How Do I Report a 1031 Exchange on My Tax Return?

You are probably aware that it is tax season again. It is during this time of the year that we receive quite a number of questions and inquiries regarding investors' 1031 tax deferred exchanges that were completed during the previous tax year.

Common 1031 Exchange Reporting Questions
Questions such as the following are very common:

• How do I report my 1031 tax deferred exchange on my income tax return?
• What IRS Forms do I use to report a 1031 exchange, including the tax deferral, boot, capital gain, etc.
• I did a partial 1031 tax deferred exchange and also have to report boot. What IRS Form do I use to report the boot?
• Is my Qualified Intermediary required to report the 1031 tax deferred exchange to the Internal Revenue Service on my behalf?
• I earned interest income on my 1031 exchange balance while it was held by the Qualfiied Intermediary. How do I report that interest to the IRS?

1031 Tax Deferred Exchange Forms and Documents Library
We have created a 1031 exchange forms and documents library and posted many of the Federal and some state income tax forms that you will need to report your real estate transactions, including your 1031 tax deferred exchange transactions.

Answers to Your Questions
The general answers to the questions listed above are as follows. However, it is very important that you have a professional tax advisor complete the forms on your behalf.

Reporting the 1031 Exchange
You can read about the reporting requirements for the sale, disposition or exchange of property in IRS Publication 544. 1031 tax deferred exchanges are reported on Internal Revenue Service Form 8824. IRS Form is generally updated each year, so make sure that you have the most recent version available.

Reporting Taxable Capital Gain from a 1031 Exchange
Boot will trigger depreciation recapture and capital gain income tax liabilities. These items are reported on Internal Revenue Service Form 4797.

Reporting Failed 1031 Exchanges
This issue can get a little tricky, so always have your tax advisor assist you. A failed 1031 exchange is reported in the year in which the investor had the right to his or her 1031 exchange proceeds. It might be taxable as an installment sale and taxed in the following year depending on the circumstances. IRS Form 6252 would be used under these circumstances.

How Long Do I Have to Hold 1031 Exchange Property?

This is a great question and one that is asked very frequently when investors are in the middle of a 1031 tax deferred exchange transaction. This question usually comes up in one of two situations when the investor wants to dispose of real estate and defer the payment of capital gain taxes through a 1031 tax deferred exchange transaction.

• The first is when the investor just acquired investment property and now wants to sell it and defer the payment of their capital gain taxes by structuring a 1031 tax deferred exchange.
• The second is when the investor has just acquired replacement property through a 1031 tax deferred exchange and wants to dispose of it already.

There are numerous versions and variations of these two examples, of course, but it clearly lays out the issue at hand. The issue is how long does an investor need to hold his or her investment property in order to qualify for the 1031 tax deferred exchange.

Once again, I must answer with It Depends!

Intent to Hold
There is no black and white answer here. The IRS and Treasury Department have never formally ruled on this issue.

The Treasury Regulations require that the investor have the intent to hold the property for investment. The investor would have to prove they had the intent to hold for investment should they ever get audited. A holding period of a few months would make it very difficult to prove that they had the intent to hold the property for investment, and property held for sale will not technically qualify for 1031 tax deferred exchange treatment.

Recommended Holding Period
It is for these reasons that most 1031 tax deferred exchange experts will recommend a holding period of at least 12 months and would prefer 24 months to ensure that you can demonstrate you had the intent to hold your 1031 exchange property long enough to qualify as investment property.

Can I Buy a Piece of a Property as Part of My 1031 Exchange?

This question can take many forms. The most common are as follows:

• I own property together with another party. I'm in the middle of a 1031 tax deferred exchange. Can I identify and buy the 50% of the property that is owned by the other party as part of my 1031 tax deferred exchange so that I now own 100% of the property?
• There is a small group of friends that want to buy property together. We would each end up owning about 20% of the property. Can I identify this 20% and buy it as part of my 1031 tax deferred exchange?
• I attended a seminar on buying/investing in tenant-in-common investment properties where I would buy a fractional interest in a large commercial property. Does this fractional interest qualify as replacement property for part of my 1031 tax deferred exchange transaction?

