Tax Deferred 1031 Exchanges
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Q
- What is a tax-deferred exchange?
In a tax-deferred transaction, 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 tax-deferred
exchange is a method by which a property owner trades one
or more relinquished properties for one or more replacement
properties of "like-kind", while deferring the
payment of federal income taxes and some state taxes on
the transaction.
The theory behind Section 1031 is that when a property owner
has reinvested the sale proceeds into another property,
the economic gain has not been realized in a way that generates
funds to pay any tax. In other words, the taxpayer's investment
is still the same, only the form has changed (e.g. vacant
land exchanged for apartment building). Therefore, it would
be unfair to force the taxpayer to pay tax on a "paper"
gain.
The like-kind exchange under Section 1031 is tax-deferred,
not tax-free. When the replacement property is ultimately
sold (not as part of another exchange), the original deferred
gain, plus any additional gain realized since the purchase
of the replacement property, is subject to tax.
Q
- What are the benefits of exchanging v. selling?
• A Section 1031 exchange is one of the few techniques
available to postpone or potentially eliminate taxes due
on the sale of qualifying properties. |
• By deferring
te tax, you have more money available to invest in another
property. In effect, you receive an interest free loan from
the federal government, in the amount you would have paid
in taxes.
• Any gain from depreciation recapture
is postponed.
• You can acquire and dispose of
properties to reallocate your investment portfolio without
paying tax on any gain.
Q
- What are the different types of 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.
Q
- What are the requirements for a valid exchange?
• Qualifying Property - Certain types of property
are specifically excluded from Section 1031 treatment: property
held primarily for sale; inventories; stocks, bonds or notes;
other securities or evidences of indebtedness; interests
in a partnership; certificates of trusts or beneficial interest;
and choses in action. In general, if property is not specifically
excluded, it can qualify for tax-deferred treatment.
• Proper Purpose - Both the relinquished property
and 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 relinquished property must be exchanged for other
property, rather than sold for cash and using the proceeds
to buy the replacement property. Most deferred exchanges
are facilitated by Qualified Intermediaries, who assist
the taxpayer in meeting the requirements of Section 1031.
Q - What are the general guidelines to follow in order for
a taxpayer to defer all the taxable gain?
• 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.
• All of the net proceeds from the
sale of the relinquished property must be used to acquire
the replacement property.
Q
- When can I take money out of the exchange account?
Once the money is deposited into an exchange account, funds
can only be withdrawn in accordance with the Regulations.
The taxpayer cannot receive any money until the exchange
is complete. If you want to receive a portion of the proceeds
in cash, this must be done before the funds are deposited
with the Qualified Intermediary.
Q
- Can the replacement property eventually be converted to
the taxpayer's primary residence or a vacation home?
Yes, but the holding requirements of Section 1031 must be
met prior to changing the primary use of the property. The
IRS has no specific regulations on holding periods. However,
many experts feel that to be on the safe side, the taxpayer
should hold the replacement property for a proper use for
a period of at least one year. If the owner later on wants
to take advantage of the home owner's exemption (up to $250,000
or $500,000 for a couple), there is now a five year holding
period requirement.
Q
- What is a Qualified Intermediary (QI)?
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.
Q
- Why is a Qualified Intermediary needed?
The exchange ends the moment the taxpayer has actual or
constructive receipt (i.e. direct or indirect use or control)
of the proceeds from the sale of the relinquished property.
The use of a QI is a safe harbor established by the Treasury
Regulations. If the taxpayer meets the requirements of this
safe harbor, the IRS will not consider the taxpayer to be
in receipt of the funds. The sale proceeds go directly to
the QI, who holds them until they are needed to acquire
the replacement property. The QI then delivers the funds
directly to the closing agent.
Q
- Can the taxpayer just sell the relinquished property and
put the money in a separate bank account, only to be used
for the purchase of the replacement property?
The IRS regulations are very clear. The taxpayer may not
receive the proceeds or take constructive receipt of the
funds in any way, without disqualifying the exchange.
Q
- If the taxpayer has already signed a contract to sell
the relinquished property, is it too late to start a tax-deferred
exchange?
No, as long as the taxpayer has not transferred title, or
the benefits and burdens of the relinquished property, she
can still set up a tax-deferred Exchange. Once the closing
occurs, it is too late to take advantage of a Section 1031
tax-deferred exchange (even if the taxpayer has not cashed
the proceeds check).
Q
- Does the Qualified Intermediary actually 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).
Q
- What are the time restrictions on completing a Section
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.
Q
- What if the taxpayer cannot identify any replacement property
within 45 days, or close on a replacement property before
the end of the exchange period?
Unfortunately, there are no extensions available. If the
taxpayer does not meet the time limits, the exchange will
fail and the taxpayer will have to pay any taxes arising
from the sale of the relinquished property, unless the IRS
has expressly granted extensions in specified disaster area(s).
Q
- Is there any limit to the number of properties that can
be identified?
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 are the requirements to properly identify replacement
property?
Potential replacement property must be identified in a writing,
signed by the taxpayer, and delivered to a party to the
exchange who is not considered a "disqualified person".
A "disqualified" person is any one who has a relationship
with the taxpayer that is so close that the person is presumed
to be under the control of the taxpayer. Examples include
blood relatives, and any person who is or has been the taxpayer's
attorney, accountant, investment banker or real estate agent
within the two years prior to the closing of the relinquished
property. The identification cannot be made orally.
Q
- Are Section 1031 Exchanges limited only to real estate?
No. Any property that is held for productive use in a trade
or business, or for investment, may qualify for tax-deferred
treatment under Section 1031. In fact, many exchanges are
"multi-asset" exchanges, involving both real property
and personal property.
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.
WhatQ
- 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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