At the conclusion of the comparison we see that after transaction 2 (the first one on this page, top left) the investor on the left sells for $705,000 paying off a mortgage of $350,000 and leaving proceeds of $355,000. Also, creating a capital gain of $235,000 of which he pays 15% in federal capital gains taxes, $35,250. Subtracting that from his proceeds leaves $319,750 cash available for re-investment into the next property. Together with a new mortgage of $350,000 the investor buys the next property for $669,750, and so on. At the end of the experiment the investor on the left has $1,010,011 available to buy more investment property. Not too bad, unless he is compared with the investor who utilized 1031’s the whole way through, shown on the right.
In total, between the three transactions above and the one on the previous page, the investor who didn’t use 1031’s has paid $187,061 more in capital gains taxes than his counterpart using 1031’s. Furthermore, because his money wasn’t able to be invested in and appreciating with his property, the property he owns is worth $327,489 less than the investor who used 1031’s every time. Of course, the investor on the left could have kept pace with the one using 1031’s, but would have had to shoulder an additional $327,489 in debt. Given the cost of debt service on a mortgage that size, that wouldn’t keep pace with the investor on the right at all. Giving investors the ability to keep more of their money’s momentum working, 1031 Exchange is widely regarded as one of the most powerful wealth building strategies still available to U.S. taxpayers. Utilized by individuals, trusts, limited liability companies, corporations, partnerships, etc. 1031 Exchange is quickly becoming standard practice for real estate investors and business owners of every stripe.
1031 Exchange is similar to taking an interest free loan from the IRS and using the money to buy more investment property for the purpose of making more money.
1031 Basics
1) Investment Property & Business Property only. To be eligible to be part of a 1031 Exchange both the relinquished and replacement property must be U.S. real property (including equipment.), which is held for investment purposes or used in the taxpayer’s trade or business. For example, any real estate in the U.S., whether improved or unimproved, that is kept for business, investment or income producing purposes, including the taxpayer’s office facilities, shop, etc. as well as the accompanying equipment. (Equipment not to exceed 15% of total value) Property which cannot be part of a 1031 Exchange includes but is not limited to:
- A taxpayer’s personal residence, except perhaps that portion of it which is rented out or is the taxpayer’s home office.
- Property purchased or held for resale.
- Land which is under development.
- Inventory Property.
- Construction for resale or Fix n’ Flips.
- Beneficial interest in a partnership.
- Stocks, Bonds, or Notes.
2) The same taxpayer that sells the “Relinquished Property” must buy the “Replacement Property. If a husband and wife own property as tenants in common or in joint tenancy, the replacement Property must be deeded to both spouses, either as tenants in common or joint tenants. Corporations, partnerships, limited liability companies, and trusts must also be on title to the replacement property the same way they were on the relinquished property, except in the case of disregarded entities. This matter is usually very straight forward for any one entity, individual or married couple. However, some transactions may present certain challenges to using identical ownership vesting. (See “Special” Issues pg.10 for a discussion of some of these issues.)
3) To avoid taxable “Boot” always buy replacement property of equal or greater value, less qualified costs. The prevailing idea behind 1031 Exchange is that since the taxpayer is merely exchanging one property for another property(ies) of “like-kind” there is nothing received by the taxpayer that can be used to pay taxes with. All the gain is still locked up in real estate and so no gain or loss can be claimed. Also, the taxpayer can choose to buy more than one property to complete their exchange or even sell multiple properties to buy a more expensive one. Qualified costs include: Escrow fees, Title fees, Real Estate commissions, exchange fees, attorney fees and some others. For whatever reason, loan fees are not considered qualified costs. So, it is recommended practice to either have loan fees being paid within the loan itself OR pay loan fees with your personal funds. In summary, if for example, the taxpayer is selling property for $500,000, and qualified costs incurred by the taxpayer are in total, between both the relinquished and the replacement properties, $40,000, then that taxpayer would need to acquire at least $460,000 ($500k – $40k = $460k) in replacement property to avoid receiving any “Boot”. (More at “Boot” Camp pg. 8)
Any “Boot” received in addition to “Like Kind” replacement property will be taxable (to the extent of gain realized on the exchange). This is not necessarily a bad thing and can be a part of a well planned exchange, depending on the taxpayer’s goals. For instance, if the taxpayer wants to get some cash or debt reduction out of the deal and is willing to pay some taxes. Otherwise, boot should be avoided in order for a 1031 Exchange to be completely tax-free.
