A 1031 exchange can be advantageous for sellers who are looking to defer paying taxes. It requires a qualified intermediary in order to complete the exchange, and it must be done within a fixed window of time. The qualified intermediary acts as a third party to handle the sales proceeds and take care of title and deed to the point that the exchange is completed.
If the exchange is not made by the fixed time frame, it can be treated as a taxable event. This can be avoided by 1031 tenancy in common where exchanging parties gain fractional ownership interests, but still have similar benefits in usage of their property.
A 1031 is considered a "like-kind exchange" is the exchanging of similar functioning business or investment properties. An example of a like-kind exchange is an investment rental property for an investment tract of land, or a taxi cab for another taxi cab or serviceable business vehicle. Remember that it does not have to be the same grade or quality, only similar in economic function. In order to qualify for a 1031 exchange, it must be investment or business property traded between two individuals, partnerships, chapter C, or chapter S corporations for the same economic purpose as a going concern. A 1031 exchange does not apply for personal property, financial securities or any foreign property being exchanged for domestic.
Filing a like kind exchange starts with filling out IRS form 8824. Form 4697 also needs to be filed if reporting any recapture gains. In order to properly fill out form 8824, you will need to know how to determine the following:
- Adjusted basis
- Depreciation recapture
- Gains
Adjusted Basis
The adjusted basis is determined by the cost of the property plus any fees and expenses. An example of a cost or fee is sales commission, escrow fees or legal fees. Also, know that the basis is adjusted lower by depreciation, qualified credits and income reducing deductions that are reported on the income tax filing.
Depreciation Recapture
Depreciation recapture is when the excess depreciation is added to gross income on the tax return. This will happen when a tax filer had reduced income by depreciation deductions. In order to recapture this portion of tax there is a requirement to add this portion to the gross income. Recaptured ordinary income is determined by the smaller of either the cash received in the exchange or the portion of realized gains that would have been taxable as ordinary income.
Gains
Since a 1031 exchange is a tax deferred exchange of property, no taxes will be paid. However, if money is received in addition to property, the exchange will be treated as a partially taxable like kind exchange where the cash received is added to the fair market value of the receiving property. The gain or loss is then added or subtracted from the adjusted basis of the property received for future reporting.
A 1031 like-kind exchange is also advantageous for bequeathing property to beneficiaries. If you need further information on 1031 exchanges you should consult a tax advisor or the IRS to understand the tax intricacies and advantages.