What qualifies for 1031 consideration?  Both real and personal property held in a business or production of income.  What that also means is property that has limited personal use.  Examples of real property include land, rental properties, shopping centers, marinas, second homes (it depends on whether the level of personal use exceeds fourteen overnights per year, was it rented to family members at fair market rent and how is it treated on the exchangor´s taxes, preferably Schedule E rather than Schedule A).  Farms and ranches are eligible, thirty year leasehold interests, water and mineral rights, and the long term rights to timberland harvest.  On the personal property side, medical equipment, computers, copiers, furniture, cars, trucks, ships, barges, railroad cars, aircraft, construction and forestry equipment qualify in addition to antique instruments, art and other collectibles.

Interested in learning about a 1031 tax deferral?  Does it make sense for your real and personal property holdings?  Want to know a few of the benefits and a couple of basic requirements?  As a Certified Exchange Specialist® with having completed over 500 exchanges over four years, I have learned to ask lots of questions all in the interest of determining whether an Internal Revenue Code Section 1031 is appropriate.  I cannot provide financial advice and always suggest the seeking of counsel from an accountant or tax attorney. 

As a Qualified Intermediary, I am responsible for providing exchange documents to sign at closing and hold the exchange proceeds in an interest bearing non comingled escrow account.  What makes the closing an exchange rather than a sale?  First, it will most likely appear on the HUD settlement statement.  Verbiage may be included in the sales and purchase of the sales agreement and is required when purchasing the replacement property.  Clearly, the exchange documents define the exchange steps in accordance with the 1031 regulations.  There is an exchange agreement, an assignment and typically a notice of assignment at the relinquished or old property closing.  The net proceeds are wired to a bank with liquidity and safety as the primary requirements.  If the exchangor has access to the funds or benefits other than the interest earned, the g(6) limitations will be violated, terminating the exchange.  At the replacement closing, the exchange proceeds are wired, the HUD reflects the exchange and an assignment and notice of assignment are the two exchange agreements for the second step of a forward exchange.

Tax deferrals were first introduced in the National Revenue Act in 1921. A number of changes occurred to the code throughout the eighty plus years to prevent the abuse what is one of the last remaining ways to build wealth. 

What qualifies for 1031 consideration?  Both real and personal property held in a business or production of income.  What that also means is property that has limited personal use.  Examples of real property include land, rental properties, shopping centers, marinas, second homes (it depends on whether the level of personal use exceeds fourteen overnights per year, was it rented to family members at fair market rent and how is it treated on the exchangor´s taxes, preferably Schedule E rather than Schedule A).  Farms and ranches are eligible, thirty year leasehold interests, water and mineral rights, and the long term rights to timberland harvest.  On the personal property side medical equipment, computers, copiers, furniture, cars, trucks, ships, barges, railroad cars, aircraft, construction and forestry equipment qualify in addition to antique instruments, art and other collectibles.

What does not qualify are personal residences, stocks and bonds, partnership interests, indebtedness and inventory.

How does it work?  All exchanges whether the old property is sold before buying the new property called a forward or delayed and even a simultaneous exchange if both the buy and sell occur at the same closing.  Or in a reverse exchange where the new property is purchased before the old property sells.  All exchanges follow the same basic rules. 

Rules

1.       Trading Up ? as long as the debt and equity in the replacement property is equal to or exceeds the debt and equity in the relinquished property, then the tax is deferred.  Otherwise the  difference is taxed. 

2.       Same Taxpayer ? the tax return that sells must be the tax return that buys.

3.       The sale and purchase can happen the same day or take up to 180 calendar days posting the first closing. 

a.       Identification Period ? by the 45^th calendar day post closing, replacement properties must be identified and identification form must be in the hands of the Intermediary by 11:59 PM or to someone at the closing office.

b.      Replacement Period ? by the 180^th day or an additional 135 calendar days post the first 45, the new property must be purchased.

4.       Holding Time ? there is no holding time in the code.  Clearly, the IRS looks at the intent and facts to support the exchange.  The time held is one fact of many.  The longer held as if to season the investment the better.  One year and a day is a healthy perspective allowing the long term capital gain of currently, 15% to be deferred, unless the Exchangor´s income is in the 10% or 15% bracket then the long term gain is 5% with a few exceptions.  Anything less than one year and a day is taxed at ordinary income rates.  The IRS suggests a hold time of two years.

So what are the potential benefits of a 1031 exchange?

1.       The federal capital gain tax is deferred until the time the replacement property is sold.

2.       The state capital gain tax if applicable and dependent upon where the Exchangor claims as residency is also potentially deferrable until the replacement property is sold.  Each state treats the 1031 differently, some have amounts to be withheld and forms to file while others require no additional taxes or forms.

3.       The recaptured depreciation or 25% of depreciation taken is deferrable until the replacement property is sold

4.       Besides the tax deferral, there are other potential benefits:

a.       The exchangor may move and wishes to have the property closer.

b.      Change from a fully depreciated property to one that can be depreciated.

c.       Change from a property not appreciating to a property in an area that is.

d.      Change from a non cash flow property such as land to one that does.

e.      Diversify from one property to many, or many to one or many to many.

What are the disadvantages?

1.       Reduced basis in replacement property.

2.       Increase in transactional costs, though tax deductible.

3.       Limitation on use of equity.

Ok, so why do so many individuals, companies, and trusts initiate an exchange?  It is all in the numbers.  Imagine receiving an interest free loan for an indefinite period of time.  In my first year of practice, the average tax deferred was $40,000.  Rather than paying the tax, those clients placed that $40,000 back to work building greater wealth.  They utilized those taxable dollars to purchase more property.  Yes, there are times to pay the tax.  Exchanges should be reviewed with the Exchangor´s accountant.  Work the numbers and see if the exchange is to your benefit. 

To learn more or talk with Andy Gustafson, Certified Exchange Specialist®  at toll free 866.521.1031  visit www.atlas1031.com.