Many real estate investment websites promote the idea of investing in US properties citing “tax free” 1031 exchanges as one of the advantages of investing in the US. As a result, potential investors may be confused or misinformed and may not have the correct information to make the proper decision. In reality, a 1031 exchange is a deferral of capital gains taxes until the final asset is disposed and not exchanged. The IRS Website explicitly warns, “Taxpayers should be wary of individuals promoting improper use of like-kind exchanges”; “Sales pitches may encourage taxpayers to exchange non-qualifying vacation or second homes”.
What is a Section 1031 Exchange or Like-Kind Exchange?
Under Internal Revenue Code Section 1031 no gain or loss is recognized on business or investment property exchanged solely for business or investment property of a like-kind. Properties of the same nature or character are considered to be like-kind even if they differ in grade or quality. Real properties are generally of like-kind whether or not the properties are improved or unimproved where the exchange is made by someone who is not a dealer in real estate. Real property and personal property can both qualify as exchange properties under Section 1031 but real property can never be like kind to personal property. Real property located outside of the US is not like-kind to real property within the United States.
If other property of a not like-kind (e.g. assumption of debt, money, or other valuable consideration) is received as part of a 1031 exchange, a taxable gain is created in the year of the exchange on the value of the other property, other consideration, or money received. A property can be exchanged for a property of lesser value triggering a taxable gain on the difference in value. There can be both deferred and recognized gain on the same transaction. A loss on a 1031 exchange is not recognized.
Section 1031 does not apply to exchanges of inventory, stock in trade or other property held primarily for sale, stocks, bonds, notes, other securities or evidence of indebtedness, interests in a partnership, certificates of trust, or other beneficial interests.
Different Structures of a Real Property 1031 Exchange
Any taxpayer entity including individuals, corporations, partnerships, and trusts may set up an exchange of business or investment properties under Section 1031. A Section 1031 exchange requires an exchange of properties used for investment or business purposes. A simultaneous swap of a qualified property for another is the simplest example but deferred exchanges are allowed that permit the disposal of property and the subsequent acquisition of another like-kind replacement property. Multiple properties can be involved in 1031 exchanges.
A Section 1031 deferred exchange must be distinguishable from a simple sale of a property and the use of the sales proceeds to buy another property. To defer the recognition of gain under Section 1031 the property that is disposed of and the acquisition of another property should be mutually dependent parts of an integrated transaction that constitutes an exchange of property.
Generally an exchange facilitator under an exchange agreement pursuant to rules provided in the Income Tax Regulations is used to facilitate a deferred exchange. You cannot act as your own facilitator nor may your real estate agent, investment banker, mortgage or investment broker, accountant, attorney, employee or anyone else who has acted in the capacity of an agent for you within the last two years. A seller has 45 days after the sale of a relinquished property to identify potential replacement properties. Replacement properties must be clearly described in writing including the legal description, street address or other distinguishable name, signed by the seller, and delivered to a person involved in the exchange such as the person that sold the replacement property or the qualified intermediary or facilitator. Title to the replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier. The replacement property must be substantially the same as the property identified within the 45-day limit.
A reverse exchange is more complex than a deferred exchange. A reverse exchange involves acquiring a replacement property through an exchange accommodation titleholder who can hold the title for a maximum of 180 days. During this period the purchaser sells or otherwise disposes of his relinquished property to close the exchange.
These limits cannot be extended for any ordinary circumstance or hardship. The single exception is a national emergency declared by the President of the US. Failure to meet time limits will result in the entire gain being taxable.
What property qualifies for a Like-Kind Exchange?
Generally, both the relinquished property you sell and the replacement property you buy must meet certain requirements. Section 1031 requires that the properties be held for use in a trade or business or for investment. Property used primarily for personal use is excluded from like-kind exchange treatment pursuant to Sec 1031(h)(2). For instance, you cannot exchange your residence or a vacation home for a rental property and defer the recognition of gain under Section 1031. You should be aware that receiving cash or other proceeds before a 1031 exchange is completed could also disqualify the transaction and make any gain immediately taxable. If cash or other proceeds that are not like-kind property are received at the conclusion of the exchange, the transaction may still qualify as a like-kind exchange. Gain, in this case would only be taxable on the amount of the proceeds that are not like-kind property. To avoid premature receipt of cash or other proceeds of a Section 1031 exchange a qualified intermediary or other exchange facilitator could hold those proceeds until the exchange is complete
How do you compute the basis in the new property?
When the replacement property is ultimately sold and is not as part of another exchange the original deferred gain plus any additional gain realized since the purchase of that replacement property will be recognized and become subject to tax. You are required to calculate and keep track of your basis in the newly acquired property. The basis of property acquired in a Section 1031 exchange is the basis of the property given up reduced by any money received and increased by any gain recognized at the time of the exchange plus other acquisition and disposal costs. This transfer of basis from the relinquished to the replacement property preserves the deferred gain for later recognition. The resulting depreciable basis is generally lower than what would otherwise be available if the replacement property were acquired in a taxable transaction.
It is important that you adjust and track basis correctly to comply with Section 1031 regulations. Gain is deferred but not forgiven in a like-kind exchange. You must report a Section 1031 exchange to the IRS on Form 8824 (Like-Kind Exchanges) which is filed with your tax return for the year in which the exchange occurred. If you do not specifically follow the rules for like-kind exchanges, the transaction may be considered to be taxable in the year of the exchange and penalties and interest may result on any underpayment of tax in the year of the exchange.
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