4) Time Limits: Identification Period - 45 days & Exchange Period – 180 days. In a 1031 Delayed Exchange the clock begins ticking when the relinquished property closes. All properties that will be used as replacement property for the exchange must be identified in writing before the end of the identification period. All replacement property purchases must be closed before the end of the exchange period.
5) There must be a valid exchange. Simply selling property and subsequently buying replacement property is not enough. Not even if all of the time limit requirements are met. Internal Revenue Code §1031 requires, among other things, that there be a written “Exchange Agreement” between taxpayer and intermediary which serves to protect the taxpayer from ever having “Constructive Receipt” of the exchange funds during the exchange period. Or as the code says it; the agreement must “Expressly limit the taxpayer’s rights to receive, borrow, pledge or otherwise receive the benefits of the money or property held by the intermediary during the period of the exchange.” So, the funds can be used right away towards completion of the exchange but not for any other purpose, during the exchange period.
There is more than one way to structure a tax-deferred exchange under Section 1031 of the Internal Revenue Code. However, the 1991 Regulations established "safe-harbor" procedures which include the use of a Qualified Intermediary, direct deeding, the use of qualified escrow accounts for temporary holding of "Exchange funds" and other procedures which now have the official blessing of the IRS. Therefore, it is desirable to structure exchanges so that they can be in harmony with the 1991 Regulations. As a result, exchanges commonly employ the use of direct deeding and the services of a Qualified Intermediary. Exchanges can also occur without the services of a Qualified Intermediary when parties to an exchange are willing to exchange deeds or if they are willing to enter into an Exchange Agreement with each other. However, two-party exchanges are relatively uncommon since in the typical § 1031 transaction, the seller of the replacement property is not the buyer of the taxpayer's exchange property.
Follow the guidelines laid out by IRS and you can use the advantages of 1031 Exchange to build and preserve wealth. As a Treasury Regulation, Section 1031 carries the full weight of the law and all parties must follow it, even the IRS.
What is a Qualified Intermediary?
A Qualified Intermediary, or QI, is formally defined as a person who is not the taxpayer or a disqualified person, who enters into a written agreement (the "Exchange Agreement") with the taxpayer and, as required by the “Exchange Agreement”, acquires the relinquished property from the Exchanger/taxpayer and transfers it to the buyer, then acquires the replacement property from the seller and transfers it to the Exchanger/taxpayer. The qualified intermediary does not actually have to receive and transfer title when direct deeding is used.
The Treasury Regulations also specify disqualified persons. Generally a person who has acted as the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker within a two year period, direct linear relations (i.e. taxpayer’s parent, child, sibling, etc.), and certain other parties are not allowed to act as the Qualified Intermediary. Furthermore, none of these persons can own as much as 10% of any Qualified Intermediary used by their clients without also becoming disqualified. For example, if even so much as 10% ownership of a Qualified Intermediary is held by a CPA or Real Estate Agent, then that QI is considered to be a “Disqualified Person” for every client who has used that CPA or Real Estate Agent in the last 2 years.
