1031 EXCHANGE REVISITED:
Changes brought about by the American Jobs Creation Act of 2004
by: Roman P. Mosqueda, Esq.
Section 1031 of the Internal Revenue Code allows owners of real and personal properties to defer payment of taxes when their property is sold.
According to the said provision, a correctly-structured exchange allows an investor to sell a property, reinvest the proceeds in a new property or properties and defer capital gains taxes.
This is what we call the Section 1031 Exchange. This author has previously written an article on 1031 Exchange, wherein he explained the mechanics and advantages of this type of exchange.
However, the enactment of the American Jobs Creation Act of 2004 brought about changes in the application of Section 1031. Hence, it is necessary to revisit our discussion on this subject matter.
To recap our previous article, Section 1031 provides that “no gain nor loss shall be recognized on the exchange of property held for productive use in trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.”
From this section, we see the four fundamentals of a 1031 exchange. Said principles can be best explained by answering these four questions:
(1) Is the property qualified for tax deferred treatment? While all types of real and personal properties can be subject to a 1031 exchange, the law specifically disqualifies some real and personal properties, such as a personal residence, land under development, construction of fix/flips for resale, property purchased or held for resale, inventory property, corporation common stock, bonds, notes, partnership interest. Hence, the property should not be specifically disqualified.
(2) What is the taxpayer’s purpose for holding the property? In order to qualify for tax-deferred treatment, the taxpayer's property must be held for productive use in a trade or business or for investment. Furthermore, the taxpayer must acquire property which he or she intends to hold for productive use in a trade or business or for investment.
(3) Is the replacement property a “like-kind” property to the one being surrendered? Replacement property acquired in an exchange must be "like-kind" to the property being relinquished. Like-kind simply means "similar in nature or character, notwithstanding differences in grade or quality."
(4) Would the transaction involve an exchange? Finally, Section 1031 specifically requires that an exchange take place. That means that one property must be exchanged for another property, rather than for cash. The exchange is what distinguishes a Section 1031 tax-deferred transaction from a sale and purchase.
As a rule, the original property and the replacement property must be held for a period of one year. While Section 1031 does not require this, the holding period is a factor to consider in determining whether the “purpose requirement” has been met.
However, in the event the property is acquired from a related person or entity, the holding period is a minimum of two years.
The Taxpayer Relief Act of 1997
Unfortunately, a personal residence does not qualify under the IRC Section 1033. However, the Taxpayer Relief Act of 1997 signed into law on August 5, 1997, brought sweeping changes to the tax rules applicable to the sale of a personal residence. The said law changed the Internal Revenue Code’s treatment for the sale of a personal residence.
It allows a single taxpayer a $250,000 exclusion from capitol gain and married couples a $500,000 exclusion. However, the law required the taxpayer to have resided in the property for two years of the last five years.
A loophole in the law would allow investors to take advantage of the homeowners' exclusion. If a person exchanged a piece of rental property for another and then shortly thereafter occupied it as their main home, there was an opportunity to sell it two years later and claim the exclusion.
While the IRS could always claim that at the time of exchange, it was already the taxpayer’s intention to live in the new property; and hence, the rental was not exchanged for similar property, because it was part of the taxpayer’s preconceived plan to acquire it as a home.
But then, this is clearly a prejudiced interpretation of the pertinent provision of the law. Being subjective, it is always open to dispute with taxpayers. The efficiency of tax administration is therefore affected.
The American Jobs Creation Act of 2004
The American Jobs Creation Act of 2004 is said to be the most significant reform of U.S. business taxation. The Act was passed by the House on October 7, 2004, and then passed by the Senate on October 11, 2004. It was signed into law on October 22, 2004.
This new law closes the loophole in the Taxpayer Relief Act of 1997. The law makes it clear that the home-sales rules do not apply to any property acquired in any transaction where gain was not recognized within five years of its sale.
As such, the holding period to qualify for the exclusion of gain for a personal residence acquired in a like-kind exchange has now been increased to five years from the former two years.
As such, taxpayers who convert rental property to a principal residence should know that a tax law change will limit their ability to exclude gain on the sale of that residence, if they obtained the property through a like-kind exchange.
The American Jobs Creation Act of 2004 does not allow any exclusion, if the taxpayer sells the home within five years of acquiring the property through a like-kind exchange. This new law applies to sales after October 22, 2004.
(The Author, Roman P. Mosqueda, a real estate broker and attorney, provides free credit report repairs to clients of his law offices and realty and loan company.)