TAX-DEFERRED EXCHANGE BASICS
When you sell your interest in investment property, you may incur federal capital gains taxes and, in some states, state taxes as well. Your attorney, tax advisor, or real estate professional may suggest a tax-deferred exchange under Section 1031 of the Internal Revenue Code. A tax-deferred exchange allows you to dispose of investment properties and acquire “like-kind” properties while deferring federal capital gains taxes and depreciation recapture. Most states with a capital gain tax offer a similar tax advantage, too. Bottom line: a tax-deferred exchange allows you to reinvest sales proceeds that would otherwise be paid to the government in the form of taxes.
TAX REDUCTIONS
Knowing some basic rules behind Internal Revenue Code 1031 can help investors defer paying capital gain tax on property dispositions, resulting in more money to invest in new property acquisition. Generally, any real or personal property can be exchanged, provided it is held “for productive use in a trade or business” or for “investment” and is exchanged for property of “like-kind” that will also be held for one of these same purposes.
LIKE-KIND REQUIREMENT
The replacement property must be considered “like-kind” to the relinquished property. Any real or personal property can be exchanged, provided it is held “for productive use in a trade or business” or “for investment” and is exchanged for property of “like-kind” that will also be held for one of these same purposes. “Like-kind” does not mean “exactly the same,” particularly with the exchange of real property. The like-kind requirement is fairly broad for real property exchanges. A single-family rental unit, for example, may be exchanged for other real property like a warehouse, retail center, office building, farm property, or even a leasehold interest in real estate of 30 years or more. All real property is considered “like-kind” to all other real property, but property inside the United States is not “like-kind” to property located outside of the United States. “Like-kind” limitations on personal property are more restrictive. Essentially, items of personal property must be classified similarly under certain government accounting classifications.
SAME TAXPAYER RULE
In order to qualify for tax-deferral treatment, the same Taxpayer selling the relinquished property must purchase the replacement property. For example, if Company B sells the relinquished property, Company B must also acquire the replacement property. An exception to this requirement is entities that are considered disregarded for tax purposes, such as single member limited liability companies and revocable trusts. For example, Sue Smith may own a commercial building in her own name. She can sell that property and acquire replacement property in her own name, or she may take title in the name of a limited liability company in which she is the sole member, or she may create a revocable trust and take title in the name of the trust. In each case Sue Smith is still considered the same Taxpayer thus allowing her to complete an exchange.
HOLDING FOR INVESTMENT PURPOSES
Both the relinquished and replacement properties must be held for investment purposes or for use in the Taxpayer’s business. Property that is held for the purpose of appreciation or for rental income should satisfy the investment requirement. Typical exchange transactions involve an office or commercial building, a rental home or an apartment building. Personal residences, vacation homes frequently used by the owner, and property held for sale (i.e., new homes constructed by a homebuilder) would not qualify. Mixed use properties such as home offices or duplexes in which the investor lives in one unit and rents the other unit can qualify for a tax-deferred exchange for the portion of the property used for business or investment purposes.
The tax code does not clearly specify a minimum time frame for which investor must continue to hold the investment property to qualify for tax-deferral treatment. However, when the IRS examines exchange transactions, the Taxpayer must be able to show that the Taxpayer intended to hold the property for investment purposes at the time it was acquired. If a Taxpayer only holds his replacement property for a few months prior to selling it, the IRS may question whether the investor actually intended to hold the property for investment purposes.
TIMING AND IDENTIFICATION
The Taxpayer has 45 days from the closing of the relinquished property to identify replacement property. Proper identification of replacement property is a requirement for a valid exchange, and the investor can only acquire property which has been properly identified during the 45-day identification period. Replacement property that is acquired (i.e., closes) within the 45-day time period is considered properly identified. For property not purchased within the 45-day time frame, the identification must unambiguously describe the property (with an address or legal description), and must be made in writing, signed by the Taxpayer and sent before midnight of the 45th day. If multiple relinquished properties are grouped together in one exchange, the 45-day time period starts to run as of the closing of the first property.
If a Taxpayer wants to identify more than one replacement property, there are several options. The two most common methods to identify multiple properties are:
- The “Three Property” rule: the investor may identify up to three properties without regard to their fair market value; or
- The “200%” rule: the Taxpayer may identify any number of properties so long as the total fair market value of all of the listed properties does not exceed 200% of the value of the relinquished property.
Once escrow closes on the relinquished property, the Taxpayer has the lesser of 180 days from the date of closing, or the date on which the Taxpayer’s tax return for the year the relinquished property was sold is due, to close the purchase transaction and complete the exchange. For exchanges closing in the final quarter of the year, the Taxpayer will need to get an extension to file his tax return to get the full 180 days.
Timing and Identification Simplified
IDENTIFICATION PERIOD
The replacement property must be identified within 45 days of the transfer of the first relinquished property. This 45-day rule may not be extended even if the 45th day should happen to fall on a Saturday, Sunday or legal holiday.
EXCHANGE PERIOD
The acquisition of your replacement property must be completed by the earlier of:
- 180 days of the transfer of your first relinquished property; or
- The due date of filling your federal income tax return for the year in which you transferred the first relinquished property, including extensions. This 180-day rule may not be extended even if the 180th day should happen to fall on a Saturday, Sunday or legal holiday.
FULLY DEFERRED EXCHANGES
For your exchange to be fully tax-deferred, your replacement property(ies) must be equal to or greater in value and equity than your relinquished property. The debt on your replacement property(ies) must also be equal to or greater than the debt on your relinquished property, unless cash is added to offset debt.
