Internal Revenue Code Section 1031 allows a property owner to sell real estate that has been held for investment or for use in a trade or business and replace that property with real estate that will be similarly held (either for investment or for use in a trade or business) without incurring tax on disposition of the relinquished property.
Vacation homes not rented and with more than minimal usage by the owner, and principal residences do not qualify. The steps in completing a Section 1031 exchange are as follows.
- The selling party enters into a contract to sell the relinquished property and includes exchange cooperation language in the contract.
The selling party then executes an exchange agreement with a qualified intermediary and assigns the seller's rights in the sales contract to the qualified intermediary.
- At closing, any mortgage is paid off and net proceeds are paid to the qualified intermediary to be held in a qualified escrow to be used later to acquire replacement property.
- The selling party then identifies in writing within 45 days of the relinquished property closing date several suitable replacement properties that, if one or more are acquired, would satisfy the exchange obligation. The maximum number of properties that may be identified generally is (i) three properties of any fair market value, or (ii) any number of properties, so long as the aggregate fair market value of all such properties is not more than twice the fair market value of the relinquished property. Fair market value is determined without regard to liabilities secured by the property, such as a mortgage.
- Within 180 days of the relinquished property closing date, the seller completes the exchange with the qualified intermediary by acquiring one or more of the identified replacement properties. To completely avoid income tax (i) all exchange proceeds must be utilized in the exchange, and (ii) the aggregate purchase price of all replacement properties must equal or exceed the sales price of the relinquished property, net of transaction costs.
It works as follows: Assume you have an apartment building under contract to be sold for a selling price of $2 million, net of commissions and other transaction costs. The investment has a mortgage of $1.3 million, a tax basis of $900,000 (original cost $1.2 million, less depreciation of $300,000), and potential taxable gain of $1.1 million ($2 million selling price, less $900,000 tax basis). The net cash proceeds from the sale will be $700,000 ($2 million sales price less $700,000 mortgage paid), representing funds available for reinvesting in replacement properties.
You identify as suitable replacement properties the following:
- A warehouse leased to a tenant with a $1 million purchase price
Two hundred fifty six acres, land and timber, with a $1.5 million purchase price
- An apartment building newly constructed and without tenants that carries a $1.8 million purchase price.<.li>
You decide to select the warehouse and the acreage having an aggregate purchase price of $2.5 million ($1 million for the warehouse and $1.5 million for the acreage). The transactions are closed within the 180-day replacement period utilizing the exchange proceeds of $700,000 and a combination of new debt and additional cash contributed aggregating $1.8 million. Since all of the exchange proceeds were reinvested and you traded up in aggregate value, the exchange is tax-free.
Michael Smith is a partner with the law firm of Gambrell & Stolz LL.P. in Atlanta. He practices in the areas of business law and taxation. Reach him at (404) 589-3419 (direct) or at email@example.com.