Neither IRC § 1031 or the Internal Revenue Service Regulations promulgated under IRC § 1031 specifically define “held for productive use in trade or business or for investment”. However, case law provides that basically any property that is connected to a trade or business (regardless if the property is continuously or actively employed) or property that is held for investment meets the criteria of IRC § 1031. This could include business equipment and machinery as well as commercial or residential rental real estate or raw land.
Yes. As stated above, promissory notes are not considered “like-kind” property for purposes of section 1031. As such, any amount of the sales price received by the investor in the form of a promissory note will be subject to tax. However, the tax payable will be reported as payments under the note are received. This is known as reporting the gain on an “installment” basis. This provides a mechanism for deferring tax payments over the length of the note.
One possible way to utilize a promissory note while still deferring tax is to have the note payable to the qualified intermediary. While not specifically approved by the IRS, some leading tax authorities argue that any payments received by the intermediary prior to the time the investor closes on replacement property can be utilized to purchase the replacement property with no tax liability. Additionally, the intermediary could potentially sell the promissory note or transfer the promissory note as part consideration of the purchase of the replacement property without tax liability to the investor.
There is no specific holding period requirement for either the relinquished property or the replacement property. The question of whether the relinquished property and/or the replacement property is, at the time of transfer or acquisition, held for business or investment purposes is essentially one of fact. If the relinquished property or replacement property is acquired immediately prior to or disposed of immediately after the exchange, the IRS will be more likely to take the position that the property was not held for a qualified purpose. The shorter period of time during which the property is held by the taxpayer before or after an exchange, the stronger the facts and circumstances must be to establish the proper intent.
Yes. Property originally utilized as a personal residence may qualify for exchange under IRC § 1031 if the individual abandons the personal use and thereafter holds it for rental income. The length of time the property has been rented or listed for rent, the length of time the property was used as a principal residence before rental, whether all personal use of the house has been permanently abandoned, the amount of rent, and the absence of a prearranged exchange are all factors in determining whether the property is held for investment at the time of the exchange.
Yes. For example, an investor may own a duplex or triplex where one of the units is used as a personal residence or a farm or ranch containing a personal residence. In these situations, the investor is exchanging like-kind property and other property (the personal residence portion). The gain on the personal residence portion of the property may be deferred under IRC §1034, or avoided altogether under IRC § 121 which allows for the one-time exclusion of gain from the sale of a personal residence of up to $125,000 for persons over 55 years of age.
Yes. An individual may also transfer a tenancy-in-common interest for a fee interest and vice versa. Additionally, a lease with 30 years or longer left to run is considered real property for purposes of IRC § 1031.
A qualified intermediary is a party whose sole purpose in the transaction is to facilitate the exchange. IRC § 1031 specifically excludes an investor’s attorney, accountant, or real estate agent from serving as the qualified intermediary.
What happens if I fail to identify or close on replacement property within the applicable deadlines?
The transaction is simply treated and taxed as a sale of the property.
No. No extensions of either the 45-day or 180-day deadline are given for any reason.
Yes. If the identified property is real property, the extent that the property will be considered “like-kind” for purposes of section 1031 will depend on the percentage of completion of the replacement property at the time the property is received by the investor. The regulations provide no guidance to determine the percentage of construction that is completed at the time the taxpayer receives the replacement property.
Example. An investor identifies raw land on which a rental property is being constructed. At the time the investor acquires the identified property, the foundation has been poured and the rental property has been framed. Assuming that it is determined that the work done as of the date of closing accounts for 40% of completion of the rental property, 40% of the sales price of the property would be considered “like-kind” property and the remaining 60% would be considered other property or “boot”. (Boot is discussed in more detail below.) Section 1031 would allow disbursements to be made from the intermediary to the builder during the construction of the replacement property.
Personal property to be produced must be fully completed prior to receipt by the investor to qualify as “like-kind” property under IRC § 1031.
Yes. IRC § 1031 allows an investor to be credited with the interest earned on funds while the funds are being held by the intermediary pursuant to the exchange agreement. Any interest earned can be used towards the purchase of replacement property but will be taxed as ordinary income to the investor.
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