I have been handling Section 1031 tax-deferred exchanges as a Qualified Intermediary for more than 30 years. The following are some of the typical exchange myths I hear repeated almost every day.
Myth # 1: The exchange will only qualify if you purchase a more expensive Replacement Property.
The Correct Answer: Should the taxpayer purchase a Replacement Property that is equal to or more expensive than the Relinquished Property (Property that was sold), the taxpayer will be successful in deferring all of its gains. But if a taxpayer acquires a Replacement Property that is less in value than the sales price of the Relinquished Property, the difference between the sales price of the Relinquished Property and the purchase price of the Replacement Property will be taxable, and the rest of the transaction will qualify for Section 1031 tax deferral.
Myth # 2: Only commercial real estate can be exchanged.
The Correct Answer: Section 1031 of the Internal Revenue Code applies to properties held for investment or for productive use in a trade or business. This law includes commercial properties, as well as, properties that are residential, rental, or even raw land. In fact, the majority of the 1031 exchanges are investment residential properties.
Myth # 3: Once I have completed my Section 1031 exchange, I will never have to pay my taxes.
The Correct Answer: A Section 1031 exchange is a tax deferral strategy and can be deferred for an undetermined period of time. With appropriate tax and legal planning, it may be possible to have the Section 1031 tax deferral result in a long-term or indefinite tax deferral. At their death, if the taxpayer leaves the Replacement Property to another family member, there is a good possibility that the taxpayer’s estate may not pay any estate taxes and additionally, the heir(s) may not pay any capital gains tax and will receive a stepped-up basis on that property.
Myth # 4: A Section 1031 Tax-Deferred Exchange defers all of the Tax Liability.
The Correct Answer: The Basic Rule on a Section 1031 Exchange is called the “Napkin Rule”. One part of that rule says: The Taxpayer (Exchangor) must use all of the funds received from the Relinquished Property Transaction (sale) towards the purchase of the Replacement Property Transaction. The receipt of any cash (which is called “boot”) not spent on the purchase of a Replacement Exchange Property is fully taxable, no matter what your adjusted basis is on the property.
Myth #5: If you are selling a rental house you must purchase a rental house (same type of real estate).
The Correct Answer: Under Section 1031, both the Relinquished Property (property being sold) and the Replacement Property (property being purchased) must be “Like-Kind”. The definition, for Section 1031 purposes of “like-kind property” is very liberal. In effect, any type of real estate can be “Like-Kind” to any other piece of real estate as long as the Relinquished Property (Property being sold) has been held for investment purposes or for the productive use in a trade or business and what is being purchased (Replacement Property) is also being held for investment purposes or for the productive use in a trade or business.
For Example, The Taxpayer could sell a rental condominium unit and purchase as its Replacement Property a shopping center, or an apartment building, or a piece of raw land, or a rental home, or an undivided interest in a large commercial piece of property, etc.
Myth #6: The Taxpayer must keep the Replacement Property for at least two (2) years.
The Correct Answer: Section 1031(a)(1) of the Internal Revenue Code states that the Replacement Property must be held for investment purposes or be held for productive use in a trade or business. IRS has NOT established a particular number of months that the Taxpayer must hold the Replacement Property before it is sold or exchanged again.
If the Taxpayer receives an offer that is so wonderful that they cannot refuse it, many tax experts recommend that the Taxpayer go forward with the transaction. There are a lot of factors that the IRS can question. But if there was a good investment reason to sell, the tax experts suggest that the Taxpayer should proceed with the transaction.
IRS could question this transaction by saying the Taxpayer has become a “Dealer”. A real estate dealer is a person who purchases real estate and sells it to customers “in the ordinary course of his or her trade or business.” Because these sales occur as a part of a dealer’s “ordinary course of business,” the dealer records the sale as a gain or loss of ordinary income, not as capital gains.
Each case, of course, is different. In 2008, Revenue Procedure 2008-16 was promulgated by the IRS. It says that if the Taxpayer holds the Property for at least two (2) years and the Taxpayer meets all of the other requirements of the Revenue Procedure, the Taxpayer will then qualify for “Safe Harbor” treatment. This means IRS will not question your exchange on the issue of how long you have held the property. I am reminded by a number of people in our industry, who correctly take the position that obtaining a “Safe Harbor” should not control your investment and exchange decisions.
LIBERTY 1031, LLC always recommends that the taxpayer should consult their tax and/or legal counsel on all matters dealing with the Internal Revenue Service.
I personally look forward to working with you on your next Section 1031 exchange. To answer any of your questions or to open a Section 1031 transaction, please contact Stephen A. Wayner, Esq. CES at our toll-free telephone number: 866-903-1031 or at firstname.lastname@example.org.