What is a 1031 Exchange?
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 1031 Exchange allows a property owner to exchange “like kind” property to deferr federal income and some state income taxes on the gain.
What are the benefits of a 1031 exchange?
- A 1031 Exchange allows you to have more money to invest in other property by deferring the taxes on any gain until a later date.
- Any gain from depreciation recapture is postponed
- You can dispose and acquire properties to reallocate your investments without paying taxes on any gain
What are the different Types of 1031 Exchanges?
- 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 occurs when there is a time gap between the transfer of the Relinquished Property and the acquisition of the Replacement Property. A Delayed Exchange is subject to strict time limits, which are set forth in the Treasury Regulations.
- Build-to-Suit (Improvement or Construction) Exchange: This technique allows the taxpayer to build on, or make improvements to, the replacement property, using the exchange proceeds.
- Reverse Exchange: A situation where the replacement property is acquired prior to transferring the relinquished property. The IRS has offered a safe harbor for reverse exchanges, as outlined in Rev. Proc. 2000-37, effective September 15, 2000. These transactions are sometimes referred to as “parking arrangements” and may also be structured in ways which are outside the safe harbor.
- Personal Property Exchange: Exchanges are not limited to real property. Personal property can also be exchanged for other personal property of like-kind or like-class.
What Properties Qualify for a valid Exchange?
- Properties that do not qualify for a 1031 are primary residence, business inventory, stocks, bonds or notes, other securities or indebtedness, interest in a partnership, certificates of trusts.
What are the Requirements for a valid Exchange?
- Correct Purpose – Both the disposed property and new replacement property must be held for productive use in a trade or business or for investment. Property acquired for immediate resale will not qualify. The taxpayer’s personal residence will not qualify.
- Like Kind – Replacement property acquired in an exchange must be “like-kind” to the property being relinquished. All qualifying real property located in the United States is like-kind. Personal property that is relinquished must be either like-kind or like-class to the personal property which is acquired. Property located outside the United States is not like-kind to property located in the United States.
- Exchange Requirement – The disposed property must be exchanged for other property, rather than sold for cash and using the proceeds to buy the replacement property.
What are the guidelines to follow?
- All of the net proceeds from the sale of the disposed property must be used to acquire the replacement property.
- The value of the replacement property must be equal to or greater than the value of the relinquished property.
- The equity in the replacement property must be equal to or greater than the equity in the relinquished property.
- The debt on the replacement property must be equal to or greater than the debt on the relinquished property.
Can I Take Cash Out Of The Exchange Account?
Yes, but only withdrawn in accordance with the regulations. The Taxpayer cannot receive any money until the exchange is complete. If you want to pull cash out of the exchange account, you must do so before funds are deposited with the “Qualified Intermediary.”
Can I Convert The Replacement Property To My Principle Residence at Some Point?
Yes, but the holding requirements of 1031 must be met prior to you converting. The IRS has no specific holding periods identified. However, the industry norm is to be on the safe side you should hold for at least one year.
How long do I have before I must determine whether to use a 1031 Exchange?
As long as the taxpayer has not transfered title, benifits or burdens of the disposed property, he can still set up a 1031 exchange. Essentially, until the closing date of escrow
What is a Qualified Intermediary?
A Qualified Intermediary is an independent party who facilitates tax-deferred exchanges pursuant to Section 1031 of the Internal Revenue Code. The QI cannot be the taxpayer or a disqualified person.
Acting under a written agreement with the taxpayer, the QI acquires the relinquished property and transfers it to the buyer.
The QI holds the sales proceeds, to prevent the taxpayer from having actual or constructive receipt of the funds.
Finally, the QI acquires the replacement property and transfers it to the taxpayer to complete the exchange within the appropriate time limits.
Does the Qualified Intermediary QI take title to the properties?
No, not in most situations. The IRS regulations allow the properties to be deeded directly between the parties, just as in a normal sale transaction. The taxpayer’s interests in the property purchase and sale contracts are assigned to the QI. The QI then instructs the property owner to deed the property directly to the appropriate party (for the relinquished property, its buyer; for the replacement property, taxpayer).
What are the timeframes for completing a 1031 exchange?
A taxpayer has 45 days after the date that the relinquished property is transferred to properly identify potential 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. Thus, for a calendar year taxpayer, the exchange period may be cut short for any exchange that begins after October 17th. However, the taxpayer can get the full 180 days, by obtaining an extension of the due date for filing the tax return.
What is the Maximum Number of Properties I Can Identify For Replacement?
There are three rules that limit the number of properties that can be identified. The taxpayer must meet the requirements of at least one of these rules:
- 3-Property Rule: The taxpayer may identify up to 3 potential replacement properties, without regard to their value; or
- 200% Rule: Any number of properties may be identified, but their total value cannot exceed twice the value of the relinquished property, or
- 95% Rule: The taxpayer may identify as many properties as he wants, but before the end of the exchange period the taxpayer must acquire replacement properties with an aggregate fair market value equal to at least 95% of the aggregate fair market value of all the identified
properties.
