1031 EXCHANGE RULES

A 1031 exchange is a tax-deferred exchange that the IRS allows on investment property. “Exchange” does not refer to the actual exchange of property between two owners, but to the process of selling one property and buying another. Section 1031 of the Internal Revenue Code governs these transactions, hence the reference to the 1031 Exchange.

A capital gain results when the selling price of an asset is higher than its original purchase price. Capital gains are subject to a minimum of 15% tax for individuals and 35% tax for corporations. The 1031 Exchange defer the capital gain tax to a later date than it would normally be paid.

ADVANTAGES OF 1031 EXCHANGE RULES

The main advantage of a tax-deferred exchange is that the taxpayer can dispose of the assets without incurring any immediate tax liability. This allows the taxpayer to maintain the earning capacity of the deferred tax dollars while simultaneously exchanging assets.

For example, instead of selling an investment property and paying capital gains tax and then using the net proceeds to buy another property, 1031 Exchange rules allow an investor to waive capital gains tax and use the total proceeds of the sale to invest in the new property, thus deferring capital gains tax until the new property is sold.

Another advantage is that the investor’s heirs get an increased basis from such inherited property. While the investor receives a reduced basis in the property (for example, the basis in the old property), upon the death of the investor, his heirs would receive the property at fair market value on the date of transfer to the heirs. When the heir is going to sell the property, he will pay tax on the difference between the new sale price and the fair market value of the property at the time of inheritance.

SIMILAR PROPERTY

1031 Exchange rules require the two properties to be “similar” properties. The rules consider the exchange of residential investment property for commercial investment property, and vice versa, to be similar. However, the property must be in the US, as a US property exchange for foreign ownership is not considered “like-kind” under the rules.

DISADVANTAGES OF A 1031 EXCHANGE

The taxpayer should also consider that there are a couple of downsides to a tax-deferred exchange, such as the following:

  • There will be a reduced base (i.e. tax value) on the replacement property as the lower base from the old property will carry over to the new one. Because of this, the taxpayer will have lower depreciation deductions on the new property than they would have had if they had purchased the property without a 1031 exchange.
  • There will be increased transaction costs to complete a tax-deferred exchange, as the owner will incur additional professional fees.
  • The taxpayer cannot use any of the net proceeds from the disposal of the property for anything, except to reinvest in real estate. Otherwise, there will be tax consequences on the amount of the income not used as reinvestment.

QUALIFIED INTERMEDIARY

A 1031 Exchange requires a Qualified Intermediary, as defined in Section 1031 of the Internal Revenue Code, to handle the entire process.

All proceeds from the sale, including non-cash proceeds (such as a pot that you could receive in trade in addition to the property), must go to the Qualified Intermediary to be used for the purchase of the new property. Anything directly or indirectly received by the seller (no matter how insignificant) will disqualify the entire transaction, resulting in the recognition of the entire profit (and in the case of a foreign buyer, withholding from the FIRPTA).

VERY SPECIFIC RULES ON: THE PERIODS OF IDENTIFICATION AND EXCHANGE

  • The new property must be located within the United States.
  • From the closing date of the old property, the seller has 45 calendar days to provide the qualified broker with a list of the properties they wish to buy (this list is called the “45-day list” and there is usually more than one property on the list in case the deal does not go through).
  • From the closing date of the old property, the seller has 180 calendar days to purchase one or more of the properties on the 45-day list;
  • The seller of the old property must take the title to the new property with the same legal name that he owned the old property.
  • The seller must buy a new property for an amount equal to or greater than the sale price of the old one.
  • The money from the sale of the old property, after paying the closing costs and liabilities, should go to the qualified intermediary and be used for the purchase of the new property.

The 45-day period must be strictly followed, as it is not extendable in any way, even if the 45th day falls on a Saturday, Sunday, or legal United States holiday. The Exchange Period ends exactly 180 days after the date the person transfers the relinquished property or on the expiration date of the person’s tax return for that tax year in which the transfer of the relinquished property occurred. , The thing that happens first. Again, the 180-day period must be strictly followed, as it is not extendable in any way, even if the 180th day falls on a Saturday, Sunday, or legal United States holiday.

Also Read: What are the rules for withdrawing your 401 (k)?

