What is a tax-deferred property exchange?
A tax-deferred exchange is simply a method by which a property owner trades property for other like-kind property and has the ability to defer any capital gain or loss which would be realized upon a sale. Section 1031 of the Internal Revenue Code allows up to 100 percent deferral of the realized gain.
What types of properties are eligible for tax-deferred exchanges?
In general, tax-deferred exchanges are structured either as a real property or a personal property exchange. Real property exchanges include single-family rental property, apartments, office buildings, commercial and industrial properties, and undeveloped land. Personal property exchanges encompass virtually all other types of property that are held for use in a trade or business or for investment.
To be eligible for the favorable tax treatment afforded by an exchange, the property or business asset to be exchanged must be of “like-kind”, to the property received. “Like-kind” is defined under Section 1031 as property that has been held by the client for productive use in a trade or business, or for investment purposes
To determine if your property qualifies as “like-kind” under §1031, ask yourself the following question: Has the property been used in a trade or business or held for investment?
If your answer is yes, you may proceed to answer the next qualifying question: What is/are the intention(s) of the party(ies) going forward? To be eligible, the property received must also be used for business, trade or investment purposes.
Who should consider a tax-deferred property exchange?
There are multiple reasons why someone might consider a tax-deferred property exchange. The primary advantage is the ability to dispose of property and defer the capital gain that would otherwise result from a sale. This capital gain can then be reinvested for the benefit of the taxpayer, which will generate a greater return versus the amount available net of the tax liability.
Tax-deferred property exchanges can be a very useful strategy in estate planning. They can also be employed to expand business operations or to maximize capital.
Of course, there are a number of issues that should be considered when approaching an exchange. The first step for anyone considering a tax-deferred exchange is to consult a knowledgeable tax advisor. Only your tax advisor has access to all of the factors that influence your tax planning strategy.
Your tax advisor can determine the anticipated capital gain from the sale of your property and then determine whether there are capital losses available to offset any potential gain, or whether capital losses can be created by the liquidation of other capital assets. Please see our Capital Gain Calculator to estimate your anticipated gain.
How does it work?
There is no simple explanation that will cover all types of exchanges. Each situation is unique, and can be fairly simple or rather complex, based on all the factors involved. In general however, most exchange are structured using the “Safe Harbor Regulations” enacted by the Department of the Treasury in 1991. The Safe Harbor Regulations created a framework for transacting exchanges that added clarity and predictability to the process.
The basic requirements that must be met in order to qualify the exchange are:
- Intent – there must be intent to conduct an exchange.
- Like-kind – both the property exchanged and received must be of like kind to each other.
- Timeliness – the exchange must be completed within the statutory period of 180 days or the due date for the taxpayer’s return, whichever comes first.
In most cases, an exchange is accomplished with the help of a qualified intermediary.
With so much at stake, you can’t afford to rely on incomplete, inaccurate or faulty information. The monetary consequences can be substantial, creating unnecessary and potentially devastating results.