1031 Tax Deferred Exchange
A 1031 tax deferred exchange represents a simple, strategic method for selling one qualifying property and the subsequent acquisition of another qualifying property within a specific time frame. Although the logistics of selling one property and buying another are virtually identical to any standard sale and purchase scenario, an exchange is different because the entire transaction is memorialized as an exchange and not a sale. And it is this distinction between exchanging and not simply selling and buying which ultimately allows the taxpayer to qualify for deferred gain treatment. So essentially, sales are taxable and exchanges are not.
Internal Revenue Code, Section 1031
Because exchanging represents an IRS-recognized approach to the deferral of capital gain taxes, it is important for us to appreciate the components and intent underlying such a tax deferred or tax free transaction. It is within Section 1031 of the Internal Revenue Code that we find the core essentials necessary for a successful exchange. Additionally, it is within the Like-Kind Exchange Regulations, previously issued by the Department of the Treasury, that we find the specific interpretation of the IRS and the generally accepted standards and rules for completing a qualifying transaction.
Any property owner or investor who expects to acquire replacement property subsequent to the sale of his existing property should consider an exchange. To do otherwise would necessitate the payment of capital gain taxes in amounts which can exceed 20-30%, depending on the appropriate combined federal and state tax rates. In other words, when purchasing replacement property without the benefit of a 1031 exchange for real estate, your buying power is dramatically reduced and represents only 70-80% of what it did previously.
Basic Exchange Rules
Let us look at a basic concept, which applies to all exchanges. Utilize this concept to fully defer the capital gain taxes realized from the sale of a relinquished property:
The purchase price of the replacement property must be equal to or greater than the net sales price of the relinquished property, and
All equity received from the sale of the relinquished property must be used to acquire the replacement property.
To the extent that either of these rules is abridged, a tax liability will accrue to the Exchangor. If the replacement property purchase price is less, there will be tax. To the extent that not all equity is moved from the relinquished to the replacement property, there will be tax. This is not to say that the exchange will not qualify for these reasons; partial exchanges do in fact qualify for partial tax deferral. It simply means that the amount of any discrepancy will be taxed as boot, or non-like-kind, property.
Property that qualifies for exchange under Section 1031 must be "like-kind", which is defined in the Regulations as follows:
1. Property held for productive use in a trade or business, such as income property, or
2. Property held for investment.
Therefore, not only is rental or other income property qualified, so is unimproved property which has been held as an investment. That unimproved property can be exchanged for improved property of any type, or vice versa. Also, one property may be exchanged for several, or vice versa. This means that almost any property that is not a personal residence or second home is eligible for exchange under Section 1031. Even the vacation home that is used for that purpose part of the year, and is rented part of the year, is considered "mixed use" property and may be exchanged under 1031 for other mixed use property.
The Exchangor has a maximum of 180 days from the closing of the relinquished property or the due date of that year's tax return, whichever occurs first, to acquire the replacement property. This is called the Acquisition Period. The first 45 days of that period is called the Identification Period. During this 45 days, the Exchangor must identify the candidate or target property which will be used for replacement. The identification must:
Be in writing,
Signed by the Exchangor, and,
Received by the facilitator or other qualified party (faxed, postmarked or otherwise identifiably transmitted through Federal Express or other dated courier service).
This must all occur within the 45-day period. Failure to accomplish this identification will cause the exchange to fail.
Three rules exist for the correct identification of replacement properties.
- The Three Property Rule dictates that the Exchangor may identify three properties of any value, one or more of which must be acquired within the 180-Day Acquisition Period.
- The Two Hundred Percent Rule dictates that if four or more properties are identified, the aggregate market value of all properties may not exceed 200% of the value of the relinquished property.
- The Ninety-five Percent Exception dictates that in the event the other rules do not apply, if the replacement properties acquired represent at least 95% of the aggregate value of properties identified, the exchange will still qualify.
These identification rules are absolutely critical to any exchange. No deviation is possible and the Internal Revenue Service will grant no extensions.
