Please Note: Many of the following situations are subject to varied interpretations and/or require more detailed information than space allows! Please call for details and always check with your CPA or tax attorney before proceeding with your exchange.
What Tax Deferred Exchange Terminlology Should I Know?
1031 Exchange: When you take property held for investment or productive use in a trade or business and replace it with like-kind property held for the same purpose.
Constructive Receipt: A term referring to the effective control of proceeds by the exchangor even though funds are not physically in their possession.
Exchangor: The property owner(s) seeking to defer tax by utilizing a Section 1031 exchange (the Internal Revenue Code uses the term “Taxpayer”).
Like-Kind Property: This term refers to the nature or character of the property, and not its grade or quality. Generally, real property is “like-kind” as to all other real property, as long as the Exchangor’s intent is to hold the properties as an investment or for productive use in a trade or business. With regard to personal property, the definition of “like-kind” is much more restrictive. For example, while you can exchange a rental house for a shopping center, you can’t exchange a cow for a bull or a car for a truck. Also, U.S. real property is only like-kind for other U.S. real property. Similar to real property, personal property used predominantly within the United States and personal property used predominantly outside the United States are not like-kind.
Boot: Fair Market Value of non-qualified (like-kind) property received in an exchange. (Examples: cash, notes, furniture, supplies, reduction in debt obligations.)
Qualified Intermediary: The entity that facilitates the exchange for the Exchangor. Some companies use the term “facilitator,” and/or “accommodator;” the Treasury Regulations use the term “Qualified Intermediary.” The QI acts on behalf of the exchangor.
Relinquished Property: The property given up by the Exchangor. This is also sometimes referred to as the “exchange” property or the “downleg” property.
Replacement Property: The new property received by the Exchangor. This is sometimes referred to as the “acquisition” property or the “upleg” property.
What are the delayed exchange deadlines?
The §1031 exchange BEGINS on the earlier of the following:
- The date the deed records.
- The date possession is transferred to the buyer.
The exchange ENDS on the earlier of the following:
- 180 days
- The date the Exchangor’s tax return is due, including extensions, for the taxable year in which the relinquished property is transferred.
The IDENTIFICATION PERIOD is the first 45 days of the exchange period. The EXCHANGE PERIOD is a maximum of 180 calendar days. If the Exchangor has MULTIPLE RELINQUISHED PROPERTIES, the deadlines begin on the transfer date of the first property. These deadlines may not be extended for any reason except Presidentially declared disasters or the taxpayer serving in combat zones.
- A deadline that falls on Thanksgiving, Christmas or New Year’s Day, does not permit extension.
- Mistakenly identifying condominium A, when condominium B was intended does not permit a change in identification after the 45 day Identification Period expires.
Failure to comply with these deadlines may result in a failed exchange.
How do I calculate my gain?
Start with the price you paid for your property, add any capital improvements, and subtract any depreciation. This figure is your adjusted basis. Subtract the adjusted basis and the non-recurring costs of sale from the current sales price and the remaining figure is your gain.
What happens if I exchange down in value?
If you exchange down in value, you can still do an exchange to defer the gain on a portion of your transaction, however, you will pay taxes on any “boot” you receive, whether it is actual proceeds not used in the purchase (cash boot) or a lesser mortgage loan on the new purchase (debt relief/mortgage boot… you are allowed to bring in additional outside cash to offset mortgage boot, however).
How do I Initiate An Exchange?
Find a Qualified Intermediary to assist you with the exchange as early in the sale process as possible. Key points to consider in selecting a Qualified Intermediary are: knowledge and experience; availability to assist your real estate agent, CPA and attorney; safety of your funds while held by the Qualified Intermediary (bonding, size of bond, etc.). Safe Harbor Exchange is such a Qualified Intermediary.
Inform your real estate agent of your selection of QI and instruct your agent to include an “Exchange Cooperation Clause” as an addendum to the purchase and sale agreement on the relinquished property (the property you are exchanging out of).
An example of an Exchange Cooperation Clause is:
“Buyer hereby acknowledges that it is the intent of the Seller to effect an IRC §1031 tax deferred exchange which will not delay the closing or cause additional expense to the Buyer. The Seller’s rights and obligations under this agreement may be assigned to Safe Harbor Exchange, Inc., a Qualified Intermediary, for the purpose of completing such an exchange. Buyer agrees to cooperate with the Seller and Safe Harbor Exchange, Inc. in a manner necessary to complete the exchange.”
Note: Substitute Buyer for Seller (and Seller for Buyer) to have a similar cooperation clause for replacement property.