IDENTIFICATION RULES
You may identify replacement property according to the following rules:
- 3-property rule – Three properties, regardless of value; or
- 200 percent rule – Any number of properties, as long as their combined fair market value does not exceed twice the value of the relinquished property; or
- 95 percent rule – Any number of properties, regardless of their combined fair market value, as long as you acquire 95 percent or more of the total value of such properties
Top Ten 1031 Exchange Terms to Know
- Qualified Intermediary: A non-disqualified party that facilitates the documentation for the exchange and holds the funds from the sale of the relinquished property pursuant to IRC Section 1031. Also known as QI, facilitator, accommodator.
- Exchanger: The party that is benefiting from tax deferral through IRC Section 1031. Also known as the taxpayer or investor.
- Relinquished Property: The property being sold by the taxpayer in a 1031 exchange. Also known as Phase 1 or Downleg.
- Replacement Property: The property being purchased by the taxpayer in a 1031 exchange. Also known as Phase 2 or Upleg.
- Delayed Exchange: An exchange where the closing of the relinquished property can occur up to 180 days after the closing of the replacement property.
- Exchange Period: The period of time between the relinquished property closing and acquisition of the replacement property. The Exchange Period ends on a date that is 180 days after the relinquished property closes, or the due date on which the tax return is due for the year the relinquished property was sold, if that is sooner. For exchanges closing in the final quarter of the year, the taxpayer will need to file an extension of the filing of their return to have the full 180-day time frame.
- Identification Period: The 45-day timeframe after the transfer of the relinquished property in which the taxpayer must identify in writing replacement properties. Proper identification of replacement property is a requirement for a valid exchange and the investor can only acquire property which has been properly identified during the 45-day identification period.
- Like-Kind Property: In the context of real estate, like-kind exchanges are valid between and among several different types of investment property, including bare land, commercial property, industrial buildings, retail stores, apartments, residential rentals, even leasehold interests exceeding 30 years. Personal property exchanges are much more restrictive than real property exchanges with regard to the interpretation of like-kind.
- Basis: The starting point for determining gain or loss in any transaction. In general, basis is the cost of the taxpayer’s property, plus capital improvements less depreciation.
- Boot: Receiving property that is not considered “like-kind” which includes cash or non-cash consideration, debt relief (mortgage boot), or promissory notes. If you receive boot in an exchange it is likely that all or some portion of the boot will be taxed.
8 STEPS TO A SUCCESSFUL 1031 EXCHANGE
Step 1: Purchase Contract- relinquished property
You and your buyer enter into a purchase contract with respect to the sale of your property (known as the “relinquished property”). This relinquished property purchase contract should contain a “cooperation clause” obligating the buyer to cooperate in structuring the transaction as a tax-deferred exchange.
Step 2: Relinquished property exchange documents
Next, contact First American Exchange to start the tax-deferred exchange process. We will prepare an ‘Exchange Agreement’, an ‘Assignment of the Relinquished Property Purchase Contract’ (assigning your rights as seller to us), a ‘Notice of the Assignment’ (for delivery to the buyer), and instructions to the settlement agent necessary to complete the transaction. All of these documents must be executed on or before the date of closing.
Step 3: Closing the relinquished property
When the conditions of closing have been met, your relinquished property will be conveyed to the buyer. While the conveyance will be directly from you to the buyer, it will represent a transfer from you to First American Exchange in exchange for other property that you will receive at a later date. It also represents the sale from First American Exchange to the buyer for cash. The cash proceeds from the sale of the relinquished property must be delivered directly to First American Exchange. At no time should you be in either actual receipt or constructive receipt of the cash proceeds, or your exchange could fail.
Step 4: Relinquished property proceeds and forms
Following the relinquished property closing, First American Exchange will hold the exchange proceeds and provide you with forms to identify potential replacement properties within the 45-day identification period.
Step 5: Purchase Contract – replacement property
After you have identified suitable “like-kind” replacement properties and made a decision as to which identified properties you intend to acquire, you will enter into a ‘Purchase Contract’ with the seller. This ‘Replacement Property Purchase Contract’ should also contain a “cooperation clause” obligating the seller to cooperate with you in completing your tax-deferred exchange.
Step 6: Replacement property exchange documents
First American Exchange will then prepare an ‘Assignment of the Replacement Property Purchase Contract’ (assigning your rights as buyer to us), ‘Notice of the Assignment’ (for delivery to the seller), and instructions to the settlement agent necessary to complete the transaction. All of these documents must be signed before or as of the date of closing.
Step 7: Closing the replacement property
When the conditions of closing have been met, First American Exchange will deliver the exchange proceeds to the settlement agent to acquire the replacement property. The seller will convey the replacement property directly to you. This conveyance will represent a purchase from the seller by First American Exchange and a transfer to you in completion of the exchange. Remember that, to qualify for tax-deferred treatment, this closing must occur by the earlier of 180 days from the date of closing on your first relinquished property or the due date of filing your federal income tax return for the year in which your first relinquished property was sold, including extensions.
Step 8: Keeping you informed and final reconciliation
Prior to or at the conclusion of your exchange, First American Exchange Company will provide you with a copy of your exchange documents, including a statement reflecting the receipt and disbursement of all exchange funds. With this information, you and your tax advisor will complete Form 8824 to be filed with your federal income tax return, as well as any state forms required to report the transaction as an exchange.
Source: All 1031 content provided by First American Exchange Company