The Role of the Qualified Intermediary
The catalyst which transforms the ordinary purchase and sale of property into an exchange, the Qualified Intermediary is a crucial component of a valid and successful 1031 Exchange. In order for a 1031 Exchange to qualify under the “safe harbor” Regulations, there must be a written agreement between the taxpayer and the intermediary stating the seller’s intent to exchange and expressly limiting the taxpayer's rights to receive, pledge, borrow or otherwise obtain the benefits of the money or property held by the intermediary. The intermediary can act with respect to the property as the agent of any party to the transaction and further, an intermediary is treated as entering into an agreement if the rights of a party to the agreement are assigned to the intermediary and all parties to the agreement are notified in writing of the assignment on or before the date of the relevant transfer of property. This provision allows a taxpayer to enter into an agreement for the transfer of the relinquished property (i.e., a contract of sale on the property) and thereafter to assign his rights in that agreement to the intermediary. Providing all parties to the agreement are notified in writing of the assignment on or before the date of the transfer of the relinquished property, the intermediary is treated as having entered into the agreement and, upon completion of the transfer, as having acquired and transferred the relinquished property. The Qualified Intermediary does not provide legal counsel or offer specific tax advice to the exchanger, but will usually perform the following services:
- Coordinate with the exchangers and their advisors, to structure a successful exchange.
- Prepare the documentation for the Relinquished Property and the Replacement Property.
- Furnish escrow with instructions and documents to effect the exchange.
- Secure the funds in an insured bank account until the exchange is completed.
- Provide documents to transfer Replacement Property to the exchanger, and disburse exchange proceeds to the closing.
- Hold the document of Identification of Replacement Properties sent by the Taxpayer.
- Submit a full accounting of the Exchange for the taxpayer’s records.
- Submit a 1099 to the taxpayer and the IRS for any growth proceeds/interest earned by exchange funds and paid to the taxpayer.
Note to exchangers in California: Effective January 1, 2003, AB 2065 changes the tax withholding requirements for sales of real property in California (the California Foreign Investment in Real Property Tax Act, or "Cal-FIRPTA"). As originally drafted, Cal-FIRPTA required buyers to withhold 3 1/3% of the sales price of real property purchased and forward those funds to the California Franchise Tax Board, but only if the funds are to be transferred to an out-of-state seller or to the seller's financial intermediary. AB 2065 expands the withholding requirement to apply to sales by California residents and nonresidents alike. Fortunately, AB 2065 exempts various transactions from the withholding requirement, including sales of principal residences, 1031 exchanges, involuntary conversions, and sales resulting in a loss. In addition, withholding on sales by corporations, LLC's, irrevocable trusts, and certain other sellers, generally remain subject to more traditional withholding requirements that turn on the seller's residency. The difficulty that AB 2065 presents for individual sellers is that they cannot request a reduction in the amount of the withholding that would limit the amount to the approximate tax that will be owed. Instead, the withholding is to be calculated on the whole sales price. Alternately, if there is a partial 1031 Exchange done and the taxpayer still has unused exchange funds at the end of the exchange, then 3 1/3% of the remaining funds will be withheld for the Franchise Tax Board.
Delayed Exchanges - The Exchange Process, Its Requirements & Timelines
In the past all exchanges were simultaneous, with the sale of one property and the purchase of another both closing at the same instant. However, in a Delayed Exchange the taxpayer, through a Qualified Intermediary, will sell the relinquished property first and then, through a Qualified Intermediary, buy the replacement property later, hence the delay. A taxpayer intending on doing a 1031 Exchange lists and/or markets his property for sale in the normal manner without regard to the contemplated 1031 Exchange. A buyer is found and a contract to sell the property is executed. Accommodation language is usually placed in the contract securing the cooperation of the buyer to the seller's intended 1031 Exchange however such accommodation language is not required to be included in the contract. When contingencies are satisfied and the contract is scheduled for a closing, the services of a Qualified Intermediary are arranged for and the taxpayer enters into an Exchange Agreement with the QI.
The Exchange Agreement usually provides for:
- An assignment of the Exchanger's contract to sell the relinquished property as well as buy the replacement property(ies) to the QI.
- A closing where the QI receives the proceeds due the seller at closing.
- Direct deeding out of the relinquished property as well as into the replacement property. ~ Compliance with the requirements of IRC §1031 that the Exchanger will not have constructive receipt of exchange funds during the exchange period or before the Exchange Agreement terminates.
