Breaking Down the 1031 Like-Kind Exchange
A 1031 exchange is a complicated transaction that has significant legal and tax issues. What it does is allow you to sell your investment or business property and to purchase or reinvest in a new investment or business property, and defer the payment of income taxes on your taxable gains. Essentially, it allows you to keep all your gains invested in your replacement property without incurring tax liability on your gains.
In the past, one could exchange real property or personal property assets, such as aircraft, vehicles, machinery and equipment, railcars, boats, livestock, artwork and collectibles. However, under the recent Tax Cuts and Jobs Act, Section 1031 may no longer be utilized to defer taxes for transactions involving personal property. Under the new law Section 1031 may only be used for real estate exchanges which are subject to the same rules and regulations as under the previous law.
The most common form of 1031 exchange is the delayed 1031 exchange. Here, you first sell your relinquished property and then acquire your like-kind replacement property following the sale of the relinquished property, either on the same day or at a later date. In order to accomplish this exchange, you need to contact a Qualified Intermediary (“QI”) who serves as the facilitator of the 1031 exchange . The QI will generate all the necessary exchange documents, and prepare an escrow account so that the proceeds of your relinquied property are wired or deposited into that account, and the QI then holds the funds. Once you close on the sale of your relinquished property, you have 45 days to identify up to three replacement property with the QI. Then, you must complete the purchase of your replacement property, which must be one of the properties identified to teh QI, no later than 180 days after you close on the sale of your relinquished property. The purchase is accomplished by the QI using the proceeds from the relinquished property to acquire the replacement property. This completes the delayed 1031 exchange.
The opposite way to do a 1031 exchange is where you acquire your like-kind replacement property first and then you sell your relinquished property at a later date. This process is known as a reverse 1031 exchange. Reverse exchanges give you the flexibility to take all the time you need to locate the ideal replacement property, without the pressure of the forward exchange deadlines. IRS Revenue Procedure 2000-37 provides that the IRS will not challenge the qualification of property as either “replacement” or “relinquished” if there is a Qualified Exchange Accommodation Arrangement (“QEAA”). Here, the property is transferred to an Exchange Accommodation Titleholder (“EAT”) in what is called a parking transaction. The purpose of the transfer is so that the taxpayer is not the holder of the property. There must be a QEAA within 5 days of the transfer of the property to the EAT. You then have 45 days after the transfer of the replacement exchange property to the EAT to identify your relinquished property. Finally, the total time period that the relinquished and replacement properties are held in the QEAA must not to exceed 180 days.
Improvement/Build to Suit Exchange
Another type of 1031 exchange transaction is called the “build to suit” or improvement exchange. In the build to suit exchange an EAT will acquire the replacement property for the Exchangor, in the same time of parking transaction used in the reverse exchange, until the construction on the property is completed. The EAT creates a special purpose entity, typically a single member LLC, and title to the replacement property is acquired by the LLC. The 1031 funds are held by the LLC and are disbursed to the contractors to complete the construction. The construction costs must be paid within the 180-day period for completion of the 1031 exchange. The LLC is then assigned to Exchangor when the construction is concluded, or the 180 days expires whichever is first.
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