The Basics of Tax Deferred Exchanges

§1031 vs §1033: The Basics of Tax Deferred Exchanges

Both Section 1031 and Section 1033 of the Internal Revenue Code provide for the nonrecognition of gain when property is exchanged for qualifying replacement property. While similar in purpose, there are distinct rules separating the two which must be followed closely in order to complete a valid, fully tax-deferred exchange.

§1031 §1033
Usage • Exchange of property held for productive use in a trade or business or for investment. • Exchange of property compulsorily or involuntarily converted as a result of eminent domain, destruction, or theft.
“Equal and Up Rule”
Replacing Equity

 

• Equity in the replacement property must be equal to or greater than the net equity of the relinquished property.

• Equity cannot be replaced by additional debt.

• Cost of the replacement property must be equal to or greater than the net proceeds received.

• Equity can be replaced with additional debt.

“Equal and Up Rule”
Replacing Debt

 

• The value of debt on the replacement property must be equal to or greater than the value of debt relieved on the relinquished property.

• Debt can be replaced with additional equity (cash).

• The value of debt on the replacement property must be equal to or greater than the value of debt relieved on the property converted.

• Debt can be replaced with additional equity (cash).

Replacement Property Standard • Like-Kind • Similar or related in service or use
Constructive Receipt/
Qualified Intermediary

 

• Property owner cannot take direct possession of sale proceeds upon disposition.

• Funds must be held in escrow with a disinterested third party (qualified intermediary).

• Property owner can take immediate possession the conversion proceeds.

• Use of an intermediary for escrow is not required.

Identification Period

 

• Within 45 days of disposition, the property owner must identify, in writing, potential replacement properties.

 

• Identification of replacement properties not required.

• Details of replacement to be reported on the replacement year tax return.

Replacement Period

 

• Within 180 days of disposition, escrow must close on one or more the properties identified as potential replacements.

 

• Within 2 years from the end of the first tax year in which gain is realized, escrow must close on one or more qualified replacement properties.

• Special rules extend this period to 3 or 4 years.

Proper Vesting • The same individual or entity holding title to the relinquished property must purchase replacement property. • The same individual or entity holding title to the property converted must purchase replacement property.
Misc.

 

• Exchange funds cannot be used to improve land already owned.

• Replacement property can be purchased from a “related” party, subject to certain rules.

• Conversion proceeds can be used to improve land already owned.

• In general, replacement property cannot be purchased from a “related” party.