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Knowledge About Tax Deferred Exchanges

Knowledge About Tax Deferred Exchanges

The following are points that participants in a tax-deferred exchange should keep in mind when starting an exchange transaction:

  • Even though an exchange may be tax-free at the federal level, it may be taxable at the state or local level.
  • One party to an exchange may qualify for tax-free treatment even though the other party does not.
  • There is no limit on the number of exchanges an investor can make.
  • Corporations can make tax-free exchanges.
  • When sale of a property would produce a loss, exchanging normally does not make sense because the loss will not be recognized for tax purposes.
  • It is legal to make an exchange solely to save taxes.

Under Code Section 1031, which provides for tax-deferred exchanges of property, no gain or loss is recognized on an exchange of real estate where:

(1) property held for productive use in a trade or business or (2) property held for investment purposes is exchanged solely for like-kind property to be held either for productive use in a trade or business or for investment purposes.

Once all requirements of a tax-deferred exchange of like-kind properties are met, the tax deferment is mandatory. Taxable gain is deferred until such time that a taxable disposition occurs.

The properties that are exchanged can either be investment properties or business properties or both investment or business properties. Thus, real estate held for productive use in a trade or business can be exchanged tax-free for other properties held for productive use in a trade or business or for investment.

Likewise, real estate held for investment can be exchanged tax-free for other real estate held for investment or for other real estate held for productive use in a trade or business.

Neither real estate which is stock in trade nor real estate held primarily for sale can be exchanged tax-free. Other properties which cannot be exchanged tax-free include property being used as a personal residence and not held for investment by its owner, certificates of trust or of beneficial interest, and other securities or evidence of indebtedness or interest.

The essential elements and characteristics of a tax -deferred exchange of like-kind properties are as follows:

  • The transaction must amount to an exchange of properties; it cannot be a sale or some other transaction.
  • The properties must be of like kind.
  • The properties must be held for productive use in business or for investment purposes.
  • The properties cannot be stock in trade or property held primarily for sale.

If an exchange otherwise qualifies but includes as part of the consideration for the exchange money or property that does not qualify, the transaction qualifies, but the tax-free treatment does not apply to the money or other property that does not qualify.

If an exchange otherwise qualifies but, as part of the consideration, the other party assumes liability or acquires property that is subject to a liability, the transaction qualifies, but the tax-free treatment does not apply to the assumption of the liability or the liability to which the property is subject.

Once an exchange is completed, the property received cannot be held for resale or as a personal residence if tax-free treatment is desired.

Where an exchange qualifies for tax-free treatment, neither parties to the exchange nor the government can treat it otherwise than as a tax-free exchange.

Deferred Like-Kind Exchanges 

A federal court decision in 1979 introduced the concept of the deferred exchange and thus expanded the scope of the tax-free exchange provision in the tax law. Congress then amended Section 1031 of the code by adding subsection  (a)(3) giving statutory approval to the deferred exchange but imposing certain limitations.

Example: Arthur and Baker agree to exchange like-kind properties. Arthur already owns the property he is to exchange and transfers title to Baker. In exchange, Baker agrees to transfer to Arthur some time in the future a specified property (or type of property). If Baker does not acquire the property, Baker will pay the price in cash. Except for the fact that the exchange of properties is not simultaneous, the exchange meets all of the requirements of Section 1031.

Two time limits must be met under the Section:

  1. The property to be received by Arthur must be identified as such no later than 45 days after the date that Arthur transfers his property to Baker. The replacement property must be identified in a written document signed by the taxpayer and delivered (by hand, mail, or telecopy) to the person involved in the exchange like the seller of the replacement property or the qualified intermediary before the end of the identification period. However, notice to an attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient.
  2. Arthur must receive the property from Baker no later than the earlier of (1) 180 days after Arthur transfers his property to Baker or (2) the due date of Arthur’s tax return for the year in which he transfers the property to Baker.

The 180 day rule has two potential traps. The rule is expressed days, not months, so the parties must count the number of actual days after the transfer of the first property. Also, the second property must be actually transferred. Merely signing a binding contract is not enough.

The one point that is clear is that the party who is to receive the identified property cannot receive cash (either actual or constructively) and purchase the property himself, since this violates the basic requirement of a tax-free exchange