The answers is yes to all of these questions.

The requirement is that the investor who sold real estate through a 1031 tax deferred exchange must also acquire like-kind real estate as his or her replacement property in order to complete a successful 1031 exchange. The replacement property does not have to be 100%; a fractional interest will qualify with no problem.

Your professional 1031 tax deferred exchange Qualified Intermediary can help you identify a fractional interest in real property when you are completing your identification form during your 45 day identification period.

Can I Move Into Property Bought In a 1031 Exchange?

It depends. I've probably mentioned this before, but that is my favorite technical answer to many 1031 tax deferred exchange related questions, or any income tax related question for that matter. It depends is often appropriate because the income tax laws and regulations are not always black and white. And, this question is no different, so the answer "It Depends" is so fitting.

Income Tax Savings
This question actually makes a lot of sense. It can be an incredible income tax planning strategy that can save an investor quite a bit on taxes. Investors can sell investment property and acquire replacement property and ultimately convert the property into their own primary residence. They can sell their primary residence after a certain amount of time and qualify for a tax free exclusion under Section 121 of the Internal Revenue Code. The timing of each step and the amount of gain to be excluded should be planned carefully, but it allows investors to turn tax-deferred income into tax free income.

1031 Tax Deferred Exchange
The 1031 tax deferred exchange requires that you sell property that was held for rental, investment or used in your business and that you acquire replacement property that is also to be held for rental, investment or also used in your business operation. The 1031 tax deferred exchange will only defer the payment of your capital gain taxes.

121 Tax Free Exclusion
Homeowners can sell their primary residence and exclude up to $250,000 if they are single or up to $500,000 if they are married from taxable income as long as they have owned and lived in the property as their primary residence for at least a total of 24 months out of the last 60 months. The 121 exclusion will only exclude capital gain taxes and will not exclude any depreciation recapture taxes that might be due.

The Reason that It Depends
There are a number of issues involved here, so I will address each of the issues independently. The issue vary depending on your individual circumstances.

First, the investor must complete his or her 1031 tax deferred exchange. Once they have completed their 1031 exchange they need to hold the acquired replacement property long enough to demonstrate they had the intent to hold the property for investment. Generally, most 1031 tax deferred exchange experts recommend at least 12 months and preferrably at least 24 months in order to demonstrate your intent to hold the property.

Second, the investor must move into the property and convert it into their primary residence and live in the property as their primary residence for at least 24 months in order to qualify for the tax free exclusion under Section 121 of the Internal Revenue Code.

Third, because the property was acquired as part of a 1031 tax deferred exchange, there is a five (5) holding requirement in order to take advantage of the 121 exclusion. This requirement would be satisfied if the investor rented the property for three (3) years and then moved into it and lived in it as his or her primary residence for two (2) years resulting in a total of five (5) years. This issue does not apply if you did not acquire the property as part of a 1031 exchange.

Fourth, because the property was held as rental property first, the amount of gain that can be excluded on a tax free basis after January 1, 2009 will be reduced by the amount of time that the property was held for non-qualified use (i.e. use other than as a primary residence). This change was included in the Housing and Economic Recovery Act of 2008.

That was a windy answer, and can be confusing. Please feel free to email me or call me with any specific questions that you might have.

Happy Valentines Day

Just a quick post to wish each of our readers a very Happy Valentine's Day.

Strategic Capital Gain Tax Liability Management: A New Way Out

1031 Tax Deferred Exchange Not Always Best Option
Investors often flock to the 1031 tax deferred exchange strategy each time they are contemplating selling real estate or personal property without considering all of the available options.

And, while I am certainly biased toward the 1031 tax deferred exchange with my 24 years in the 1031 exchange industry, and the 1031 exchange is generally the best tax deferred solution available, I am also the first to admit that the 1031 tax deferred exchange strategy may not always be the best option for certain investors under certain circumstances.

