In 1979, this treatment was expanded by the courts to include non-simultaneous sale and purchase of real estate, a process sometimes called a Starker exchange.
[1] To qualify for Section 1031 of the Internal Revenue Code, the properties exchanged must be held for productive use in a trade or business, or for investment.
The properties exchanged must be of "like kind", i.e., of the same nature or character, even if they differ in grade or quality (such as one commercial apartment to another).
But after the rendering of the decision in Starker v. United States,[3] a contract to exchange properties in the future is practically the same as a simultaneous transfer.
A Qualified Intermediary must also be used to facilitate the transaction, by holding all the profits from the sale, and then disbursing those monies at the closing, or sometimes for fees associated with acquiring the new property.
§ 1031) states the recognition rules for realized gains (or losses) that arise as a result of an exchange of like-kind property held for productive use in trade or business or for investment.
The loss is not recognized at the time of the transaction, but must be carried forward in the form of a higher basis on the property received.
Prior to the 2018 tax law changes, exchanges of personal property could qualify under Section 1031.
For this reason, exchanges (particularly non-simultaneous changes) are typically structured so that the taxpayer's interest in the relinquished property is assigned to a Qualified Intermediary prior to the close of the sale.
Although it is not used in the Internal Revenue Code, the term "boot" is commonly used in discussing the tax implications of a 1031 exchange.
The most common sources of boot include the following: There is and has been much confusion surrounding the use of Section 1031 and second homes.
Until 2008 many people were exchanging in and out of their second homes as there was little to no guidance surrounding what did and did not constitute property held for investment.
IRS rules control the length of time that the replacement property must be held before it may either be sold or used to enter into a new tax deferred exchange.
With recent legislation, however, capital gains taxes on such a transaction are no longer completely avoided.
As long as the money continues to be re-invested in other real estate, the capital gains taxes can be deferred.
[5] An alternative to a 1031 exchange for someone who wants to defer capital gains tax, but who does not want to continue to hold property is a structured sale.
This method offers both buyer and seller many benefits and is regarded as an excellent possibility for those looking to retire from or exit from the real estate or business market.
Retain the services of a Qualified intermediary, typically a federally-licensed enrolled agent (EA), or state-licensed tax counsel or Certified Public Accountant (CPA).
Make sure your escrow officer/closing agent contacts the Qualified Intermediary to order the exchange documents.
The 1031 Exchange Agreement must meet with federal tax law requirements, especially pertaining to the proceeds.
The funds should be placed in a separate, completely segregated money market account to insure liquidity and safety.
The taxpayer sends written identification of the address or legal description of the replacement property to the Qualified Intermediary, on or before Day 45 of the exchange.
An amendment is signed naming the Qualified Intermediary as buyer, but again the deeding is from the true seller to the taxpayer.
When conditions are satisfied and escrow is prepared to close and certainly prior to the 180th day, per the 1031 Exchange Agreement, the Qualified Intermediary forwards the exchange funds and gross proceeds to escrow, and the closing statement reflects the Qualified Intermediary as the buyer.
The IRS has also determined that the reverse sequence also will avoid capital gains taxes, provided certain requirements are met.
Rather than selling the home, which will no longer be his personal residence, he chooses to rent it out for a period of time.
After ten years, he decides that he wants to sell it but, at the same time, he has a grown son who will be going to college in yet another state.
He decides that he wants to buy an apartment building in the college town for the son and other students to rent while they are in school.
Therefore, he arranges for a section 1031 exchange, and buys the new property, thus avoiding the capital gains tax at that time.
In the aforementioned example, the investor would need to substantiate his or her investment intent to the IRS by showing an arm's length lease to the son and other students.