The past several years a growing portion of U.S. ranch transactions have
been done utilizing Section 1031 language in the U.S. tax code. Several
sources have indicated that nationally between 35-45 percent of ranch
purchases have been done via Section 1031 Exchange rules, and several
brokers and Realtors have indicated they think that trend could grow
even more, perhaps above 50 percent over the next few years.
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 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. 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, the original deferred
gain, plus any additional gain realized since the purchase of the
replacement property, is subject to tax.
The following are answers to some commonly asked questions that WLJ
presented to a couple of property acquisition specialists with the IRS.
Q: What are the benefits of 1031 exchanges?
A: A Section 1031 exchange is one of the few techniques available to
postpone or potentially eliminate taxes due on the sale of qualifying
properties. By deferring the tax, there is more money available to
invest in another property. It’s like receiving an interest-free loan
from the federal government, in the amount that would have paid in
taxes. Any gain from depreciation recapture is postponed. Finally,
properties can be acquired and disposed of to reallocate an investor’s
portfolio without paying taxes on any gain.
Q: What are the five types of exchanges allowed?
A: They are:
• Simultaneous Exchange: The exchange of the relinquished property for
the replacement property occurs at the same time.
• Delayed Exchange: This is the most common type of exchange. A delayed
exchange is when there is a time gap between the transfer of the
Relinquished Property and the acquisition of the Replacement Property.
It is subject to strict time limits set by the U.S. Department of the
• Build-to-Suit Exchange: This technique allows the taxpayer to build
on, or make improvements to, the replacement property, using the
• Reverse Exchange: When the replacement property is acquired prior to
transferring the relinquished property. The IRS has offered a safe
harbor for reverse exchanges, which became effective Sept. 15, 2000.
These transactions are sometimes referred to as "parking arrangements"
and may also be structured in ways that are outside the safe harbor.
• Personal Property Exchange: These are not limited to real property.
Personal property can also be exchanged for other personal property of
like-kind or like-class.
Q: What makes up a valid exchange?
A: First it must be said that certain types of property are specifically
excluded from Section 1031. Among those exclusions are property held
primarily for sale; inventories; stocks, bonds or notes; other
securities or evidences of indebtedness; interests in a partnership; and
certificates of trusts or beneficial interest. If property is not
specifically excluded, it can qualify for tax-deferred treatment. Both
relinquished and replacement property must be held for productive use in
a trade or business or for investment. Taxpayers’ personal residences do
not qualify. Replacement property acquired must be "like-kind" to the
property being relinquished. In addition, relinquished property must be
exchanged for other property, rather than sold for cash and using the
proceeds to buy the replacement property.
Q: How can all taxable gain be deferred?
A: According to brokers, the value of the replacement property must be
equal to or greater than the value of the relinquished property; equity
in the replacement property must be equal to or greater than the equity
in the relinquished property; debt on the replacement property must be
equal to or greater than the debt on the relinquished property; and all
of the net proceeds from the sale of the relinquished property must be
used to acquire the replacement property.
Q: Can replacement property be converted to a primary residence or
A: Yes, but the holding requirements of Section 1031 must be met prior
to changing the primary use of the property. There are no specific
regulations on holding periods. However, it’s recommended that taxpayers
hold replacement property for a proper use for a period of at least a
Q: Are there time restrictions?
A: A taxpayer has 45 days after the date relinquished property is
transferred to identify possible replacement properties. The exchange
must be completed by the date that is 180 days after the transfer of the
relinquished property, or the due date of the taxpayer's federal tax
return for the year in which the relinquished property was transferred,
whichever is earlier.
Q: What if replacement property isn’t identified within 45 days, or
there is failure to close on replacement property before exchange
A: If taxpayers do not meet time restrictions, the exchange will fail
and taxes arising from the sale of relinquished property have to be
paid. There are no extensions available!
Q: What’s the limit on identified properties?
A: There are three rules that limit the number of properties that can be
identified. Taxpayers must meet the requirements of at least one of
these rules. The three-property rule limits buyers to three potential
replacement properties without regard to their value. The 200 percent
rule allows an unlimited number of properties to be identified but their
total value cannot exceed twice the value of relinquished property. The
95 percent rule allows people to identify as many properties as desired,
but must also acquire replacement properties with an aggregate fair
market value equal to at least 95 percent of all the identified
Q: Are 1031 exchanges limited to real estate?
A: No. Any property that is held for productive use in a trade or
business, or for investment, may qualify for tax-deferred treatment
under Section 1031. In fact, many exchanges are "multi-asset" exchanges,
involving both real property and personal property. — WLJ