The New Way Out
There may be a New Way Out; an innovative tax deferred strategy available to investors that are selling real estate, businesses or other assets that do not wish to acquire like-kind replacement property as required under the 1031 tax deferred exchange or may not be able to do so because of real estate, lending, or credit market conditions.

It can be exceptionally challenging to structure 1031 tax deferred exchange for the sale of a business or assets used in a business. Identifying suitable like-kind replacement property can be most challenging, if not down right impossible in cases like this.

Deferred Sales Trust
This new and innovative capital gain tax deferral strategy is called the Deferred Sales Trust™ and operates very similar to an installment sales contract under Section 453 of the Internal Revenue Code.

The Deferred Sales Trust permits the investor to sell real or personal property, especially a business, and defer the payment over the term of the installment sale contact or seller carry back note. The Deferred Sales Trust can be an exceptional estate planning tool and even a rescue vehicle for a failed 1031 tax deferred exchange.

Can I Use the 1031 Exchange for Property Owned in My Self-Directed IRA?

We should first discuss Self-Directed IRAs or Individual Retirement Accounts. The term Self-Directed IRA is a little misleading since all IRAs are technically "self-directed."  What you ask? Yes, because investors decide where to place or deposit their IRA. They can change financials institutions as often as they like merely by requesting an IRA-to-IRA transfer to a new IRS Custodian. 

Self-Directed IRA 

The use of the term Self-Directed IRA is really referring to the ability of the investor to choose or "self-direct" his or her own investments within his or her own IRA. The difference is that many IRA Custodians limit the investment options that investors can invest. 

The wire houses like Merrill Lynch and big banks like BofA, Wells Fargo and Chase limit the investors choice of investments to publicly traded securities like stocks, bonds, and mutual funds. The same goes for online brokerage firms like Charles Schwab & Company. 

Alternative Investments

Some specialty IRA Custodians allow investors to invest in non-publicly traded investments, including real estate, mortgage loans, deeds of trust, tax lien certificates, non-traded REITs, and much more.  These specialty investments are often referred to as non-traditional investments, non-standard investments or "Alternative Investments."  

The retirement industry generally refers to these as Self-Directed IRAs, not because of the IRA Custodian but because of the ability of the investor to choose or "self-direct" unique investments inside of their IRA. 

1031 Exchange inside of a Self-Directed IRA 

This brings us to the question. Can an investor use a 1031 Exchange to defer the payment of taxes within an IRA for real estate that was acquired inside of the IRA and is now being sold. The answer is "it depends."

The IRA is already tax deferred in the case of a Traditional IRA, SEP-IRA or SIMPLE IRA or Traditional Individual 401(k) Plan or tax-free in the cast of a Roth IRA or Roth Individual 401(k) Plan, so the sale of the real estate inside the Self-Directed IRA is either tax-deferred or tax-free since the real estate is held inside of the IRA. The 1031 exchange would not add any value to the transaction.

Enter UBTI or UDFI

However, under certain circumstances, the sale of real estate held inside of a Self-Directed IRA could trigger a taxable event called Unrelated Business Taxable Income (UBTI) or Unrelated Debt Finance Income (UDFI).  UBTI or UDFI would trigger a taxable event and the Self-Directed IRA would have to file a 990-T tax return and may have to actually pay income taxes depending on the circumstances.  

In this case, completing a 1031 Exchange on the sale of real estate could defer the taxable event and avoid having to file a tax return since any taxable event under a 1031 Exchange qualifies for non-recognition of gain.  The 1031 Exchange can often allow the Self-Directed IRA owner to defer the taxable event and provide time to permanent resolve the issue depending upon the circumstances. 

Can Replacement Property Be Acquired in any State?

This is actually a very common question because taxpayers are often selling property in one particular state that has "peaked" in its real estate market cycle and they are looking into acquiring property in another state that is currently undervalued.

Generally, the answer is yes. Like-kind property means that property must be held for rental, investment or business use. It does not have to be the same type (i.e. condo for a condo) and it does not have to be located in the same state.

There are a few exceptions, so it is always a good idea to consult with your legal and tax advisors as to state specific laws and regulations.