Keep your Qualified Intermediary informed about any purchase and sale agreement and advise them well in advance of the closing date, so the appropriate Exchange Agreement, the Assignment Agreement, and the Exchange closing instructions can be executed prior to closing on the property being sold. Be sure that your Purchase Agreement contains the appropriate verbiage. If you have selected Safe Harbor Exchange as your QI, have your escrow holder/closing agent call (714) 263-0280 for the balance of the escrow documentation.
§1031 Do’s and Don’ts
DO NOT miss your identification and exchange deadlines. Failure to identify within the 45 day identification period or failure to acquire replacement property within the 180 day exchange period will disqualify the entire exchange. Reputable Intermediaries will not act on back-dated or late identifications.
DO keep in mind these three basic rules to qualify for a complete tax deferral:
- Use all proceeds from the relinquished property for purchasing the replacement property.
- When not going up in value, make sure the debt on the replacement property is equal to the debt on the relinquished property. (Exception: A reduction in debt can be offset with additional cash. A reduction in equity cannot be offset by increasing debt, however.)
- Receive only like-kind replacement property. See FAQ explaining “like-kind.”
DO NOT plan to sell and invest the proceeds in property you already own. Funds applied toward property already owned is not an exchange.
DO attempt to sell before you purchase. Occasionally Exchangors find the ideal replacement property before a buyer is found for the relinquished property. If this situation occurs, a reverse exchange (buying before selling) is the usual option. Although there is considerable legal precedent for reverse exchanges, Exchangors should be aware they are considered a more aggressive exchange variation and IRS guidelines are complicated. Consult a Reverse Exchange Accommodator before proceeding!
DO NOT dissolve partnerships or change the manner of holding title during the exchange. A change in the Exchangor’s legal relationship with the property may jeopardize the exchange.
DO complete and file IRS Form 8824 with your income tax return to document the exchange.
What if I live in part of the property?
You can exchange a portion of your property if it has been held for investment purposes. Frequently a farm or ranch falls into this category. A multi-family property might also be part residential and part investment property. Make sure that your escrow instructions indicate a value for the portion that was investment property as separate from the value of the portion that was for your personal use.
What about Boot?
BOOT RECEIPT = GAIN RECOGNITION
An Exchangor who receives boot in an exchange transaction generally recognizes gain to the extent of the value of boot received.
Some common examples of boot:
- Cash proceeds taken by the Exchangor at close of escrow and not used as part of the exchange
- Cash proceeds an Exchangor receives at the end of the exchange from the Qualified Intermediary;
- Proceeds taken from the exchange in the form of a note* or contract for sale of the property;
- Relief from debt on the relinquished property caused by the assumption of a mortgage, trust, deed, or contract, or an agreement to pay other debt;
- Proceeds from real property if used to acquire personal property;
- Personal Property received which is not “like-kind.” Personal Property is never “like-kind” to real property, and it must match very closely in order to be “like-kind” to other personal property exchanged.
- Recurring costs paid in escrow. Interest, taxes, insurance, etc.
* An Exchangor may utilize IRC §453 to recognize the gain (boot) of a seller carry-back note received in an exchange transaction under the installment sale rules. Consult with your tax counsel
What Property Qualifies for §1031 Treatment?
The Exchangor must hold the relinquished property for investment or for productive use in their trade or business to qualify for §1031 treatment. The Exchangor’s purpose in holding the property, rather that the type of property, is the critical issue. The following are examples of qualifying properties:
|Bare Land||Farmer’s Land|
|Commercial property||Residential Rental property|
|Industrial property||Doctor’s office|
|30-year leasehold interest||Percentage interest in investment property|
The intent to hold the property for personal use will prevent the property from qualifying for §1031 treatment. Therefore, sales of second homes will not qualify for §1031 treatment unless the property owner changes how they treat or use the second home. For example, a taxpayer could convert their second home to a valid exchange property and establish this intent by properly renting the property and holding it as a legitimate rental property. Keeping this in mind, a purchase of a second home is not considered like-kind. As with other decisions regarding tax consequences, consultation with a tax advisor is important whenever a taxpayer changes how they intend to hold property.
The intent to hold property “primarily for sale” will prevent the property from qualifying for §1031 treatment. Most properties held by developers, builders and people who perform rehabilitation work are held primarily for sale and may not be the subject of an exchange. When these properties are sold, they are subject to ordinary income taxes rather than capital gain taxes.
