by the taxpayer.
◦ 180-Day Receipt Rule: The taxpayer must close on the purchase of the replacement property within 180 days after the first property was sold.
◦ Your replacement property must be of equal or greater value to the property you have sold to get a full tax deferral.
◦ If your relinquished property has debt, you must plan equal or greater debt on the replacement property at time of closing.
*The Internal Revenue Service has recently issued Revenue Procedure 2000-37, which allows an investor to complete a Reverse Exchange. A Reverse Exchange allows an investor to acquire a replacement property before the investor has sold the relinquished property. This allows the investor to make sure that the replacement property fits the investor’s requirements before selling or relinquishing their old property.
A reverse exchange works in a similar manor as a regular exchange. Through the use of a Qualified Intermediary, an investor can purchase a replacement property, and within 45 days of closing on the replacement property, identify their property to be relinquished. That investor has up to 180 day from closing on the replacement property to sell and close an identified relinquished property, to qualify for a reverse exchange.
*Above information obtained from sources believed to be reliable, but no representations of any kind – expressed or implied-are made as to the accuracy of such information. All references to income/expenses are approximate only. Buyer should conduct an independent investigation of all pertinent property information. We bear no liability for any errors, inaccuracies or omissions.
Section 1033 Roll-Over: Casualty and Eminent Domain Proceeds
Section 1033 provides an alternative tax-free mechanism for the receipt of proceeds from casualty and eminent domain. If Section 1033 applies, a taxpayer has a period of two to three years (depending on how the property was condemned, lost, taken through condemnation) to roll over the proceeds in a new investment that is “similar or related in service or use” or in certain instances “like-kind.” Unlike Section 1031, the taxpayer must make a specific election to qualify for the Section 1033 roll-over.
Involuntary Conversion Events
To qualify for a Section 1033 roll-over, one of the following events, sometimes referred to as an “involuntary conversion”, must occur:
◦ A destruction of the property that is beyond the control of the taxpayer
◦ A theft of the property
◦ A seizure or requisition of the property
◦ A taking of the property through condemnation or eminent domain
◦ The disposition of the property upon the threat or imminence of condemnation or eminent domain
Qualifying Replacement Property
Section 1033 has two sets of rules for qualifying replacement property depending upon whether the property involuntarily converted falls into either of the following categories: (1) real property held for investment or in a trade or business that has been seized, condemned or sold on account of a threat of such seizure or condemnation; and (2) all other property.
For all other property, the replacement property must be “similar or related in service or use.” Such a test focuses on whether the property is functionally similar to and has the same uses as the property being converted, which usually means that the properties are physically similar and the taxpayer’s relationship to each of them is substantially the same.
In comparison with the like-kind test, the “similar or related” test is narrower where real estate is concerned and in many instances broader in the context of personal property. A careful analysis is therefore required to determine whether the replacement property will qualify.
Comparisons with Section 1031
In certain instances, a taxpayer may have the option of utilizing either a Section 1031 Exchange or a Section 1033 roll-over. In particular, this may occur when there is a sale of property under the threat or imminence of a condemnation or seizure. On the other hand, where there is an involuntary conversion due to theft or destruction or if the property is not held for investment or used in a trade or business, then Section 1033 will be the only option.
If there is a choice between the two provisions, a number of factors should be considered, including the following:
◦ The Section 1033 roll-over permits a period of more than two years for reinvestment rather than the 180 days. This period is extended to three years for seized or condemned real property meeting the qualifying for the like kind treatment. Technically, it is two (or three) years after the close of the taxable year in which the gain is realized.
◦ The Section 1033 roll-over does not require that the technical rules of Section 1031 apply, including the use of a qualified intermediary.
◦ The like-kind requirements of Section 1031 will need to be compared to the “similar use” requirements of Section 1033.