1031 Exchange Explained

Pre-Exchange Refinancings

The current position of authority states that where a pre-exchange refinancing is completed as part of an exchange transaction, the cash received by a taxpayer from the refinancing will be treated as cash ("boot") received on the disposition of the relinquished property. And consequently, the boot will be taxable.

Post-Exchange Refinancings

If the taxpayer completes a post-exchange refinance, there should be less concern for tax purposes than a pre-exchange refinance. Thus, if a taxpayer refinances property immediately upon taking title, receipt of the cash will not be treated as boot and will not be taxable.

The theoretical difference between the pre- and post-exchange lies with the concept of repayments of the debt. In a post-exchange refinancing, the taxpayer has the responsibility for repayment of the debt, whereas the taxpayer in a pre-exchange refinancing is relieved of the liability upon the transfer of the relinquished property.

Sellers should view tax-deferred exchanges as a viable tax planning tool. Properly structured taxdeferred exchanges can defer significant gain and the corresponding tax liabilities. Most important to remember is that sellers do not have to enter into a simultaneous exchange which, more often than not, is nearly impossible to effectuate.

Tax-deferred exchanges under Section 1031 of the IRS code allow taxpayers a reasonable period of time in which to complete a tax-deferred transaction.125

GLOSSARY * Adjusted basis - the basis of the property, plus any improvements, reduced by any depreciation taken on the property

* Basis - the seller's original cost of the property (before depreciation)

* Boot - any considerations (cash or property) received other than real property. It does not qualify under Section 1031 and may be taxable

* Deferred Exchange - an exchange qualifying for nonrecognition of gain, whereby the sold property (relinquished property) is replaced (replacement property) within the statutory time, as provided by the IRC

* Exchange Period - date that seller must close on the replacement property before the earlier of 1). 180 days after the transfer of the relinquished property; or 2). the due date of the seller's federal income tax return (including extensions) for the year in which the relinquished property is transferred

* Identification Period - begins on the date the seller transfers the relinquished property and ends on midnight of the 45th day thereafter

* Parking - term used to refer to the holding of a replacement property by an unrelated third party in the case of a reverse exchange

* Qualified Intermediary (QI) - a person or entity that acquires the replacement property for the seller in exchange for the seller's relinquished property

* Realized gain - the difference between the sale price (cash and other property), and the adjusted basis

* Recognized gain - that portion of the realized gain that is taxable

* Relinquished property - the property that the seller disposes of in the exchange

* Replacement property - the like-kind property the seller acquires in the exchange

* Reverse exchange - strategy used by the seller to complete a deferred exchange whereby an unrelated third party acquires and holds the replacement property until the relinquished property can be sold.

1031 Tax |