1031
Exchanges
What is Tax-Deferred
Exchange?
Under Section 1031 of the Internal Revenue Code, owners of real estate held for investment
or use in a trade or business can swap their property tax-free for "like-kind"
real estate. Exchanges are made for people wanting to stay invested in real estate,
increase their leverage and to avoid paying hefty taxes upon the sale of property.
Like Kind
- Apartments
- Rental Houses
- Retail Properties
- Commercial
- Raw Land
- Office Buildings
- Industrial
- Ranches
Non Qualifying
Properties
- Personal Residences
- Dealer Property
- Partnership Interests
- Inventory
Reason to Exchanges
- Restoring Depreciation that will soon expire - by exchanging one property for another
of greater value.
- To upgrade size and/or quality of investment. An exchange can be utilized to combine the
equity of one or more properties into a larger singular investment.
- To change investment location. An exchange can be executed in anticipation of market
trends to maximize appreciation potential.
7 Steps for a
Successful 1031 Tax Deferred Exchange
Step 1:
Consult with your tax and financial advisors to determine if a tax deferred exchange is
appropriate for your circumstances and compatible with your investment goals.
Step 2:
Listing the Relinquished Property for sale with a licensed real estate broker. During the
first step the Exchanger will list the Relinquished Property with a real estate broker.
The broker/agent will disclose the intent to complete an exchange in the listing
agreement.
Step 3: Offer,
Counter Offer and Acceptance. The Exchanger enters into a contract with the Buyer for the
sale/exchange of the Relinquished Property. The broker/agent discloses the
Seller/Exchanger's intent to exchange into the Purchase Agreement and Receipt for Deposit.
Step 4: Open
escrow for the Relinquished Property and coordinate with the Facilitator. The Facilitator
prepares the exchange agreement and coordinates with the escrow holder to close escrow as
Phase I of a tax deferred exchange. Important: The exchange agreement must be in place and
signed by all parties prior to close of escrow. Additionally, all earnest money deposits
should be placed with the title company.
Step 5:
Replacement Property Identification. After closing escrow for the sale of the Relinquished
Property, the Exchanger must identify all Replacement Property within 45 days from day
after close of escrow.
Step 6: Contracting
for the Replacement Property. After closing on the Relinquished Property the Exchanger has
180 days to acquire the Replacement Property. With the help of his or her agent the
Exchanger enters into contract to purchase the Replacement Property from the Seller. In
the contract to purchase the agent discloses the Exchanger's intent to complete the
exchange and obtains the Seller's cooperation.
Step 7: Open
escrow for the Replacement Property. The Facilitator prepares the Phase II Exchange
Agreement and coordinates with the Replacement Property Escrow holder. The funds held in
trust by the Facilitator are placed in escrow and the Replacement Property is purchased by
the Facilitator from the seller. The Facilitator then transfers the Replacement Property
to the Exchanger and the transaction is closed as Phase II of a delayed exchange.
Identification of
Replacement Property
Regardless of the number of relinquished properties transferred by the Exchanger as part
of the same exchange, the maximum number of replacement properties that the Exchanger can
identify is as follows:
3 Property Rule: Three
properties without regard to the fair market values of the replacement properties.
- Or -
200 Percent Rule: Any
number of properties as long as their aggregate fair market value as of the end of the
identification period does not exceed 200 percent of the aggregate fair market value of
all the relinquished properties as of the date the relinquished properties were
transferred by the exchanger.
Exception
95 Percent Rule: Any number of replacement properties identified before the end of the
identification period and received before the end of the exchange period, but only if the
Exchanger receives before the end of the exchange period identified replacement property
the fair market value of which is at least 95 percent of the aggregate fair market value
of all identified replacement properties.
Glossary of Terms
Accommodator:
A principal involved in the exchange transaction who agrees to assist the exchanger to
effect a tax-deferred exchange. Same as Facilitator or intermediary.
Accommodating Party: In an exchange of properties there is always a person or
entity that steps in to accommodate or facilitate the exchange transaction. Depending on
how the transaction is structured, the accommodating party may incur additional liability
in their efforts to assist in the exchange.