- An interval of time within which the Exchanger must locate and identify suitable replacement property and another interval within which the replacement property must be received by the taxpayer. These intervals of time are subject to the 45-Day and 180-Day rules.
- A closing where the QI uses the exchange funds in its possession to acquire the replacement property(ies) for the Exchanger.
Identification
The 45-Day Rule for Identification: The first timing restriction for a 1031 Delayed Exchange regards the “Identification Period”. The taxpayer must identify all potential replacement property(ies) within 45 days from the date of transfer of the relinquished property. The 45-Day Rule is satisfied if replacement property is received before 45 days has expired. Otherwise, the identification must be by written document (the identification notice) signed by the taxpayer and sent to the Qualified Intermediary. The identification notice must contain an unambiguous description of the replacement property. This includes, in the case of real property, the legal description, street address or a distinguishable name. During the Identification Period the taxpayer can change the list of “Identified Properties”. However, after midnight on the 45th day no further changes can be made. Restrictions are also imposed on the number of replacement properties which can be identified in an exchange. More than one potential replacement property can be identified as long as you satisfy one of these rules:
The Three-Property Rule: Any three properties regardless of their market values.
The 200% Rule: Any number of properties as long as the aggregate fair market value of the replacement properties does not exceed 200% of the aggregate FMV of all of the Relinquished Properties as of the initial transfer date.
The 95% Rule: Any number of replacement properties if the fair market value of the properties actually received by the end of the exchange period is at least 95% of the aggregate FMV of all the potential replacement properties identified.
Although IRC Regulations only require written notification within 45 days, it is wise practice for a solid contract to be in place by the end of the 45-day period. Otherwise, if the deal(s) falls apart for any reason and the 45 days have passed, and if the taxpayer has no other identified property to buy instead, the exchange fails and the gain becomes taxable. After 45 days have expired, it is not possible to close on any other property which was not identified in the “identification notice” letter. Failure to submit the “identification notice” letter before the end of the identification period (45 days after sale closes) causes the Exchange Agreement to terminate.
The 180-Day Rule for Receipt of Replacement Property: The replacement property must be received and Exchange completed no later than the earlier of 180 days after the transfer of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the exchanged property was transferred. The replacement property received must be substantially the same as the property which was identified under the 45-day rule described above. IRS has never given an extension of the 180 or 45 day deadlines to any individual taxpayer. There is no provision for extension of the 180 days for any circumstance or hardship, except in the case of natural disaster. If the exchanger, the Qualified Intermediary, the identified replacement property, title, escrow, attorney or real estate agent is in an area federally designated as a “Disaster Area” during the exchange, the Identification Period and the Exchange Period may be extended by 120 days. This was the case with hurricanes Rita and Katrina, when IRS issued a notice giving extensions to those adversely affected.
As noted above, the 180-Day Rule is shortened to the due date of a tax return if the tax return is not put on extension. For instance, if an Exchange commences late in the tax year, the 180 days can be later than the April 15 filing date of the return. If the Exchange is not complete by the time for filing the return, the return must be put on extension. Failure to put the return on extension can cause the Exchange to terminate on the due date of the return. This can be a trap for the unwary if you file your tax return before completing your exchange.
Caution: If the exchanger will combine funds from two exchanges to buy any one replacement property, then the timing for BOTH exchanges begins when the first relinquished property sale closes. The replacement property must be identified as such for BOTH relinquished properties within 45 days from the first relinquished property closing, whether or not the second relinquished property is even sold by that time.
“Boot” Camp
Although it is not used in the Internal Revenue Code, the term “Boot” is commonly used in discussing the tax implications of a 1031 Exchange. Boot is an old English term meaning “Something given in addition to.” “Boot received” is the money or fair market value of “Other Property” received by the taxpayer in an exchange. Money includes all cash equivalents, debts, liabilities or mortgages of the taxpayer assumed by the other party, or liabilities to which the property exchanged by the taxpayer is subject. “Other Property” is property that is non-like-kind, such as personal property, a promissory note from the buyer, a promise to perform work on the property, a business, etc.