Partnership interests, notes secured by real property, contract vendors’ interests and foreign property (under the Revenue Reconciliation Act of 1989) do not qualify for §1031 treatment as it pertains to US real property.
What is Like-Kind Property?
Unlike personal property, all real property is like-kind with all other real property. Like-kind real estate refers to how the property is held by the taxpayer, not the type or character of property. The Exchangor must have held the relinquished property for investment or for productive use in their trade or business and intend to do the same with the replacement property. The following are examples of like-kind exchanges:
- Residential rental property for commercial property
- Bank building for swamp land
- Bare land for residential rental
- Fee simple interest for 30-year leasehold
- Single family rental for multi-family rental
- Non-income producing for income producing
- Rental mountain cabin for a dental office in which the exchangor intends to practice dentistry (it is possible to operate the exchangor’s business from the new replacement property).
If the Exchangor is exchanging personal property the rules are far more restrictive. Definitions of what is considered real property and personal property can vary from state to state. It is essential to consult with a tax advisor when structuring personal property exchanges because one transaction may have multiple exchanges, involving tax deferral on both the personal and real property. Personal property is considered like-kind only if it appears in the same General Asset Class or Product Class. Therefore the Exchangor may exchange:
- Dump truck for a dump truck
- Garbage routes for garbage routes
- Restaurant equipment for restaurant equipment
What Vesting Issues Should be Examined?
Husband relinquishes ……………….. Husband acquires
Trustee relinquishes……………….. Trustee acquires
Johnson LLC relinquishes ……………….. Johnson LLC acquires
Les Mis Partnership relinquishes……………….. Les Mis Partnership acquires
The Exchangor’s legal relationship to the relinquished property must be the same as the Exchangor’s legal relationship to the replacement property. Exchangors must anticipate this issue as part of their advanced planning for the exchange. Business considerations, liability issues and lender requirements may make it difficult to meet this rule.
- If a husband is relying on the wife’s income to qualify for financing, then the lender will require the wife to appear on the deed.
- Lenders seldom loan to trustees, they loan to individuals.
- Exchangor’s who want different LLC’s for each property may not do so within the exchange format unless structured properly (i.e. tenant-in-common purchase).
The Exchangor will want to talk to their advisor, attorney, lender and Intermediary as they structure the exchange. These issues are easier to resolve before loan documents are sitting on the closing table. The following changes in vesting usually do not destroy the integrity of the exchange:
- Change of vesting from a trustee, who is also the trustor, to their individual capacity (i.e. living/revocable trusts).
- The Exchangor dies after closing on the relinquished property, and the Estate may complete the exchange.
What about Exchanging with a Related Party?
Any property that is part of a 1031 Exchange either sold to or acquired from a related party may not be transferred for a period of two years. For example, if you sell your relinquished property to one of your children, they may not sell it for a period of two years after the exchange, or your exchange could be disallowed. If your replacement property was acquired from a related party, then you must hold title to it for a period of two years, or your exchange could be disallowed. In the instance of purchasing from a related party, it is often required that the related party enter into an exchange as well; if the property purchased is the related party’s principal/primary residence, this is especially problematic, as the related party is unable to effect an exchange. It is highly recommended that you consult with your CPA/Tax Counsel regarding any such purchase.
What about Partnerships?
The more commonly asked question is “Can one or more partners drop out of the partnership and exchange their interest for a like-kind replacement property?” Since an interest in a partnership is personal property, one possible solution is to liquidate the partnership under IRC §708 so that each partner will now own their respective interest as tenants-in-common with the other former partners.
If either the entire partnership or one or more parties to the partnership receive a direct interest in the underlying assets of a liquidated partnership interest, the next key issue to do determine is if the relinquished property was considered to be held for productive use in a trade or business or for investment purposes. Both the IRS and the Tax Court seem to utilize the substance-over-form doctrine in situations like these. In both Bolker v. Commissioner, 753 F2d. 490 (1983) and Magneson v. Commission, 760 F2d. 1039 (1985), the taxpayer’s transaction qualified under IRC §1031.
Transactions of this type can be complicated and should be carefully reviewed by qualified tax and legal counsel to determine whether the facts and circumstances are strong enough to support a defensible tax deferred exchange. For example, in Chase v. Commissioner, 92 T.C. 53 (1989), the taxpayer did not properly liquidate a partnership interest prior to an exchange and was denied non-recognition treatment.
What about Build-to-Suit or Improvement Exchanges?
