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TAX-FREE (ACTUALLY, TAX-DEFERRED) PROPERTY EXCHANGES

Like-kind property (under section 1031 of the Internal Revenue Code) can be exchanged for other property, and the taxable gain on the transaction deferred until the sale of the replacement property. However there are numerous rules to comply with in doing an exchange and a thoroughly documented paper trail is required.

Property must be like-kind and must be held for productive use in a trade or business

The definition of like-kind is fairly broad. Property is of like-kind if it is of the same nature or character. Property held for productive use in a trade or business or for investment must be exchanged solely for property of a like-kind which is to be held either for productive use in a trade or business or for investment.

Examples of like-kind exchanges would be:

• Seller who rents out Iowa farmland sells it and buys a rental house, duplex or apartment building or other farmland.
• Business owner sells building he or she owns and buys a replacement building to continue the business.

Examples that are not considered like-kind:

• Seller who rents out Iowa farmland buys a second home they occupy exclusively.
• Seller who owns farmland sells it and reinvests in stocks and mutual funds.

The following classes of property are not entitled to tax-deferral treatment:

1. Property held for resale (inventory)
2. Stocks, bonds and notes
3. Other securities or debt obligations
4. Interest in a partnership
5. Certificates of trust

Simultaneous transfers of property

One needs to make sure the sale and acquisition are not independent transactions. Both a sales agreement and a purchase agreement must include language setting forth the intent to do a 1031 exchange.

If the taxpayer has actual or constructive control over cash proceeds, the expenditure of the cash on the replacement property will not be eligible for tax-deferral treatment.

Non-simultaneous transfers of property and the use of a Qualified Intermediary to complete exchange

The law allows a properly established Qualified Intermediary to escrow the sale money and assist in completing the exchange. A typical Qualified Intermediary is a bank or exchange service that holds the sale proceeds so the taxpayer does not have actual or constructive receipt of the proceeds. There should be a written exchange agreement between the parties.

The sale proceeds can be held under the seller's social security number and the seller may earn interest during the holding period.

45 day identification period

A seller has 45 days to identify possible replacement property, and the period begins to run on the date a seller transfers or deeds the relinquished property.

A person can identify up to three (3) properties or properties whose sale price is up to 200% of the sales price of the relinquished property.

The identification of replacement property needs to be in writing and timely submitted to the Qualified Intermediary.

180 day exchange period

A taxpayer has the lesser of 180 days or the due date (including extensions) of the seller's income tax return to acquire the replacement properties. Often property relinquished late in a taxpayer's year means they may need to file an extension of their income tax return until the exchange is finalized.

You need not acquire all the replacement properties you have identified. A taxpayer can stop the transaction at any time by telling the Intermediary in writing you have completed purchasing your replacement property.

Fractional interest and Partial replacement property acquisition

A fractional interest may be exchanged for an entire interest in other property. For example a brother and sister may inherit their parents' Iowa farm. After renting it out for a few years, they decide to sell it to the farm tenant. Sister wants to be cashed out so she can invest in the stock market and is willing to pay the capital gains tax on the difference between the sale price and the cost basis at which she inherited the farm. Brother wishes to reinvest his in rental income-producing property in Phoenix, Arizona, where he resides and can better manage a property.

If brother spends all of his 50% share of the farm sale proceeds on the rental property, he can avoid any current capital gain tax by the exchange.

However, if Brother can only find rental properties with a purchase price of $200,000 and his share of the farm sale proceeds is $300,000 -- then $200,000 is considered reinvested and tax deferred, but he must recognize on his income tax return the taxable share of the $100,000 portion not reinvested.

Not every dollar of sale proceeds needs to be reinvested as the amount deferred and the amount taxable are computed proportionately based on the sale price of the relinquished property.

Miscellaneous Requirements

The tax deferral benefit does not apply if one of the properties is outside the United States.

If the relinquished property was encumbered by a mortgage one needs to remember the reinvestment deferral is computed from the sale price and not the net proceeds. It may be necessary to borrow a like sum to receive the non-recognition of income tax benefit.

Exchanges between related parties require the property be held for two (2) years from the date of the last exchange or any property transferred is treated as if the exchange had not occurred and income tax is recognized.

A remainder interest in farmland can be exchanged for another remainder interest in farmland (or a fee interest).

Conclusion

This article is intended to inform readers of some of the general principals of doing a tax deferred exchange of property. It is by no means an all-inclusive statement of the code, regulations and case law on this subject.

-- February 1, 2002

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