1. What is a 1031 exchange?

The numbers "1031" refer to a section of the Internal Revenue Code entitled: "Exchange of property held for productive use or investment".  Section 1031 provides that gain or loss is not recognize when property held for productive use in a trade or business, or for investment, is exchanged for like-kind property to be held for productive use in a trade or business, or for investment.  Section 1031 exchanges are often referred to as "Like-Kind" exchanges, "Tax-Deferred" exchanges, "Starker" exchanges, "Tax-Free" exchanges and "Swaps".  Although not referenced as "Section 1031" when first enacted in 1921, the rationale used as justification for not recognizing gain or loss on the exchange of property was similar to the "economic stimulus packages" of today, whereby, continuity of investment and administrative convenience will, in the long run, result in economic growth. The principals of 1031 Exchange Specialists, Inc. (1031 ESI) have helped investors exchange over two billion dollars of real estate in 41 states and the US Virgin Islands.

2. Why would someone choose to do a 1031 exchange versus just paying taxes?

No one enjoys paying taxes!  Putting emotions aside, there are several practical financial reasons for choosing to complete a 1031 exchange, such as; (1) consolidation or diversification of investments; (2) greater appreciation and leverage opportunities; (3) increased cash flow; (4) relocation of investments; and (5) exchanging low basis property for high basis property.  A taxpayer should consider the money they are not paying in taxes as an interest free loan from the government to help them build wealth. 1031 Exchange Specialists, Inc. (1031 ESI) can provide expert guidance when deciding whether a 1031 exchange is the best tax savings tool for the taxpayer.

3.  What taxes are imposed on a person when they sell an investment property?

A taxpayer who chooses not to complete a Section 1031 exchange may be subject to numerous federal, state and local taxes.  If the property being sold is held less than one year, the gain on the sale of the property is taxed federally at ordinary income tax rates, and although constantly changing, may potentially fall in the high thirty percentile.  If the property is held more than one year, the gain on the sale of the property is taxed at the federal capital gains rate, currently at fifteen percent.  If the property being sold was a depreciable property, the portion of the gain resulting from the depreciation deduction is federally taxed at a twenty-five percent rate or at ordinary income tax rates, depending on the asset.  In many instances, the sale of a property may affect the calculation of Alternate Minimum Taxes (AMT) for a taxpayer.  These "tax preference" items are generally taxed by the federal government at a rate of twenty-six to twenty-eight percent.  Let's also not forget our State and local governments, who, for the most part, do not have fixed capital gains rates and impose taxes at their respective ordinary income tax rates. 1031 Exchange Specialists, Inc. (1031 ESI) can assist the taxpayer in evaluating their tax liability when a 1031 exchange is not utilized.

4.  How do the individual states tax 1031 exchanges?

All states, for the most part, follow the federal 1031 law and also allow the deferment of state taxes.  For example, Pennsylvania, recognizes 1031 exchanges for C-Corporations, but not for individuals, partnerships, trusts, etc.  Several states, including Oregon for example, have a "clawback" provision requiring the payment of Oregon tax on the sale of a replacement property, even if the replacement property is located in another state.  Some "clawback" states require an Annual Report be filed until such time as the replacement property is sold.  Other states, New Jersey, for example, impose a non-resident withholding tax on the sale of property within the state by individuals domiciled outside the state.  However, exemptions to the withholding tax are granted in New Jersey to persons completing a 1031 exchange and to property owned by corporations, partnerships and LLC's.  Some non-resident withholding states require several weeks time before sale to grant the withholding exemption.  An experienced Qualified Intermediary will be able to advise you of the individual state tax requirements. 1031 Exchange Specialists, Inc. (1031 ESI) can readily identify individual state tax requirements both in and outside the use of the 1031 exchange.

5.  Are 1031 exchanges just for real estate?

Section 1031 of the Internal Revenue Code applies to real property, personal property, certain intangibles and other non-depreciable personal property.  Often state law will determine the classification of real property.  For example, a co-operative (stock ownership) apartment in New Jersey is considered real property under state law and is therefore "like-kind" to a fee simple interest in real estate within or outside of New Jersey.  Other examples of "like-kind" real estate may include 30 year leases, cell towers, conservation easements, oil, gas and mineral interests, timber, water rights, improvements to be constructed, options, and more.  Personal property exchanges, such as a car for a car, are more restrictive in that a car cannot be exchanged for a truck, and a specific class of liquor license cannot be exchanged for another class of liquor license.  The IRS has issued "like-class" provisions for personal property but only as a safe-harbor.  An exchange may still be "like-kind" and meet the requirements of a Section 1031 exchange, even if not "like-class". 1031 Exchange Specialists, Inc. (1031 ESI) can advise the taxpayer on the "like-kind" requirements of real and personal property exchanges.