Mechanics of a Delayed Exchange
It is important that any exchange be carefully planned with the help of an experienced, competent and creative exchange professional. Preferably one who is completely familiar with the tax code in general, not just Section 1031, and who has extensive experience in doing many different kinds of exchanges. Thorough planning can help avoid many subtle exchanging pitfalls and also ensure that the Exchangor will accomplish the goals which the transaction is intended to facilitate.
Once the planning is complete, the exchange structure and timing are decided, and the relinquished property is sold and the transaction is closed, the facilitator becomes the repository for the proceeds of the sale. The money is kept in the facilitator's secured account until the replacement property is located and instructions are received to fund the replacement property purchase.
The funds are wired or sent to the closing entity in the most appropriate and expeditious manner, and the replacement property is purchased and deeded directly to the Exchangor. All the necessary documentation to clearly memorialize the transaction as an exchange is provided by the facilitator, such as exchange agreement, assignment agreement and appropriate closing instructions.
Partnership Exchanges and IRC §1.761-2(a) Elections
The Tax Reform Act of 1984 made it very clear that partnership interests cannot be exchanged and qualify for deferred gain treatment under IRC Section1031. The regulations also interpret no difference between general partnership interests or limited partnership interests. Although actual partnerships can exchange with other partnerships under Section1031, the exchange of an individual interest is prohibited. However, the Omnibus Budget Reconciliation Act of 1990 did amend IRC Section1031 to incorporate the use of IRC Section1.761-2(a), Election of Partnerships to not be treated under Subchapter K of Chapter 1 of the Code, for the purposes of taxation. This means that Section1.761-2(a) can potentially provide an avenue to utilize Section1031 to those investors currently owning partnership interests.
In every case involving an election under Section1.761-2(a), it is critical to evaluate the status of your election and exchange with the advice of a qualified tax professional. They will relate your situation to specific Internal Revenue Letter Rulings and other interpretations, which could assist in the strategic structuring of your transaction.
The issue of constructive receipt is one that continues to concern taxpayers, their accountants and tax advisers alike. Over the years that the public has benefited from tax deferred exchanges, various elements of control have been reviewed by the courts in attempting to determine whether the taxpayer has in fact exercised sufficient control over the proceeds from the disposition of the relinquished property so as to be considered in receipt of such funds and thereby taxed.
Clearly if a taxpayer receives the proceeds from the disposition of his relinquished property, the terms "exchange" or "relinquished property" have no meaning since the transaction will be viewed as a sale and the taxpayer taxed accordingly. Where someone other than the taxpayer receives and controls the use of the proceeds from the disposition of the relinquished property, the relationship between that person or entity and the taxpayer is closely scrutinized to determine whether or not it is so closely related to the taxpayer that it can be considered that the taxpayer has constructively received the funds.
Selecting Your Facilitator
There are virtually no state or federal regulations governing the function of facilitators, other than the fiduciary responsibilities that govern the conduct of any entity holding or handling other people's money. For this reason, care in selecting a facilitator for you or a client's exchange is an important process of evaluation. Select the facilitator as you would an attorney for personal representation or a physician to treat your children. Look for experience in doing exchanges and reputation in the real estate, legal or tax communities.
Talk to escrow and closing professionals that handle exchanges and get their opinion. If possible choose a facilitator who is thoroughly familiar with the process, since many times other aspects of the process will bear significantly on your exchange (for instance, the handling of Promissory Notes, bulk transfers or other variations). Ask the facilitator if their firm handles reverse exchanges. If they do not, the company and its personnel may not be adequately experienced. Ask about the security of your funds, and what options you as an Exchangor may have to assure that your funds will be safeguarded. Although the costs and fees for an exchange are relatively insignificant, ask about them, and get a clear explanation of what you will be charged. With a few notable exceptions, fees are very similar, one facilitator to the next. What is of far greater importance is the competence and ability of the facilitator and its personnel to complete your exchange promptly, professionally and legally.
