The United States Internal Revenue Code is a portion of the federal statutory tax laws which is published in different volumes of the United States Statutes at Large. It is separated as Title 26 of the code and it covers taxes, its procedures, and administration. The IRC is administered by the Internal Revenue Service (IRS) and this article will help you understand it better.
Section 1031 of the code, popularly called the 1031 exchange, makes a provision for taxpayers to defer the recognition of capital gains and other related federal income taxes. It states that no gain or loss will be recognized on the exchange of property provided it satisfies some technical requirements.
To put it simply, a 1031 exchange, also called a like-kind exchange, is when a property is swapped for another and therefore not subjected to any form of tax or enjoys limited tax because it meets certain requirements. In other words, when you exchange property or investment without a capital gain or without cashing out, you will not be taxed on theoretical gains. With a tax-deferral, your investment can continue to grow. Please note that this does not equate to forgiveness of tax.
You can do 1031 as many times as you want as there are no limits or frequency to it. You can also roll over any gain from a piece of real estate investment to another and keep doing so. While you may gain some profit from each swap, you will avoid paying taxes till you sell the property for cash. With this, you pay only one tax coming at a long-term capital gain rate depending on your income.
Until the year 2018, a variety of properties qualified for the tax deferment that Section 1031 allows though the Tax Cuts and Jobs Acts of 2017 limited this to mostly real properties.
Requirements for a Like-Kind
To qualify for timeline and identification requirements of Section 1031 exchange, the following conditions must be met:
- From the time a relinquished property closes, an Exchanger has 45 days to identify or nominate a replacement property and must within 180 days acquire such. The whole exchange should be completed in 180 days or by the due date of the tax return of the user. A user may identify up to three different properties to use for the exchange.
- As long as both a relinquished property and the replacement are used in a trade, business, or investment, any form of property can be exchanged.
- The properties involved should be located in the United States which includes the 50 states and the District of Columbia but not the U.S territories.
- A person can sell or acquire more than one property.
- The only kind of properties that may be exchanged includes vacant land, duplexes, office buildings, single-family homes for rentals, apartments, farms, warehouses, etc.
- Properties such as primary residences, stocks, notes, bonds, cash, mortgages, equipment, and the likes may not be exchanged.
Benefits of Like-Kind
- Tax deferral
- Passive income
- Potential tax forgiveness to heirs
- Diversification of portfolio.
The Role of an Intermediary
A successful like-kind is not a project you can handle by yourself. You need to follow the IRS rules and therefore require a qualified intermediary (QI). They may also be referred to as facilitators or exchange accommodators. According to the IRS, a qualified intermediary must be a person other than your relatives or agent (except you have not been represented by the agent within the last two years).
Basically, a qualified intermediary sells your property, buys a replacement property on your behalf, and then transfers the deed in your name. It is their responsibility to get the proceeds, prepare all necessary documents, and to ensure that the whole transaction is completed within the stipulated time frame. On the seller’s part, before closing the sale of the relinquished property, a written agreement must be executed with the qualified intermediary and in this way, the benefits of tax deferral can be preserved.
Other responsibilities of the qualified intermediary includes activities such as coordinating with the seller and their advisers on the 1031 structure, providing accompanying documents to the escrow account, being in charge of the funds and preventing the seller from taking receipt of funds from the sale. They also receive and hold information about replacement properties and disburse funds for the selected purchase property. They submit the complete account records of the 1031 and submits a 1099 to both the exchanger and the IRS for interest earned. You can read more about this here: https://www.thebalance.com/how-a-qualified-intermediary-faciliates-a-1031-exchange-1798718.
Choosing a Qualified Intermediary
When choosing a qualified intermediary, ask for references and ensure the person or company has errors and omissions insurances, as well as fidelity insurance cover. This help to protect you against any form of negligence or fraud. Your local escrow officer may be of immense help in this regard. Also, remember that there are companies that are dedicated to doing this, companies that are recognized by the IRS. This may be a better option for you.