There are many ways for a taxpayer to receive “Boot”, even inadvertently. It is important for a taxpayer to understand what can result in boot if taxable income is to be avoided.
The most common sources of boot include the following:
Cash boot taken from the exchange. This will usually be in the form of "Net cash received", or the difference between cash received from the sale of the relinquished property and cash paid to acquire the replacement property(ies). Net cash received can result when a taxpayer is "Trading down" in the exchange (i.e. the sale price of replacement property(ies) is less than that of the relinquished.)
Debt reduction boot which occurs when a taxpayer’s debt on replacement property is less than the debt which was on the exchange property. As is the case with cash boot, debt reduction boot can occur when a taxpayer is "Trading down" in the exchange.
Sale proceeds being used to pay non-qualified expenses. For example, service costs at closing which are not closing expenses. If proceeds from the sale are used to service non-transaction costs at closing, the result is the same as if the taxpayer had received cash from the exchange, and then used the cash to pay these costs. Taxpayers are encouraged to bring cash to the closing of the sale of their property to pay for the following: Non-transaction costs: i.e. Rent perorations, Utility escrow charges, Tenant damage deposits transferred to the buyer, and any other charges unrelated to the closing.
Excess borrowing to acquire replacement property. Borrowing more money than is necessary to close on replacement property will not result in the taxpayer receiving tax-free money from the closing. The funds from the loan will be the first to be applied toward the purchase. If the addition of exchange funds creates a surplus at the closing, all unused exchange funds will be returned to the Qualified Intermediary, presumably to be used to acquire more replacement property. Loan acquisition costs (origination fees and other fees related to acquiring the loan) with respect to the replacement property should be brought to the closing from the taxpayer’s personal funds. Taxpayers usually take the position that loan acquisition costs are being paid out of the proceeds of the loan. However, the IRS may take the position that these costs are being paid with Exchange Funds. This position is usually the position of the financing institution also. Unfortunately, at the present time there is no guidance from the IRS on this issue which is helpful.
Non-like-kind property which is received from the exchange, in addition to like-kind property (real estate).
Non-like-kind property could include the following:
- Seller financing, promissory note.
- Sprinkler equipment acquired with farm land.
- Ditch stock in a mutual irrigation ditch company acquired with farm land (possible issue).
- Big T Water acquired with farm land (possible issue).
Acquisition of ditch stock or Big T water is a possible issue with the IRS. In reporting their exchanges of farm land most taxpayers take the position that water on the farm land is like kind to the land. The IRS has been known to have a different view.
Boot Offset Rules
Only the net boot received by the taxpayer is taxed. In determining the amount of net boot received by the taxpayer, certain boot off-set rules come into play. They are as follows:
- Cash boot paid (replacement property) always offsets cash boot received (relinquished property).
- Debt boot paid (replacement property) always offsets debt-reduction boot received (relinquished property).
- Cash boot paid always offsets debt-reduction boot received. Debt boot paid never offsets cash boot received (net cash boot received is always taxable).
- Qualified costs paid (between both the relinquished and replacement property closings) always offset net cash boot received.
Boot tips
- Always trade "Across" or up. Never trade down. Trading down always results in boot received, either as cash, debt reduction or both. The boot received can be off-set by qualified costs paid by the Exchanger.
- Bring cash to the closing of the replacement property to cover loan fees or other charges which are not qualified costs. (See above)
- Do not receive property which is not like-kind.
- Do not over-finance replacement property. Financing should be limited to the amount of money necessary to close on the replacement property in addition to exchange funds which will be brought to the replacement property closing.
Adjusted Basis
Before you enter into any exchange of real estate, you must first figure the adjusted basis of the replacement property you are acquiring to see how it fits in with your financial and tax plans. For real property assets, basis is the term given to the price that was originally paid for the property, plus any capital improvements, less depreciation.
