MYTHS ABOUT IRC 1031 EXCHANGES
New York Real Estate Journal – New York City June 17-29, 2003
The truths behind re-occuring myths about IRC 1031 Exchanges
By: Diane Schaefer, President – Exchange Solutions, Inc.
While tax deferred exchanges are gaining popularity on the East Coast, there are still some misconceptions regarding exchanges that I would like to clarify in this article. I have highlighted a few frequently asked questions that should be addressed to ensure comfort when seeking replacement property.
Must the property the taxpayer is selling be similar or identical to the property the taxpayer is acquiring in exchange?
No, the property does not have to be identical in order for it to be “like kind”. The term “like kind” property is defined in Section 1031(a)(1) as “property held for productive use in a trade or business or for investment…”. The property can be personal, intangible or real property, however, the property must be held for the purpose defined by the Code and not primarily held with the intention of selling it. The key element to remember is that unlike personal property, real property is like kind in nature or character and not to its grade or quality. Personal property is like kind as to its class or asset group.
If the taxpayer is exchanging personal property such as an airplane, then the taxpayer must purchase an airplane and not an automobile in the exchange. The property must be within the same general asset class and/or product class. If the taxpayer is not sure which class the asset belongs to, an accountant can determine the proper class through its SIC code, a code system that designates a business’ activity classified by its industry. It is most important for one to divide multiple personal properties into separate exchange groups before engaging in a multiple property asset exchange, in order to determine what multiple asset groups need to be acquired to coordinate a successful exchange.
As for real property exchanges, again the taxpayer must keep to the IRS term as defined above. The taxpayer may exchange a vacant lot in Maine for an apartment complex in New York. It does not have to be similar in use, as long as it is an investment or business use property. The taxpayer may sell one property and acquire two replacement properties, or sell three properties and acquire one replacement property to consolidate and more easily manage their investment.
Must the property be large or commercial property to enjoy the benefits of IRC 1031?
No, all taxpayers have the freedom to avoid tax consequences on long-term investment property by investing in other property. While investors in large or commercial properties frequently utilize the advantage of Section 1031, any investment or business property, regardless of its size, can be exchanged for other property. For example, a single-family rental home can be exchanged for a multiple family dwelling or various other small properties. In general, a taxpayer may want to consolidate, diversify, create a greater cash flow, or relocate their investment property.
Can’t I save time and money by engaging my attorney or real estate broker as my intermediary to facilitate the exchange?
No, because a taxpayer’s attorney or real estate broker is considered a disqualified party. Any attorney, broker, tax advisor who has represented the taxpayer within two years prior to the exchange is considered a disqualified party. Linear family members, siblings or spouses (of the taxpayer) are also disqualified. If the taxpayer’s agent has control over the funds on behalf of the taxpayer, then constructive receipt becomes an issue and the exchange will be tainted. Since the qualified intermediary is not an agent of the taxpayer, there is no issue of actual or constructive receipt. The funds may not be accessible to the taxpayer or the taxpayer’s agents and the intermediary must follow the Code’s restrictions as to the exchange proceeds. Ultimately, it is best to pay a nominal fee to a professional qualified intermediary to ensure accuracy. Your Q.I. will set up the correct agreements and hold the funds in escrow. To close a pure sale and purchase without agreements with your agent as your intermediary, and label it an exchange, will disqualify the transaction from tax deferred treatment.
It is not costly nor complicated to utilize a qualified intermediary while engaging in a tax deferred exchange. On the contrary, with assistance from your tax advisor, a professional intermediary will guide you through the steps, time deadlines, restrictions and requirements to make the exchange a flawless and clean asset preservation tool.
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