6.  What is the role of the Qualified Intermediary in a 1031 exchange?

The role of the Qualified Intermediary, as provided in the Regulations, cannot be that of a disqualified person or an agent of the taxpayer for purposes of a tax-deferred exchange.  A disqualified person or agent is one who has acted as the taxpayer's employee, attorney, accountant, investment banker or broker, or real estate agent or broker in the two years prior to the exchange, related parties and other beneficial interests.  In order to meet the requirements of the Regulation and have a successful exchange, the Qualified Intermediary must (1) enter into an Exchange Agreement with the taxpayer whereby the taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property are expressly limited; (2) be assigned the sales and purchase agreements for the relinquished property and replacement property, with written notification of the assignment to all parties to those agreements; and (3) hold the net sale proceeds in its account or with a qualified escrow or trust. 1031 Exchange Specialists, Inc. (1031 ESI) will ensure every aspect of the taxpayer's 1031 exchange meets the requirements of the regulation.

7.  Do you need a Qualified Intermediary in each state that you sell or purchase property?

The Qualified Intermediary you choose will remain in the transaction from the sale of your relinquished property(s) to the acquisition of your replacement property(s), or the termination of the exchange, whichever comes first, regardless of which state either transaction occurs.  Some states, however, in response to Qualified Intermediary bankruptcies and defalcations, have enacted laws governing exchange facilitators.  These laws may include, but are not limited to, registration, insurance, notification and other restrictions imposed on the Qualified Intermediary for transactions where the relinquished property is located within the state or the Qualified Intermediary is considered "doing business" within the state. 1031 Exchange Specialists, Inc. (1031 ESI) can facilitate 1031 exchanges in most of the 50 states and the US Virgin Islands. 

8.  How is the taxpayer's money protected while held by the Qualified Intermediary?

As mentioned previously, the Qualified Intermediary industry is unregulated with the exception of a few states.  The number of defalcations and bankruptcies has been few.  However, despite the size of the Qualified Intermediary or its parent company, or the presence of a Fidelity Bond, Errors and Omission, or Directors and Officer's insurance policies, or the availability of audited financial statements, defalcations and bankruptcies still occurred, resulting in the loss of the client's equity.  There are safeguards a taxpayer should consider when selecting a Qualified Intermediary.  These safeguards include: (1) depositing the taxpayer's funds in FDIC insured accounts; (2) depositing taxpayer funds in accounts that are principal preserved and liquid; (3) depositing taxpayer funds in segregated accounts under the client's name and federal identification number; (3) requiring dual signatures within the Qualified Intermediary company and, where practical, the signature of the taxpayer for any withdrawals; (4) ensure the proper wording is contained in the Exchange Agreement to protect the taxpayer's funds from a Qualified Intermediary bankruptcy; (5) the use of a Qualified Escrow and Trust Agreement; (6) the use of a Security or Guarantee Arrangement; and/or (7) deposit taxpayer funds in a financial institution selected by the taxpayer.  The most important safeguard for a taxpayer is to rely on the referrals of their accountants, attorneys, Realtors and former clients of the Qualified Intermediary.  1031 Exchange Specialists, Inc. (1031 ESI) utilizes various safeguards to ensure liquidity and preservation of principal for the taxpayer's funds.

9.  What are the time restrictions of a 1031 exchange?

Various time restrictions are included throughout the 1031 Regulations and Revenue Procedures.  The most critical of these time restrictions are the 45 Day Identification period and the 180 Day exchange period, which apply to forward, reverse and build-to-suit exchanges.  These time restrictions may be impacted by something as significant as federally declared natural disasters, or as insignificant as the filing deadline of the taxpayer's income tax return.  Secondarily, time restrictions relating to holding periods of two years and 24 months, respectively, are required when exchanging with a related party or suggested when qualifying a property.  Additional time restrictions relating to minimum rental periods and maximum personal use periods are also provided in the safe harbors of a 1031 exchange.  A competent Qualified Intermediary will guide you through these time-frames. 1031 Exchange Specialists, Inc. (1031 ESI) can advise the taxpayer of the time-frames within the regulations and Revenue Procedures and ensure the time-frames are adhered to for a successful 1031 exchange. 

10.  What are some of the complex areas of "1031 exchanges"e.g.  Partnerships, dealers, seller financing, vacation homes, related parties, partial exchanges?