An Exchangor should consider a build-to-suit exchange when the aggregate value, debt or equity of the replacement property will not result in complete deferral of the capital gain tax. This situation arises when the purchase of replacement properties results in a decrease in debt or equity. Either exchange proceeds or additional debt can be used to pay for the replacement property’s improvements. If additional debt is used for improvements, loan documents should be executed by the Qualified Intermediary.
The regulations require that identification, made no later than the 45th day of the exchange period, specify as much detail…regarding construction of the improvements as is practicable at the time the identification is made [Treas. Reg. §1.1031(k)-1(e)(2)(I).]. Typically, a Qualified Intermediary will request the legal description of the property along with floor plans and specifications for new construction or a complete description of the renovation.
As always, advance planning is essential. Due to the weather, local government permits and approvals, normal construction delays and labor problems, investors can be limited in the amount of improvements that can be constructed within the exchange period. The tax code provides only 180 days from closing on the relinquished property to acquire replacement property and this deadline applies to build-to-suit exchanges as well. However, not all improvements must be completed within the 180 day period. For an Exchangor to receive complete deferral of the capital gains tax, they must receive title to the replacement property which consumed all of the proceeds in the exchange account and has a fair market value of equal (or greater than) the relinquished property.
What about “Reverse” Exchanges?
Most “reverse” exchanges are facilitated through parking the title. In one variation of the parking arrangement, the exchangor enters into an agreement with a Qualified Intermediary (in this situation also known as the Exchange Accommodation Titleholder or EAT) who acquires the replacement property and holds title until a buyer is found for the relinquished property. When the relinquished property is ready to close, the Qualified Intermediary enters into a simultaneous exchange with the exchangor, transferring ownership of the parked replacement property to the Exchangor and acquires ownership of the relinquished property, which the Qualified Intermediary then sells to the third party buyer. Alternatively, the relinquished property is parked with the Qualified Intermediary until a buyer can be found and then sold by the Qualified Intermediary to that buyer. The Intermediary will typically enter into a property management agreement or triple net lease executed between the Intermediary and Exchangor or property management company, designated by the Exchangor, during the period of time the Intermediary is on title to either the replacement or relinquished property.
Only a few Intermediaries will take title to the property and bear the risks of ownership during the parking period. The structuring of “reverse” transactions must be done carefully to avoid agency and constructive receipt issues, which can disqualify an exchange. Investors should always receive the advice of their tax or legal counsel before proceeding with this type of exchange.
What is the Role of the Qualified Intermediary?
Acts as a Principal:
The Exchangor must assign to the Qualified Intermediary (1) their interest as seller of the relinquished property and (2) their interest as buyer of the replacement property. By being an actual party to the exchange, a reciprocal trade takes place even when there are three or more parties involved in an exchange transaction (i.e. when the Exchangor is purchasing the replacement property from someone other than the buyer of the their relinquished property.)
Holds Exchange Proceeds:
If the Exchangor actually or constructively receives any of the proceeds from the sale of their relinquished property, those proceeds will be taxable as boot. Safe Harbor Exchange, Inc. will hold the proceeds from the sale in a separate exchange account until the funds are used to purchase the replacement property. All exchange proceeds held by Safe Harbor Exchange, Inc. are covered by $5 million in fidelity bond insurance coverage.
Prepares Legal Documentation:
Several legal documents are necessary in order to properly effect an exchange. The Qualified Intermediary will prepare an Exchange Agreement, Assignment Agreement, and Exchange closing instructions for each closer.
Provides Quality Service:
Although the process is relatively simple, the rules are complicated and filled with potential pitfalls. Safe Harbor Exchange, Inc. has developed a reputation as the industry leader because of our unyielding commitment to our clients. Safe Harbor Exchange, Inc. works closely with all parties involved in an exchange to ensure a smooth transaction.
What are the rules of identification?
The Three Property rule: Any three properties can be identified (complete address or legal description) and any one or more of these then needs to be acquired.
The 200% Rule: The Exchangor may identify as many properties as he desires as long as the total fair market value of the properties does not exceed 200% of the value of the relinquished property.
The 95% exception: Automatically used if neither of the above rules apply. Simply stated, the Exchangor must acquire 95% of the fair market value of what was identified!
If more than three properties are identified, the exchangor must either purchase all of those identified properties, or the combined value of the identified properties must not be greater than twice the value of the relinquished property. This certainly keeps people from identifying entire blocks of potential properties!
Note that all property, improved or otherwise, must be clearly identified, i.e. property name, street address and unit or building number, if any. For vacant land include parcel numbers and/or legal description. If you are identifying a co-ownership or tenant-in-common interest, you must also specify the exact percentage of the undivided interest into the property that you are identifying.
