As we’ve discussed, a 1031 exchange is a potentially highly useful type of transaction for those who own investment or business real estate. Since we regularly deal in the commercial real estate world, it’s useful to talk about 1031 exchanges from time to time. These transactions can get a bit tricky, and so we’ve tried to shed light on how these transactions work. We’ve just lightly touched on the mechanics of traditional “delayed” exchanges and “reverse” exchanges. Today, we will shed light on a few basic terms which a person will likely see if they conduct an exchange.
At its basic level, a delayed exchange is a contractual arrangement between a taxpayer and a facilitator, and that arrangement protects the taxpayer from receiving the funds from the sale of his or her property. If a taxpayer receives the funds without this arrangement, then the receipt would trigger a taxable consequence. Taxpayers can receive funds in two different ways: they can actually receive them and they can constructively receive them. Basically, constructive receipt means the ability to access or control the funds, even if that ability isn’t tapped into. If someone has the potential to use the funds, then they would be in construct receipt of those funds.
Sometimes, a taxpayer can receive some cash or other property at the end of the exchange period in addition to receiving their new replacement property. Whenever a person receives property which isn’t of a “like-kind” to the replacement property, that will trigger a taxable consequence. This other property is referred to as “boot,” which means that it’s a form of non-qualifying property which will be taxed to the extent of the gain. Most boot takes the form of cash boot, but there’s also mortgage boot (meaning debt reduction), stock boot, and so forth.
Section 1031 has four basic requirements which must be met. One of those basic requirements is the “like-kind” requirement. The property you acquire has to be sufficiently similar to the property you sell. Whether a given property qualifies as like-kind is a legal question, which means that courts determine whether a given property falls within the meaning of this term on a case-by-case basis. In general, though, any property which is classified as “real estate” under local law will be classified as like-kind to real estate for purposes of Section 1031.
The “identification period” is the 45 day time period which occurs after the sale of the relinquished property. During this 45 day time window, taxpayers have to identify potential replacement property. Only property which is properly identified may be acquired in the exchange. There are 3 rules which govern the number of properties a taxpayer can identify. Because taxpayers can only acquire properly identified replacement property, if no replacement properties are identified at the end of the identification period, the exchange will automatically fail.
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