Q – What is a “multi-asset” exchange?
A multi-asset exchange involves both real and personal property. For example, the sale of a hotel will typically include the underlying land and buildings, as well as the furnishings and equipment. If the taxpayer wants to exchange the hotel for a similar property, he would exchange the land and buildings as one part of the exchange. The furnishings and equipment would be separated into groups of like-kind or like-class property, with the groups of relinquished property being exchanged for groups of replacement property.
Although the definition of like-kind is much narrower for personal property and business equipment, careful planning will allow the taxpayer to enjoy the benefits of an exchange for the entire relinquished property, not just for the real estate portion.
Q – What is a reverse exchange?
A reverse exchange, sometimes called a “parking arrangement,” occurs when a taxpayer acquires a Replacement Property before disposing of their Relinquished Property. A “pure” reverse exchange, where the taxpayer owns both the Relinquished and Replacement properties at the same time, is not allowed. The actual acquisition of the “parked” property is done by an Exchange Accommodation Titleholder (EAT) or parking entity.
Q – Is a reverse exchange permissible?
Yes. Although the Treasury Regulations still do not apply to reverse exchanges, the IRS issued “safe harbor” guidelines for reverse exchanges on September 15th, 2000, in Revenue Procedure 2000-37. Compliance with the safe harbor creates certain presumptions that will enable the transaction to qualify for Section 1031 tax-deferred exchange treatment.
Q – How does a reverse exchange work?
In a typical reverse (or “parking”) exchange, the “Exchange Accommodation Titleholder” (EAT) takes title to (“parks”) the replacement property and holds it until the taxpayer is able to sell the relinquished property. The taxpayer then exchanges with the EAT, who now owns the replacement property. An exchange structured within the safe harbor of Rev. Proc. 2000-37 cannot have a parking period that goes beyond 180 days.
Q – What happens if the exchange cannot be completed within 180 days?
If the reverse exchange period exceeds 180 days, then the exchange is outside the safe harbor of Rev. Proc. 2000-37. With careful planning, it is possible to structure a reverse exchange that will go beyond 180 days, but the taxpayer will lose the presumptions that accompany compliance with the safe harbor.
Q – Can the proceeds from the relinquished property be used to make improvements to the replacement property?
Yes. This is known as a Build-to-Suit or Construction or Improvement Exchange. It is similar in concept to a reverse exchange. The taxpayer is not permitted to build on property she already owns. Therefore, an unrelated party or parking entity must take title to the replacement property, make the improvements, and convey title to the taxpayer before the end of the exchange period.
Q- What is the difference between “realized” gain and “recognized” gain?
Realized gain is the increase in the taxpayer’s economic position as a result of the exchange. In a sale, tax is paid on the realized gain. Recognized gain is the taxable gain. Recognized gain is the lesser of realized gain or the net boot received.
Q – What is Boot?
Boot is any property received by the taxpayer in the exchange which is not like-kind to the relinquished property. Boot is characterized as either “cash” boot or “mortgage” boot. Realized Gain is recognized to the extent of net boot received.
Q – What is Mortgage Boot?
Mortgage Boot consists of liabilities assumed or given up by the taxpayer. The taxpayer pays mortgage boot when he assumes or places debt on the replacement property. The taxpayer receives mortgage boot when he is relieved of debt on the replacement property. If the taxpayer does not acquire debt that is equal to or greater than the debt that was paid off, they are considered to be relieved of debt. The debt relief portion is taxable, unless offset when netted against other boot in the transaction.
Q – What is Cash Boot?
Cash Boot is any boot received by the taxpayer, other than mortgage boot. Cash boot may be in the form of money or other property.
Q – What are the boot “netting” rules?
Cash boot paid offsets cash boot received
Cash boot paid offsets mortgage boot received (debt relief)
Mortgage boot paid (debt assumed) offsets mortgage boot received
Mortgage boot paid does not offset cash boot received
Q – I bought the property as a single person and I would like to acquire the replacement property together with my spouse?
The most conservative way is to stay consistent and complete the exchange the same way it was started and to add the spouse after the completion of the exchange. An exception can be made if there is a lender requirement that the spouse has to be added in order to qualify for a loan. If an exchange is planned well ahead of time, another solution would be to add the spouse to the title of the currently held property. Timing should be discussed with the CPA.
Q – I closed escrow on my first replacement property within the 45 day identificationperiod. Can I now identify three more properties within my 45 day identification period?
If you are using the three property rule, the completed acquisition counts as one and you may identify only up to two additional properties.
Q – How do I identify two different properties (or percentages of ownership through a TIC) covered by ONE purchase contract?
If the properties could be sold separately at a later date, they should be identified as two properties.
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