Can I exchange my vacation home?
Vacation homes fall under very strict guidelines to determine if they are actually investment property. If you’ve rented the property out while you owned it, it may be qualified for tax deferral. In addition, if you have not personally used the property, you might be able to convince the IRS it was purely held for investment. Generally, the exchangor’s personal use must be 14 days or less per year (maintenance, etc. is exempt from this number, but be sure that you are able to prove the nature of the work done if it is requested by the IRS). The IRS recently stated in Rev. Proc. 2008-16 that if the vacation home is rented to an unrelated party at least 14 days per year in the two years prior to the exchange and meets the above requirement regarding personal use, it should qualify as investment property under §1031. Talk with your CPA/Tax Counsel to be certain that the property qualifies.
I’m dissolving a partnership, how does that effect the exchange?
The same entity that relinquishes property must acquire property to qualify for an exchange. If some of the partners simply want cash and do not intend to exchange, they can be cashed out when the sale closes and the partnership can remain intact and acquire property. However, if various partners want to go their separate ways but still want to exchange, then the only real option is for the partnership to deed the appropriate percentages to the various partners, before the sale closes. There is a risk in this, however, in that §1031 is for property HELD for productive use in business, trade or for investment purposes. If the partnership deeds to the individual partners, has the property then been “held” by the individuals? Again, talk with your CPA/Tax Counsel.
Can I receive the interest on the funds while held?
Depending on the exchange agreement, the Exchangor may earn some interest while the funds are held by the Qualified Intermediary. This interest may only be paid to the Exchangor once the exchange is completed, in accordance with Treasury Regulation §1031(k)-1(g)(6). Interest earnings on exchange funds are considered ordinary income and will be taxed accordingly.
Can I take money out of the exchange?
No funds can be disbursed to the Exchangor while held by the Qualified Intermediary.
Can I borrow against the funds held by the Qualified Intermediary?
Borrowing or pledging against the funds held by the Qualified Intermediary would represent the Exchangor’s control of the money, which would make it taxable and would disqualify the exchange.
Is a Qualified Intermediary needed if all properties are closing concurrently?
It is recommended, if there are more than two properties involved, or if the properties are not within the same county. If two Exchangors each want the other’s property(ies) a qualified intermediary is not required. If three or more parties are involved, someone either has to go through the chain of title to make the exchange work or a Qualified intermediary should prepare the documents required by the IRS to show the trade.
Why can’t my real estate agent act as a Qualified Intermediary?
Your real estate agent is a “disqualified person” as defined in Treasury Regulation §1.1031(k). A disqualified person cannot act as a Qualified Intermediary, and also cannot accept identifications from or make identifications on behalf of the Exchangor. Related parties are also disqualified persons, along with attorneys or CPAs who have represented the taxpayer within the last two years.
When can I get my money if I choose not to exchange?
In order to qualify for an exchange, the Exchangor’s access to the funds MUST be restricted by the Qualified Intermediary. IRS Code §1031 clearly states the Exchangor may receive the exchange funds on the 46th day if the Exchangor fails to identify within 45 days, or the Exchangor may receive the funds on the 181st day if the Exchangor fails to acquire the identified property(ies) after the 45th day has expired.
What happens if I forgot to put a cooperation clause into my sales contract?
The cooperation clause is designed to clearly show the Exchangor’s intent to exchange. It is possible to accomplish an exchange by adding this statement after the initial acceptance of the offer, before the sale closes.
Or, to simply have the buyer sign the Assignment of the Purchase Contract prepared by the Qualified Intermediary (which is the extent of cooperation required). Certainly, it’s best to get an agreement to cooperate early in the transaction.
Can the Qualified Intermediary advance funds from the exchange for fees and costs needed to acquire the replacement property?
If the Exchangor advances any of these funds they may be reimbursed to him at the close of the escrow without realizing the appropriate gains taxes, provided such excess funds are remaining at close of escrow.
I’ve been asked to carry back a purchase money note for my buyer, how does that effect the exchange?
A seller carry-back can be treated as an installment sale or may be deferrable upon certain conditions (call for an in-depth review). The important thing to remember is that the method of handling a carry-back note will have important tax ramifications to the Exchangor and the options must be discussed and an action determined early in the transaction; most definitely BEFORE THE SALE CLOSES.
How many properties can I buy or sell in one exchange?
In light of the exchange deadlines and identification restrictions, you may buy as many as you can afford and can close within the time period. Sell as many as you can provided they can all close within the time period set by the closing of the first sale.