Basis is used as the start point for the calculation of capital gain on a transaction. Capital gain is described as the difference between the basis and the adjusted sales price of a property, less costs. So, if a taxpayer purchased property for $10.00 and sold it for $12.00 and incurred qualified costs of $0.25, the capital gain would be $1.75 (Sale: 12 – Original Price: 10 – Costs: 0.25 = Gain 1.75). When a taxpayer uses a 1031 exchange to defer gain from a sale, the gain is ultimately passed along to the replacement property where it awaits the next sale and the taxpayer’s anticipated eventual cashing out. The basis of the replacement property is the price paid for it less the gain previously deferred, less any further depreciation. For example, if a taxpayer bought a property ten years ago for $50,000 and has depreciated that property at $1,666 a year for the last ten years, the taxpayer’s basis on that property is now $33,340. If the taxpayer then sold that property for $85,000 and did a 1031 Exchange into a property priced at $100,000, the substituted basis on the new property would be only $48,340. (Sale price: 85,000 – Basis: 33,340 = Gain: 51,660) (Replacement property price: 100,000 – Deferred gain: 51,660 = adjusted basis: 48,340)
If the property from the above example was later sold for cash the amount of capital gain would be determined by subtracting the costs of the sale and the substituted basis from the new sale price. The remainder is the capital gain. If the sale price was $150,000 and qualified costs to the taxpayer were $12,000, the capital gain in this example would be $89,660. (New Sale Price: 150,000 – costs: 12,000 - Adjusted basis: 48,340 = Gain: 89,660)
Capital Gain vs. Equity
Do not confuse capital gain with equity. The two terms cannot be compared with each other. Equity is the amount of money you have left over after you have sold the property and paid off all related liabilities and mortgages. As an example lets say you bought a property for $200,000 five years ago, it has a mortgage of $130,000 and has a basis of $166,667. If you sold that property today for $400,000, and paid out $30,000 in closing costs and commissions, you have equity of $240,000 (the amount of cash you would get out of the closing). However your capital gain on this property would be the difference between your basis: $166,667 and your adjusted sales price of $370,000 (Price: 400k – Costs: 30k = 370k), in this case $203,333. If this sale is not turned into 1031 Exchange, there will be capital gains tax owed on the entire gain. At the base federal rate of 15%, that’s $30,499.95 due in federal taxes alone. Be careful here if you have refinanced since your original purchase, it is in this area you want to be very cautious not to trap yourself. In a situation like this you are almost obligated to exchange unless you have the additional funds to pay the taxes. For example, a taxpayer buys property for $100,000 with a mortgage of $70,000. Later its value increases to $210,000 and the taxpayer refinances with a new mortgage of $140,000.If the taxpayer sells this property for $210,000 and does not use a 1031 Exchange, the gain of $110,000 will require the payment of $16,500 in federal taxes alone. (Sale price: 210,000 - Basis: 100,000 = Gain: 110,000 x Federal Cap Gains tax: 15% = Taxes due 16,500) The larger the transactions and the more money and leveraging involved the greater tax burden of cashing out. The advice of your tax advisor is priceless in this instance.
