This is the second installment of a three-part series on Section 1031 like-kind exchanges. Part 1 explained WHY you should consider use of a Section 1031 like-kind exchange when selling commercial or investment real property. Part 2 covers the key rules for HOW to implement a Section 1031 like-kind exchange. Part 3 will cover special issues applicable to a Section 1031 like-kind exchange when a Tenant-In-Common [TIC] interest is being acquired.

KEY RULES FOR SECTION 1031 EXCHANGES

U.S. Tax image [iStock]The following is an outline of key rules applicable to Section 1031 exchanges. Become familiar with these rules. Unless you intend to completely cash out of real estate investing, a Section 1031 exchange may work to your benefit. If you intend to keep investing in real estate or using real estate in your trade or business, a Section 1031 exchange will maximize the capital you have available to reinvest.

Key Elements of a Section 1031 Exchange*

What is Section 1031?

Section 1031 refers to Section 1031 of the Internal Revenue Code of 1986, as amended.

What does it do?

Section 1031 permits a taxpayer (the Exchangor) to dispose of certain real estate and personal property and replace it with like-kind property without being required to pay taxes on the transaction.

What property qualifies?

To qualify for a Section 1031 exchange, the property being disposed of (the Relinquished Property) must have been used in the Exchangor’s trade or business and/or must have been held for investment purposes. The property being acquired (the Replacement Property) must likewise be acquired for use in the Exchangor’s trade or business or for investment.

What property is considered like-kind?

For real estate, to be like-kind means simply that real estate must be exchanged for real estate. The rules related to personal property are significantly more complex. Personal property is any property that is not real estate.

Real estate exchanges are fairly straightforward. A warehouse may be exchanged for another warehouse or for any other qualifying real estate including, for instance, a factory building, office building, shopping center, single-tenant store, parking garage, or even a parcel of vacant ground so long as it qualifies as being acquired for use in the Exchangor’s trade or business or is to be held for investment. This is not a difficult test to pass. Similarly, a qualifying parcel of vacant ground or a shopping center or office building or factory or other parcels of investment real estate may be exchanged for any other qualifying real estate investment.

Personal property exchanges are not so straightforward. For personal property, the property must be substantially similar and of the same type or class. For example: a car can be exchanged for another car; and a bull can be exchanged for another bull; and a cow can be exchanged for another cow; but, a bull may not be exchanged for either a cow or a car.

Although personal property exchange rules are substantially more technical and complicated than real property exchange rules, generally speaking, depreciable tangible personal property held for productive use in a trade or business can be exchanged for other depreciable tangible personal property held for productive use in a trade or business so long as they fall within the same NAICS classification code.

For instance, Limited Service Restaurants such as fast food restaurants, pizza delivery, sandwich shops, etc. fall within 2012 NAICS Code 722513. Accordingly, the assets of one can be exchanged for the assets of the other under Section 1031. But, note that the NAICS Code for a bar, tavern or nightclub is 722410, and the NAICS Code for a full service restaurant is 722511, so an exchange of assets of either of these for the assets of the other, or the assets of a Limited Service Restaurant (even though otherwise physically identical), may not likely be considered “like kind”.

The point, for purposes of this post, is that exchange rules for personal property are substantially more complex than exchange rules for real property. Accordingly, if you are exchanging personal property – either in conjunction with an exchange of real property or purely as a personal property exchange – great care must be taken to comply with the personal property exchange rules to receive the benefits of a tax deferred exchange under Section 1031.

What property is excluded?

Some types of property are expressly excluded from tax deferred exchange treatment by statute, rule or regulation The following types of property do not qualify for aSection 1031 exchange: stocks, bonds, partnership interests, limited liability company interests, personal residences, stocks in trade or inventory, and certain other intangible property.

Are there timing issues?

Section 1031 exchanges can be simultaneous, but they are not required to be. In fact, most exchanges made pursuant to Section 1031 are not simultaneous. There are, however, strict timing rules that apply tonon-simultaneous exchanges and strict rules prohibiting access to funds.