Acquisition Property: Replacement
property
Actual Receipt: When
the Exchanger actually receives the funds from the sale of the Relinquished Property.
Receipt of cash by the Exchanger before he receives the Replacement Property may be enough
to destroy the tax deferred treatment of the transaction.
Adjusted Basis:
Generally speaking the adjusted basis is equal to the purchase price plus capital
improvements less depreciation. Transactions involving exchanges, gifts, probates and
receiving property from a trust can have an impact on calculating the property's adjusted
basis. The taxpayer's C.P.A. or tax advisor is the party to look to for these types of
questions.
Boot: Boot is
any type of property received or given up in an exchange that does not meet the like kind
requirement. Generally speaking, receiving boot will trigger the recognition of gain and
taxes. If the Exchanger receives boot, they will be taxed. Boot added or given up by the
Exchanger does not necessarily trigger a taxable event. In a real property exchange, boot
received is any type of property received by the exchange which is not real property held
for investment or productive use in a trade or business.
Cash Boot:
Cash Boot consists of cash and nonqualifying property. A car, a boat or receipt of the
beneficial interest in a promissory note are all examples of Cash Boot.
Mortgage Boot:
Mortgage Boot consists of the secured debt given up and received as part of the same
exchange. If the exchanger increases the amount of debt on the Replacement Property verses
the Relinquished Property, they have given mortgage boot. If the exchanger decreases the
amount of debt on the Replacement Property verses the Relinquished Property, they have
received mortgage boot. Generally speaking, mortgage boot received triggers the
recognition of gain and it is taxable, unless offset by Cash Boot added or given up in the
exchange.
Constructive Receipt: Even
if the Exchanger does not actually receive the proceeds from the disposition of the
Relinquished Property, the exchange will be disallowed if the Exchanger is treated as
having constructively received the funds.
Delayed Exchange:
Also called non-simultaneous, deferred and Starker. A delayed exchange is a tax deferred
exchange where the Replacement Property is Received after the transfer of the Relinquished
Property. In a delayed exchange the Exchanger must identify all potential Replacement
Properties within 45 days from the transfer of the Relinquished Property and the Exchanger
must Receive all Replacement Properties within 180 days or the due date of the Exchanger's
tax return whichever occurs first.
Like-Kind Property: Refers
to the nature of the property the Exchanger gives up or receives as part of the same tax
deferred exchange transaction. In order to qualify as like kind the property given up or
received must be held for productive use in a trade or business or held for investment to
qualify as like-kind.
Realized Gain: Refers
to a gain that is not necessarily taxed. In a successful exchange the gain is realized but
not recognized and therefore not taxed.
Recognized Gain: Refers
to gain which is subject to tax. When someone disposes of property at a gain or profit in
a taxable transfer such as a sale, the gain is not only realized, but recognized and
subject to tax.
Relinquished Property:
The property given up by the exchange to start the 1031 exchange transaction. This
property usually passes through an accommodator before transferring to the ultimate Buyer.
Reverse Exchange: An
exchange where the Exchange acquires or gains control of the Replacement Property before
disposing of the Relinquished Property.
Simultaneous Exchange:
Also referred to as a concurrent exchange. A simultaneous exchange is an exchange
transaction where the Exchanger transfers out of the Relinquished Property and Receives
the Replacement Property at the same time.
Transfer Tax: A
tax usually assessed by a city or county on the transfer of property. It may be based on
equity or value. When structuring a multi-party exchange an exchange agreement will
usually call for direct deeding to eliminate additional transfer tax.
April 15th
A taxpayer must identify replacement property within 45 days after the transfer of the
relinquished property, and acquire the replacement property within the earlier of 180 days
of the relinquished property closing, or the due date of the taxpayer's tax return. This
means that 1031 escrows that close after Oct. 18 will not have the full 180 days to
acquire the replacement property unless the taxpayer files an extension.
Contact your CPA or tax
attorney for advice.
