1031 Exchanges

The 15 most frequently asked questions about 1031 tax-deferred exchanges

1. How is capital gain tax calculated?

Capital gain tax on property held for more than 365 days is computed at a flat rate of 20% and is due and payable in full on the next tax reporting year following the sale (commonly April 15th for most individuals). Gain is defined by taking the net closing proceeds and subtracting the “basis” of the property consisting of the actual purchase price together with closing costs and capital improvements, which enhanced or extended the life of the property. Real property taxes and general maintenance are not taken into consideration when establishing basis.

2. What is a deferred exchange?

Section 1031 of the Internal Revenue Code defines a deferred exchange as one when which a taxpayer transfers property held for productive use in business or for investment and later receives property to be held for similar purposes. The key is intent. Accordingly, if a party owns a vacant lot and the intent was for investment purposes and later replaces this property with a condominium or house with the primary intent of rental or investment purposes the properties are deemed to be like kind.

3. What properties qualify for a tax deferred exchange?

Any property, which is not a primary residence may qualify. However, you must demonstrate the primary purpose was investment. In many instances where the property was held for investment purposes “basis” may have been reduced if depreciation had been taken on previous tax returns making a 1031 exchange more desirable.

4. Can more than one property be involved in an exchange?

Yes. Up to three properties can be sold and replaced with one property. Similarly, up to three properties may be utilized as a replacement property.

5. What is a "Qualified Intermediary?"

A Qualified Intermediary is a third party, not related or disqualified, who is designated to hold the net proceeds from the sale of the relinquished property in an independent escrow account to be utilized for the purchase of the replacement property. Should the seller have access to any funds following the closing the tax benefit will be lost.

6. When can gain be recognized in the deferred exchange?

If a Seller actually or constructively receives money or other non-like kind property (boot) for the property sold that portion of the transaction is treated as proceeds of sale and taxed accordingly.

7. Can replacement property be less than the fair market value of the relinquished property?

Yes. However, any funds that are ultimately received are considered to be boot and thereby subject to capital gains at the rate of 20%.

8. When must the replacement property be identified?

Within 45 days of the date of the sale of the relinquished property, notice must be sent to the Qualified Intermediary in writing, signed and dated by the taxpayer setting forth the legal description of the replacement property to be acquired.

9. When must the replacement property be purchased?

No later then 180 days from the initial sale and closing of the sale of the relinquished property.

10. Can escrow funds be used to pay closing costs?

Yes. The use of money including interest earned in a qualified escrow account can be utilized to pay specific transactional expenses listed as the responsibility of Buyer or Seller.

11. Are any limits placed on the replacement property?

Yes. The aggregated fair market value of the replacement property cannot exceed 200% of the fair market value of the relinquished property. Furthermore, if furniture is involved in the sale, it must be incidental to the property and cannot exceed 15% of the aggregated fair market value of the replacement property.

12. Are reverse exchanges allowed?

Yes. Effective September 15, 2000 the I.R.S. set forth guidelines, which allow replacement property to be purchased in advance of selling the property to be purchased. However, rules are complex and must be strictly followed.

13. Can new construction qualify for 1031 treatment?

Yes. Under careful guidelines. However, construction on an existing lot currently owned by the taxpayer will not qualify. Funds must be utilized for the acquisition of property and not just improvements.

14. Can a motor home, mobile home, yacht, or sailboat qualify as part of the exchange?

No. These items are considered personal property and only real property can qualify.

15. Are 1031 excanges limited to U.S. citizens?

No. Any individual or entity may qualify for a 1031 exchange regardless of whether or not they are U.S. Taxpayers, however, real property located outside the U.S. will not be deemed “like kind”.