1031 EXCHANGE RULES - 
CAPITAL GAINS TAX DEFFERAL

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A 1031 Exchange is a tax-deferred exchange that the IRS allows on investment property. “Exchange” refers not to the actual exchange of properties between two owners, but to the process of selling of one property and buying another. Section 1031 of the Internal Revenue Code governs these transactions, hence the reference to 1031 Exchange.

A capital gain results when the selling price of an asset is higher than its original purchase price. Capital gains are subject to a minimum of 15% tax for individuals and a 35% tax for corporations. A 1031 Exchange defers the capital gains tax to a later date than it would normally be paid. 

ADVANTAGES OF 1031 EXCHANGE RULES

The primary advantage of a tax-deferred exchange is that the taxpayer may dispose of property without incurring any immediate tax liability. This allows a taxpayer to keep the earning power of deferred tax dollars while at the same time exchanging assets.

For example, rather than sell an investment property and pay the capital gains tax and then use the net proceeds to buy another property, the 1031 Exchange rules allow an investor to forego paying the capital gains tax and use the total proceeds of the sale to invest in the new property, thereby deferring the capital gains tax until the new property is sold.

Another advantage is that the investor’s heirs get a stepped-up basis on such inherited property. While the investor receives a reduced basis in the property (e.g., the basis in the old property), upon the investor’s death, his or her heirs would receive the property at fair market value at the date of transfer to the heirs. When the heir goes to sell the property, they will pay tax on the difference between the new selling price and the fair market value of the property at the time of inheritance.

 

LIKE-KIND PROPERTY

1031 Exchange rules require that the two properties be “like-kind” property. The rules consider the exchange of residential investment property for commercial investment property, and vice versa, to be like-kind. However, the property must be in the US, as an exchange of US property for foreign property is not considered “like-kind” under the rules.


DISADVANTAGES OF A 1031 EXCHANGE

The taxpayer should also consider that there are a couple of disadvantages to a tax-deferred exchange, as follows:

  1. There will be a reduced basis (i.e., tax value) in the replacement property, since the lower basis from the old property will transfer to the new property. Because of this, the taxpayer will have lower depreciation deductions on the new property than he or she would have had if he or she purchased the property without a 1031 exchange.
  2. There will be increased transactional costs for completing a tax-deferred exchange, as the owner will incur additional professional fees.
  3. The taxpayer may not use any of the net proceeds from the disposition of the property for anything except reinvestment in real property. Otherwise, there will be tax consequences on the amount of the proceeds not used as reinvestment.

 

QUALIFIED INTERMEDIARY

A 1031 Exchange requires a Qualified Intermediary, as defined by Section 1031 of the Internal Revenue Code, to handle the entire process.

All of the proceeds from the sale, including non-cash proceeds (such as a boat that you might receive in trade in addition to the property), must go to the Qualified Intermediary to be used for the purchase of the new property. Anything received directly or indirectly by the seller (no matter how insignificant) will disqualify the entire transaction, resulting in the recognition of the entire gain (and in the case of a Foreign Buyer, resulting in FIRPTA withholding).

 

VERY SPECIFIC RULES RE: THE IDENTIFICATION
AND EXCHANGE PERIODS

  1. The new property must be located within the US.
  2. From the closing date of the old property, the seller has 45 calendar days to provide the Qualified Intermediary with a list of properties they want to buy (this list is called “The 45-Day List” and there is typically more than one property on the list in case a deal falls through).
  3. From the closing date of the old property, the seller has 180 calendar days to purchase one or more of the properties on The 45-Day List;
  4. The seller of the old property must take title to the new property in the same legal name in which they owned the old property.
  5. The seller must buy new property for an amount equal to, or greater than, the sale price of the old property.
  6. Cash from the sale of the old property, after paying closing costs and liabilities, must go the Qualified Intermediary and be used for the purchase of the new property.

The 45-day timeline must be strictly followed, as it is not extendable in any way, even if the 45th day falls on a Saturday, Sunday or legal US holiday. The Exchange Period ends at exactly 180 days after the date on which the person transfers the property relinquished or on the due date for the person’s tax return for that taxable year in which the transfer of the relinquished property has occurred, whichever is earlier. Again, the 180-day timeline must be strictly followed, as it is not extendable in any way, even if the 180th day falls on a Saturday, Sunday or legal US holiday.

