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ABOUT SECTION 1031 EXCHANGES

In a typical transaction, the property owner is taxed on any gain realized from the sale. However, through a Section 1031 Exchange, the tax on the gain is deferred until some future date.

Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment.

A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of "like kind", while deferring the payment of federal income taxes and some state taxes on the transaction.

The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer's investment is still the same, only the form has changed (e.g vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a paper gain.

The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.

$500,000 EXCLUSION OF SALE OF PERSONAL RESIDENCE

$500,000 exclusion for sale of personal residence requires 5-Year ownership if the property was received in a 1031 Tax-Deferred Exchange. The American Jobs Creation Act of 2004 imposes a new five-year ownership requirement for tax-free sale of a personal residence originally received as replacement property in a tax-deferred like-kind exchange.

Taxpayers generally may exclude up to $250,000 ($500,000 for married couples filing a joint return) in gain realized on the sale of a personal residence if they have owned the residence and resided in it for periods adding up to two-years of the five-year period ending on the date of sale (IRC §121).

Under the new law, the exclusion of gain on the sale of a personal residence does not apply if the sale occurs within five years of the acquisition date of the property if the property was received as replacement property in a tax-deferred exchange under IRC §1031.

In the context of 1031 Exchanges, taxpayers frequently exchange investment property for replacement property that they intend to eventually convert (tax-free) into a personal residence. Usually the conversion occurs a year or so after the residence is acquired as 1031 replacement property and held for the required investment purposes. Then, the taxpayers move into the residence, live there for two-years making the residence eligible for the exclusion for sale of a personal residence.

Using this strategy, it has been possible for taxpayers to cash out of several investment properties sequentially over a period of years, acquiring replacement property more suitable for potential personal residency, converting it to personal residences for the required two-years, selling it tax-free and then moving on to the next tax-deferred exchange and conversion to a personal residence.

The IRS has been aware of this tax-planning “loophole” and has desired to extend the two-year ownership requirement for personal residence exclusion of gain. The American Jobs Creation Act of 2004 does this.

Observation 1 – A taxpayer is not compelled to live in the residence for five-years. The taxpayer is only compelled to own the residence for five-years from the acquisition date and reside in it for periods of time adding up to two-years during the five-year period for the full gain exclusion.

Observation 2 – IRC §121(a) provides a reduced (prorated) exclusion that applies when a taxpayer sells a residence before residing in it for two-years in cases of employment changes, health or other qualifying reasons. The new law doesn’t provide any exceptions to the five-year ownership requirement for such situations.

EXCHANGE MANUAL

For information on the 1031 Exchange Manual see (1031cpas.com/1031literature.htm).

The above information is provided by 1031 Corporation, an exchange company specializing in tax-deferred exchanges. For more information see their home page,
(www.1031cpas.com).