1031 EXCHANGE FOR FOREIGN INVESTORS

Non-US sellers may also qualify for 1031 treatment of their assets

The US government makes it possible for a foreign seller to use the 1031 exchange provisions. In addition to the normal rules outlined above, the FIRPTA imposes an additional requirement for 1031 Exchange rules to avoid the 10% withholding. The additional requirement is that the person responsible for transferring the old property from the Foreign Seller to the buyer / transferred (such as a title or escrow company) must receive from the Foreign Seller

  • A Certificate of Withholding issued by the IRS that penalizes the particular exchange and allows the transferee to avoid withholding any tax, or;
  • Notice from the Foreign Seller certifying that the seller has requested a Withholding Certificate.

First, any foreign owner should plan ahead for obtaining an ITIN well in advance of transferring any property, and request a certificate of retention as soon as any transfer of ownership has been arranged. Second, it is critical that any foreign seller wishing to complete a 1031 Exchange consult with a professional and qualified broker early in the sale process, and also obtain tax or financial advice from experienced advisors, to assist them with the closing and process. filing taxes in the United States.

Additional resource from our CPA:

In general, a 1031 transfer, or exchange of the same type, is a method used to defer taxes on capital gains from investment real estate in the United States when it is sold, or exchanged, for a Different investment real estate is considered “as-kind property” meaning that real investment real estate must be exchanged for investment real estate, and not real estate used for personal reasons or non-real estate. We assume, without deciding, that the requirements of section 1031 are met for the purposes of this memorandum.

However, in this case, the property is owned by a non-US person for tax purposes (foreign natural person), which would also make this exchange covered by FIRPTA. FIRPTA withholding is governed by the rules of section 1445. Under FIRPTA, if a property is purchased from a nonresident alien, the US buyer must retain 15% of the property’s value in the transaction to send it to the IRS. However, as this is a 1031 transaction, in limited circumstances if certain conditions are met no hold is required.

As a general rule, under Article 1.1445-2 d) 2), the assignee is not required to withhold if there is a withholding exception available, for example, if the assignor provides a written notice to the assignee stating that due to an IRC non-recognition provision, the transferor is not required to recognize any gain or loss with respect to the transfer, and the transferee provides written notification to the IRS within 20 days of the transfer , at the following address

P.O. Box 21086, Drop Point 8731, FIRPTA Unit, Philadelphia, PA 19114-0586

This written notice must contain the following information, in accordance with section 1445-2 (d) (2) (iii), and must be verified as true and signed under penalty of perjury by the transferor, the nonresident alien:

a) A statement that the document presented constitutes a notification of a non-recognition transaction or a treaty disposition in accordance with the requirements of Article 1.1445-2 d) 2);

b) The name, the social security number (or some other identification number) and the address of the domicile of the foreign person;

c) A statement that the foreign person is not required to recognize any gain or loss with respect to the transfer;

d) A brief description of the transfer; and

e) A brief summary of the law, section 1031 in our case, and the facts that support the claim that recognition

No profit or loss is required with respect to the transfer.

In addition to the steps listed above, Article 1445-2, paragraph d), paragraph 2, subparagraph iv) provides that the above-mentioned withholding exclusion is only available to participants in a transaction under Article 1031, if the transaction occurs simultaneously, that is, if both transfers under the 1031 exchange come into effect on the same day. Also, there should be no start-ups, for example cash, received by the foreign person as part of the transactions. Thus, if the property delivered by the foreign individual has a higher value than the property received by the foreign individual, and there is a cash payment to the foreign individual to match the consideration, the FIRPTA is activated and the withholding will be mandatory. This could also occur if the property delivered by the foreign individual does not have a mortgage but the property received has an assumed mortgage.

If the restrictions of special section 1031, that is, the concurrent requirement and the no-start requirement, are not met, the only way to avoid FIRPTA withholding is to obtain a withholding certificate from the IRS. The details and planning of that certificate are outside the scope of this memo.
In summary, the following steps are necessary, assuming the requirements of section 1031 are met:

1) Make sure that there are absolutely no boots, that is, no cash is transferred in the exchange to the foreign individual.

2) Ensure that the exchange contract and closing documents specifically result in both transfers being effective on the same day.

3) Ensure that the foreign individual who is the other party to the exchange provides a written notification of non-recognition that contains the above-mentioned notification requirements.

4) Make sure the other party to the exchange that receives the notification sends it to the IRS, at the following address:

          to. P.O. Box 21086, Drop Point 8731, FIRPTA Unit, Philadelphia, PA 19114-0586

An attorney should be consulted and provided with legal advice to ensure these matters are carried out at closing.

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