WHAT IS A SECTION 1031 EXCHANGE AND HOW DOES IT SAVE TAXES?

Section 1031 of the Internal Revenue Code permits taxpayers to defer taxes on the disposition of eligible property held for investment or for use in a trade or business by exchanging rather than selling such property for other eligible property to be held for investment or for use in a trade or business.

WHY IS A QUALIFIED INTERMEDIARY, LIKE CENTURY 1031 EXCHANGE INC., USUALLY USED IN A SECTION 1031 EXCHANGE TRANSACTION?

In most instances, a taxpayer will not find another person who has eligible Section 1031 Exchange property that the taxpayer wants and who wants taxpayer's property. Thus, under the Deferred Exchange Treasury Regulations, the IRS permits a taxpayer to enter into an Exchange Agreement with a Qualified Intermediary, who must be an unrelated person as defined in such Regulations. The taxpayer "conveys" its property to the Qualified Intermediary who then "conveys" such property to the buyer. In actual fact, the taxpayer conveys the property directly to the buyer at the direction of the Qualified Intermediary. The buyer pays the sales price to the Qualified Intermediary who uses the cash to purchase the Replacement Property. Prior to the completion of the Exchange, the taxpayer gives up the right to actual or constructive receipt of such cash except under specific exceptions.

WHAT IS THE 45-DAY RULE?

The Deferred Exchange Treasury Regulations provide that within 45 days of the date of disposition of the Relinquished Property, the taxpayer must designate which Replacement Property or Properties the taxpayer will acquire, even if the taxpayer is not then under contract to acquire such property. There are a number of rules that apply.

• Under the 3-Property Rule, the taxpayer can identify any number of properties, regardless of their value.
• Under the 200%-Rule, the taxpayer can identify any number of properties, so long as their aggregate fair market value does not exceed 200% of the selling price of the Relinquished Property.
• Under the 95%-Rule, the taxpayer can identify any number of properties regardless of their value, so long as the taxpayer acquires 95% of the properties designated based on their fair market value.

WHAT IS THE 180-DAY RULE?

Section 1031 requires that all Replacement Properties be acquired within 180 days of the date the Relinquished Property is sold or earlier if the taxpayer's tax return is due and no extension has been obtained. There are exceptions in the case of certain natural disasters and similar events affecting the taxpayer or the Replacement Property.

IS SECTION 1031 ONLY AVAILABLE FOR CAPITAL GAINS PROPERTY?

Section 1031 may be used to defer ordinary income that would result from the sale of personal property held for investment or used in a trade or business. For instance, in the case of an aircraft used in a trade or business, the useful life, compared to real estate, is relatively short and the gain from any depreciation recapture is taxable as ordinary income. Therefore, exchanging an aircraft in a Section 1031 exchange could defer significant taxes.

WHAT TYPES OF PROPERTY ARE ELIGIBLE FOR SECTION 1031 EXCHANGES?

The property that you are selling, referred to as the Relinquished Property, must be held by you for investment or for use in your trade or business. There is no authority on how long a property must be held to meet this requirement.

The property that you are purchasing, referred to as the Replacement Property, also must be held by you for investment or for use in your trade or business. Once again there is no authority on how long a property must be held to meet this requirement.

Land is a good example of an investment property. Rental property or a factory are good examples of property used in a trade or business. Your personal residence can never be eligible for Section 1031 deferral.

WHAT IS “BOOT?”

“Boot” is the word used to describe the taxable income that may arise in a Section 1031 Exchange transaction. In general, there are 2 sources of boot:

• If all of the cash proceeds are not invested, the remaining cash will be considered boot.

• If the debt on the Replacement Property is less than the debt on the Relinquished Property, that difference will also be treated as boot. This is sometimes referred to as boot from debt relief. One way to avoid this type of boot is to add cash in an amount at least equal to the amount of debt relief amount. For example, assume that the Relinquished Property generated $10,000,000 in cash and was subject to a $20,000,000 mortgage. If the new property costs $35,000,000 and requires the taxpayer to assume a $19,000,000 mortgage, the taxpayer will avoid any boot from debt relief or otherwise by having the Qualified Intermediary reinvest all of the cash and by adding an additional $6,000,000 of cash of the taxpayer’s money. The additional cash added more than offsets the $1,000,000 of debt relief thereby erasing any boot.

HOW LONG DO I HAVE TO HOLD REPLACEMENT PROPERTY AFTER COMPLETING A SECTION 1031 EXCHANGE?

There is no authority on how long a Replacement Property must be held.

CAN A CORPORATION, PARTNERSHIP, LIMITED LIABILITY COMPANY, OR TRUST UNDERTAKE A SECTION 1031 EXCHANGE?

Yes. Any legal entity that otherwise meets the requirement of Section 1031 can claim its benefits in connection with the disposition of its property.

CAN A TAXPAYER REFINANCE A REPLACEMENT PROPERTY AFTER THE PROPERTY IS ACQUIRED?

There is no restriction on refinancing Replacement Property if the taxpayer begins the refinancing process after the property is acquired.