Although the vast majority of 1031 exchange transactions are straight-forward, one-for-one exchanges, with little or no complications, a competent experienced Qualified Intermediary can also guide the taxpayer, their accountant, attorney and Realtor through the very complex transactions, as listed above.  A Qualified Intermediary"s familiarity with the Regulations, Revenue Procedures and Private Letter Rulings (PLR) will prove beneficial to the taxpayer when deciding whether the 1031 exchange is a viable tax saving and wealth building tool for their transaction.  Please contact 1031 Exchange Specialists, Inc. (1031 ESI) to discuss your specific circumstances and goals.

11. Can a person buy a property before they sell their property in a 1031 exchange"(reverse exchange)?"

In 2000, the Internal Revenue Service issued a Revenue Procedure providing a safe harbor permitting an Exchange Accommodation Titleholder ("EAT") to acquire, with all of the benefits and burdens of ownership, the relinquished property or the replacement property in an exchange and hold it for up to 180 days while the taxpayer attempts to sell the relinquished property and/or improve the replacement property.  Please see 1031 Exchange Specialists, Inc. (1031 ESI) web page entitled "Reverse Exchanges" for additional details about reverse and build-to-suit exchanges.

12.  A 1031 exchange is a deferral of taxes.  Are there strategies for eventually eliminating the taxes that were deferred?"

A taxpayer has several options available to avoid or eliminate being taxed on the sale of their investment property.  The first option is to continue taking advantage of Section 1031 of the tax code, without limitation, when an investment property is sold.  This strategy affords the taxpayer use of additional equity, which otherwise would have been paid in taxes, to leverage into higher priced property and build wealth.  The taxpayer is also utilizing the unpaid tax dollars interest free from the government.  The second option is to convert a 1031 replacement property into a primary home and take advantage of the primary home exclusion.  This strategy has been tightened over the last several years as time restrictions, depreciation recapture and allocations of the gain to "qualified" and "unqualified" usage have been imposed.  Lastly, if the taxpayer holds the 1031 replacement property until death, the taxpayer's heirs receive the property at a "stepped-up" basis or fair market value on the date of death, whereby, the gain becomes part of the taxpayer's estate, potentially exempt from taxation, and not passed along to the heirs. The principals of 1031 Exchange Specialists, Inc. (1031 ESI) are in their 12th year of providing consulting services and documentation to real estate investors, their accountants, and tax attorneys ensuring individual goals are attained.

13.  Can a 1031 exchange and a primary home exclusion be combined to maximize tax savings?

A taxpayer has several options available to maximize tax savings when combining a 1031 exchange and a primary home exclusion.  The first option is when a taxpayer has two separate structures used concurrently, such as a Duplex, whereby, part of the property is used for business or investment and the other part is the taxpayer's primary residence.  Since the usage of the property is clearly defined and distinguishable between personal and business use, the taxpayer can apply the primary home exclusion to the portion lived in and complete a 1031 exchange on the business portion.  The second option is available for a single structure used concurrently, such as, a Boarding house.  Since the usage is not clearly definable, the taxpayer would first apply the primary home exclusion to the entire gain and complete a 1031 exchange for the balance of the gain.  The third option is available when a single structure is used consecutively, such as, when a principal residence is converted to a business or investment property.  The tax application is similar to the Boarding house example above, however, time restrictions are imposed on the taxpayer.  Please see 1031 Exchange Specialists, Inc. (1031 ESI) web page entitled "Mixed Use Property" for further information.

14.  Are there any disadvantages of a 1031 exchange?

The disadvantages of completing a 1031 exchange are insignificant in comparison to the tax savings and wealth building opportunities afforded those who have taken advantage of this great tax tool.  Among the disadvantages of a 1031 exchange are (1) a reduced basis in the replacement property resulting in a lower depreciation expense deduction; (2) an increase in transactional costs; (3) limitation on the use of equity, however, a taxpayer may refinance the replacement property after acquisition to avail themselves use of the property's equity; and (4) unknown future tax rates in the event the taxpayer decides to sell the property without the benefit of a 1031 exchange or any other tax saving strategies as discussed above. 1031 Exchange Specialists, Inc. (1031 ESI) can provide expert guidance when deciding whether a 1031 exchange is the best tax savings tool for the taxpayer.

15.  What changes have occurred in the last 2 years that impact 1031 exchanges and the primary home exclusion?

Changes to the tax regulations, the issuance of Revenue Procedures and positions taken by the Internal Revenue Service on Private Letter Rulings affecting 1031 exchanges and the primary home exclusion can be found on 1031 Exchange Specialists, Inc. (1031 ESI) web page entitled "1031 Update".  Please refer to this page for the most recent changes.

*CPA lic. Inactive