1031 Exchange Rules - tax deferred exchange

 

1031 EXCHANGE FOR FOREIGN INVESTORS 

Non US sellers can also qualify for 1031 treatment of their assets 

The US government makes it possible for a Foreign Seller to use the 1031 Exchange provisions. In addition to the normal rules noted above, FIRPTA imposes an additional requirement upon 1031 Exchange rules in order to avoid the 10% withholding. The additional requirement is that the individual responsible for transferring the old property from the Foreign Seller to the buyer/transferee (such as a title or escrow company) must receive from the Foreign Seller either:

  1. A Withholding Certificate issued by the IRS that sanctions the particular exchange and allows the transferee to avoid withholding any tax, or;
  2. Notice from the Foreign Seller that certifies that the seller has applied for a Withholding Certificate.

First, any foreign property owner should plan ahead to obtain an ITIN far in advance of transferring any property, and to apply for a withholding certificate as soon as any property transfer has been arranged. Second, it is critical that any Foreign Seller wishing to complete a 1031 Exchange consults with a knowledgeable, professional, qualified intermediary early in the sale process, and as well procures tax or financial counsel from experienced advisors, to assist them with the closing and US tax filing process. If you would like references for a Qualified Intermediary, please let us know. 

Additional resource from our CPA:

Generally, a section 1031 Transfer, or a Like-Kind Exchange, is a method used to defer capital gains taxes on investment real estate property in the United States when it is sold, or exchanged, for a different investment real estate property that is considered “like-kind property”, meaning that actual investment real estate must be exchanged for investment real estate, and not real estate used for personal reasons or non-real estate assets. We assume without deciding that for purposes of this memo the requirements of section 1031 are satisfied.

However, in this case, the property is owned by a non-US person for tax purposes (foreign individual) which would also make this exchange fall under FIRPTA. FIRPTA withholding is governed by the rules of section 1445. Under FIRPTA, if a property is purchased from a non-resident alien, the US buyer must withhold 15% of the value of the property in the transaction to send to the IRS. However, since this is a 1031 transaction, in limited circumstances if certain conditions are met no withholding is required.

As a general rule, under section 1. 1445-2(d)(2), a transferee is not required to withhold if there is a withholding exception available, e.g., if the transferor provides a written notice to the transferee stating that due to a nonrecognition provision of the IRC, the transferor is not required to recognize any gain or loss with respect to the transfer, and the transferee provides the written notice to the IRS within 20 days of the transfer at the following address:

P.O. Box 21086, Drop Point 8731, FIRPTA Unit, Philadelphia, PA 19114-0586

This written notice must contain the following information, according to section 1445-2(d)(2)(iii), and be verified as true and signed under penalties of perjury by the transferor, the non-resident alien:

  1. a)  A statement that the document submitted constitutes a notice of a nonrecognition transaction or a treaty provision pursuant to the requirements of §1.1445-2(d)(2);

  2. b)  The name, social security number (or some other identifying number), and the home address of the foreign individual;

  3. c)  A statement that foreign individual is not required to recognize any gain or loss with respect to the transfer;

  4. d)  A brief description of the transfer; and

  5. e)  A brief summary of the law, section 1031 in our case, and facts supporting the claim that recognition

    of gain or loss is not required with respect to the transfer.

 

In addition to the steps listed above, section 1445-2(d)(2)(iv) states that the above withholding exclusion is only available to participants of a section 1031 transaction, if the transaction is done simultaneously, i.e., both transfers under the section 1031 exchange take effect on the same day. Moreover, there must be no boot, e.g. cash, received by the foreign individual as part of the transactions. Thus, if the property surrendered by the foreign individual is worth more than the property the foreign individual receives, and there is a cash payment to the foreign individual to equalize the consideration, FIRPTA is triggered and withholding will be mandatory. This could also arise if the property surrendered by the foreign individual has no mortgage but the property received has a mortgage which is assumed.

In the absence of meeting the special section 1031 restrictions, i.e. the simultaneous requirement and the no- boot requirement, the only avenue to avoid FIRPTA withholding is to obtain a withholding certificate from the IRS. The details and planning for such certificate is beyond the scope of this memo.
To summarize, the following steps are necessary, assuming the requirements of section 1031 are otherwise complied with:

  1. 1)  Ensure that there is absolutely no boot, i.e., no cash is being transferred in the exchange to the foreign individual.

  2. 2)  Ensure that the exchange contract and closing documents specifically result in both transfers being effective on the same day.

  3. 3)  Ensure that a written notice of non-recognition is provided by the foreign individual the other party to the exchange containing the requirements for the notice listed above.

  4. 4)  Ensure that other party to the exchange receiving the notice sends the notice to the IRS, at the following address:

              a. P.O. Box 21086, Drop Point 8731, FIRPTA Unit, Philadelphia, PA 19114-0586

Legal counsel should be consulted and provide legal advice to make sure these matters are accomplished at closing.

 

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