Tax Consequences of Exchanging
In order to assess the tax consequences inherent in any exchange transaction, it is first necessary to understand the definition and exchange related meaning of terms such as “cost basis”, “adjusted basis”, “capital gain”, “net sales price”, “net purchase price and boot” “new adjusted basis.” Cost Basis: This is where all tax related calculations in an exchange begin. Cost basis essentially refers to your original cost in acquiring a given property. Therefore, if the original purchase price of the property you anticipate exchanging was $175,000, your cost basis is $175,000. Adjusted Basis: At the time of your exchange it is necessary to determine your current, or adjusted, basis. This is accomplished by subtracting any depreciation reported previously from the total of the original cost basis, plus the value of any improvements.
Capital Gain: “Realized gain” and “recognized gain” are the two types of gain found in exchange transactions. Realized Gain reflects the difference between the total consideration or total value received for a given property and the adjusted basis.
Recognized Gain: reflects that portion of the Realized Gain, which is ultimately taxable. The difference between realized and recognized gain exists because not all realized gain is ultimately determined to be taxable and issues such as boot can affect how and when gain is recognized.
Net Sales Price: This figure simply represents the sales price, less costs of sale.
Net Purchase Price: This figure simply represents the purchase price, less costs of purchase.
Boot: When considering an exchange of real property, the receipt of any consideration other than real property is determined to be “boot.” So, essentially, a working definition of boot is: any property received which is not considered like-kind. And remember, non-like-kind property in an exchange is taxable. Therefore, boot is taxable. There are two types of boot, which can occur in any given exchange. They are mortgage boot and cash boot. Mortgage boot typically reflects the difference in mortgage debt which can arise between the exchange or relinquished property and the replacement property.
Overhanging Dept: As a general rule, the debt on the replacement property has to be equal to, or greater than, the debt on the relinquished or exchange property. If it is less, you'll have what is called "overhanging debt" and the difference will be taxable.
Types of Exchanges
Although the vast majority of exchanges occurring presently are delayed exchanges, let us briefly explain a few other exchanging alternatives.
To qualify as a simultaneous exchange, both the relinquished property and the replacement property must close and record on the same day.
Improvement and Construction Exchange
In some cases, the replacement property requires new construction or significant improvements to be completed in order to make it viable for the specific purpose the Exchangor has intended for the property. Such construction or improvements can be accomplished as part of the exchange process, with payments to contractors and other suppliers being made by the facilitator out of funds held in a trust account. Therefore, if the replacement property is of lesser value than the relinquished property at the time of the original transaction, the improvement or construction costs can bring the value of the replacement property up to an exchange level or value which would allow the transaction to remain tax free.
Business or Personal Property Exchange
Although our discussion in this tutorial involves the typical exchange of real property, Internal Revenue Code Section 1031 does allow the exchange of many types of property other than real estate. Investors may exchange, for example, rail cars, trucks, ships, classic cars or livestock, among other assets. Therefore, business exchanges are a common transaction.
While the basic exchange rules are the same, certain complications arise in classifying the non-real estate assets into one of several categories or SIC classes so that they meet the associated like-kind requirements. While this is a simple enough process for the experienced facilitator, it can be thoroughly confusing for the uninitiated Exchangor, making the selection of his Intermediary or facilitator extremely important to the successful structuring of the exchange. If you desire additional information regarding business or personal property exchanges, please consult an experienced tax professional to first determine the classes of properties available to be exchanged.
The reverse exchange is actually a misnomer. It represents an exchange in which the Exchangor locates a replacement property and wants to acquire it before the actual closing of the relinquished or exchange property. Since the Exchangor cannot purchase the replacement and later exchange into property that he already owns, he must find a method to acquire the replacement property and still maintain the integrity of his exchange. Reverses are typically accomplished in two formats based upon transaction logistics and the financing needs of the Exchangor.
Generally, when one discusses exchanges, the type of exchange referred to is the delayed or Starker exchange. This term comes from the name of the Exchangor who was first challenged for a delayed exchange by the IRS. From this tax court conflict came the code change in 1984 that formally recognized the delayed exchange for the first time. This is now the most common type of exchange. In a delayed exchange, the relinquished property is sold at Time 1, and after a delay, the replacement property is acquired at Time 2.
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