Recording a 1031 exchange properly is a crucial part of the process. This involves filling out IRS Form 8824 and submitting it along with your federal income tax return. Each individual 1031 exchange you undertake within a tax year requires a separate Form 8824 to be accurately recorded. This form provides a detailed account of both the relinquished and acquired properties involved in the transaction. By diligently recording this information, you ensure the IRS is made aware of the capital gains deferred through your 1031 exchange.
Why is recordkeeping so crucial for a 1031 exchange?
Successful execution of a 1031 exchange is a valuable tool investors can use to increase the leverage of their investments. For example, if an investor sells a commercial building using standard means, they will owe up to 20 percent of the appreciation in long-term capital gains taxes (more if they have only owned the building for less than a year.)
Suppose you decide to sell an office building you purchased three years ago. If you have a cost basis in the asset of $500,000 and you can sell it for $700,000, the appreciation (capital gain) is $200,000. If your capital gains rate is 20 percent, you will owe the IRS $40,000, leaving you with $660,000 to reinvest.
Instead, if you sell the asset using a 1031 exchange, you can defer the capital gains taxes and reinvest the entire $700,000. Since those taxes are merely delayed, not erased, it's important to the IRS to track the transaction for the current sale and the later disposition of the replacement property.
The deferred taxes accumulate with additional 1031 exchanges.
Suppose you sell the replacement property two years after completing the initial like-kind exchange and use the 1031 exchange process again. The taxes that you deferred from the original process now accrue to the next property, along with taxes that would be due on the second transaction.
So, for example, you deferred $40,000 of capital gains taxes with the first exchange. If you complete another one and again have taxes that would be due, that amount is added to the earlier $40,000. If you eventually dispose of the final replacement asset in a traditional sale, you will owe the accumulated taxes, along with any depreciation recapture taxes you have also deferred.
On the other hand, if you continue using the 1-031 exchange tool to reinvest the proceeds from each sale until you dispose of the asset in your will, your heir will not owe the accumulated taxes. Instead, they will receive the bequest at a stepped-up value.
Who keeps track of the 1031 exchange documentation?
The recordkeeper for a 1031 exchange is the Qualified Intermediary. The QI maintains all relevant documents related to the exchange, including the identified replacement properties. However, the exchanger, not the QI, is responsible for transmitting the exchange information to Form 8824. In fact, your tax accountant may not also serve as your QI since the 1031 exchange rules prohibit your agent or employee from being the QI.
It's helpful to note that inaccurate or incomplete information on Form 8824 can result in the like-kind exchange being deemed ineligible.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.