What are the time limits?

The Replacement Property or properties must be identified, in writing, not later than forty-five days after the Relinquished Property is transferred (the Identification Period). The Replacement Property or properties must be acquired not later than the earlier of (i) 180 days after the Relinquished Property was transferred, or (ii) the due date for the Exchangor’s tax return, including any extensions (the Acquisition Period). The Identification Period is included within the Acquisition Period.

How many Replacement Properties may be identified?

There is no fixed limit to the number of Replacement Properties that may be identified, but there are two primary rules that apply: (1) the Three-Property Rule, and (2) the 200% Rule.

1. The Three-Property Rule allows you to identify up to three (3) properties as potential Replacement Properties, regardless of value. You need not acquire all three properties, but as of the end of the Identification Period, not more than three properties may be identified. This is the most commonly used identification rule.

2. The 200% Rule allows you to identify any number of potential Replacement Properties so long as the aggregate value of all identified properties does not exceed 200% of the value of the Relinquished Property. You need not acquire all identified properties.

Generally, if you identify more properties than permitted, you are treated as if you have not identified any properties. However, there is one more rule that might save the day. The 95% Rule allows you to identify any number of potential Replacement Properties, regardless of value, so long as you actually acquire within the Acquisition Period at least 95% of the value of all properties identified. Use of the 95% Rule is rare, and is generally considered more a safety valve rule than an intentionally used exchange rule

Must all exchange proceeds be used?

There is no requirement that all proceeds received upon sale of the Relinquished Property be used to acquire the Replacement Property. Any exchange proceeds not used, however, are taxable.

What constitutes exchange proceeds?

Exchange proceeds means the net sale price of the Relinquished Property, including all net equity and the amount of any mortgage encumbering the Relinquished Property, whether paid off at closing or assumed by the purchaser. It is not sufficient to merely reinvest the net equity received upon sale. The purchase price of the Replacement Property must equal or exceed the aggregate of the net equity received upon sale of the RelinquishedProperty plus any mortgage encumbering the Relinquished Property at the time of the sale closing.

Example: If the Relinquished Property is encumbered by a $700,000 mortgage and is sold for $1 million as part of a Section 1031 exchange transaction, to defer all taxes, the purchase price of the Replacement Property must be at least $1 million, not merely $300,000.

When can the Exchangor obtain access to unused proceeds?

Proceeds from sale of the Relinquished Property may be accessed only when the exchange is completed, fails, or expires. If no potential Replacement Properties are identified within the Identification Period, the exchange fails, and the Exchangor may receive the funds. Those funds will, however, be taxed in the year received. But note: If a mortgage was paid off at the Closing of the Relinquished Property, and the amount of the mortgage was greater than the tax basis of the Relinquished Property, the amount paid to satisfy the mortgage in excess of the tax basis of the Relinquished Property is taxable in the year of Closing of the Relinquished Property.

If all properties identified within the Identification Period are acquired within the Acquisition Period, the exchange is completed, and any remaining funds may be received by the Exchangor. Those remaining funds are taxable. If less than all identified properties are acquired, but the Acquisition Period expires, all remaining funds may be received by the Exchangor, but are taxable.

Conclusion:

These are the basics. As tax rates rise, Section 1031 exchanges become increasingly valuable.

A Section 1031 exchange is not a new and exotic tax shelter scheme. Tax deferred exchanges of like-kind property have been recognized by the Internal Revenue Service as a valid tax deferral strategy since the early 1920s. The structure and effect of a Section 1031 exchange were specifically authorized by Congress by enacting Section 1031 of the Internal Revenue Code of 1986, as amended, and the Internal Revenue Service has promulgated extensive regulations for its implementation.

Use Section 1031 to your advantage, but be sure to strictly comply with the Section 1031 rules.

* Special Thanks to my tax partner, James M. Mainzer, for consulting on this post.

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As required by the Internal Revenue Service under Circular 230, you are advised that any U.S. federal tax advice contained in this article is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this article.