1031 Exchanges Basics

1031 Exchange Definition A 1031 exchange is a legitimate process sanctioned by the Internal Revenue Service where like-kind property is exchanged wherein the property owner, referred to as exchanger, is not liable for immediate taxation. 1031 exchanges are basically carried out for real estate transactions although other tangible and intangible properties could also qualify. The IRS requires an unbiased third party to facilitate the exchange. This party is called facilitator, qualified intermediary (QI) or accommodator. Why Consider an Exchange? If you own a business or some property, then a 1031 exchange could prove to be a powerful investment tool. Property, which are transferred or sold for gain can be taxed and those taxes can accumulate quickly. As the property seller, you may be accountable for taxes that tote up to 40% or more. On the other hand, in a 1031 exchange, the exchanger can keep all the equity of the property for re-investment. This allows the exchanger to get a replacement property with less management, a better location, and better flow of cash. Eligibility for an Exchange Like-kind property is generally defined as any real property within the USA or some of its territories. Property that is possessed for productive use in a business or for investment may be qualified to be exchanged as like-kind property. For example, a duplex can be exchanged for a raw land. Personal property on the other hand, is not like-kind real property. An industrial building cannot be exchanged for a private jet for instance. Personal property is evaluated based upon its General Asset Class, its NAICS categorization and its character and nature. Properties Ineligible for Exchange The Internal Revenue Code 1031 was revised in 1986 to prohibit some property from being exchanged. These include personal residence (although the part of the residence that is used for investment or business purposes such as a home office may be exchanged), bonds, securities, stocks, notes, stocks in trade or other proof of financial obligation, goodwill of a company, and partnership gains. Also excluded from being exchanged are property possessed mainly for sale such as property retailed at once after being improved or after purchase, developed lots, and business inventory. 1031 Exchange Cornerstones 1. An exchange must be carried out, not a sale. One party has to give up a property, referred to as relinquished property, and receive another property in return, which is referred to as the replacement property. 2. The property being exchanged must be of like-kind, meaning, they must be of similar classes of property. Like-kind describes the nature and character of the property. 3. The napkin test must hold. This means that the mortgage, equity and value on the replacement property should be greater than or equal to that of the relinquished property. 4. The side, which relinquished a property, must obtain the corresponding replacement property. Timeline Requirements The exchanger is given 45 days to identify the probable replacement properties and acquire the final replacement property in 180 days. The first 45 days are measured from the closing day of the relinquished property. Note that the entire exchange has to be carried out within 180 days, not 225 days. What are the Rules for Identification? The exchanger is obliged to provide an explicit account of the probable replacement properties earlier than twelve midnight of the 45th day measured from the close of the relinquished property. A legal report or property address is enough. In addition, a submitted purchase agreement is also considered to be sufficient identification. Furthermore, properties purchased and closed within the 45 days can qualify as identification. Exceptions It has been mentioned earlier that personal residences are excluded from being exchanged. However, vacation homes and other second homes may be eligible for 1031 exchanges depending on certain conditions defined by the Internal Revenue Service on February of 2008.