“Special” Issues
Multiple-Asset Exchanges and Personal Residences: A Multiple-Asset Exchange occurs when a taxpayer is selling/exchanging a property which includes more than one type of asset. A Common example is a farm property including a personal residence, farm land and farm equipment. The Treasury Department has issued Regulations which govern how multiple-asset exchanges are to be reported. The Regulations establish "Exchange Groups" which are separately analyzed for compliance with the like-kind replacement requirements and rules of boot. Farm land must be replaced with qualifying like-kind real property. Farm equipment must be replaced with qualifying like-kind equipment. A personal residence is not 1031 property and is accounted for under the rules applicable to the sale of a personal residence. The Multiple-Asset Regulations are ambiguous concerning how the personal residence portion of a multiple-asset exchange should be accounted for. However, it is common practice for the closing on the Exchange Property to be bifurcated into two separate closings; one for the personal residence and the other for the remainder of the property. The proceeds applicable to the sale of the personal residence are usually disbursed to the taxpayer directly. The balance of the proceeds is disbursed to the Qualified Intermediary for use in acquiring like-kind replacement property under the Exchange Agreement. Another common example of multiple-asset exchanges is a real property sale that includes personal property (i.e. furniture and appliances). Rental properties including this type of personal property are multiple-asset exchanges. Hotel properties are a good example of a multiple-asset exchange including real and personal property. Even a sale/exchange of a TIC Investment includes a combination of real and personal property. In practice, the value of the personal property that is transferred with a TIC Investment is commonly disregarded for calculation and income tax reporting purposes. However, there is no rule which permits a taxpayer to disregard the value of personal property, even if it is nominal. The Multiple-Asset Regulations are complex and require the services of a tax professional for analysis purposes and income tax reporting. The tax professional is essential and will help in determining values, allocations of sale price and purchase prices to the elements of the transaction. Exchanges that include personal property of significant value should reference the personal property in the exchange agreement and be completed in a manner that complies with all of the exchange rules concerning identification, etc.
Sale/Lease Back as an Exchange: A lessee's interest in a lease with a term of 30 years or longer on real property is considered “like-kind” to other real property. In addition, property which is subject to a lease can, if the lease is for a term of 30 years or longer, be the subject of a tax-deferred exchange. However the receipt of prepaid lease payments in an exchange for a 30-year or longer lease is taxed as ordinary income and will not qualify for tax-deferred treatment.
Partnership and Co-Ownership Issues: Investment real estate is commonly owned by a partnership containing two or more partners, or by co-owners as tenants in common. An exchange of a tenant in common interest in real estate poses no problems and is eligible for 1031 Exchange treatment. Each tenant can exchange separate from the others. A partnership can exchange real estate that it owns but ownership interest in a partnership itself cannot be exchanged under IRC §1031. Real property is real property, but a partnership is only an idea, an agreement, and not real property. If a partnership desires to exchange property that it owns the partnership will be the entity that is the Exchanger and party to the Exchange Agreement. The partnership will take title to the Replacement Property. Frequently, individual partners in a partnership desire to exchange their share of the sale of the partnership’s property, replace it with qualifying property in their own names and end their relationship with the partnership. This presents problems that require careful planning by the taxpayer’s legal/tax advisor and is not without tax risk. If a two-partner partnership wishes to discontinue the partnership, sell the property and go their separate ways with either the cash or a 1031 Exchange, it is necessary for the individual partners to receive deed to the property from the partnership in advance of the sale of the property. This is done in the context of a distribution of property from the partnership to its partners. The individual partners are then generally required to hold the property as tenants in common for an unspecified period of time (“a decent interval of time”) in order to comply with the requirement for a taxpayer to have "held" the property for business or investment purposes prior to the exchange. If a partnership with multiple partners wishes to exchange property but some of the partners want to "Cash-out" or go separate ways, it is common for the partnership to do a "Split-off." The partnership distributes tenancy in common title to a portion of the partnership property to those individual partners who wish to part ways, and the partnership (and its remaining partners) proceed separately with an exchange in the name of the partnership. The services of a tax professional are essential for tax planning and structuring of successful exchanges of partnership and co-ownership interests in real estate.
Incidental Property: For purposes of completing a proper identification within the 45-day identification period, it should be noted that property which is incidental to Real Estate property, such as furniture, laundry machines, appliances, pumps, etc. is not treated as separate property from the real estate property if 1) In standard commercial transactions the property is typically transferred together with the real estate property, and 2) The aggregate market value of the incidental property does not exceed 15% of the market value of the real estate property. For description purposes, the legal description or street address of the real estate property can be used to describe the entire property. There is no need to list the particular incidental property attached to it.
Seller Carry-Back Financing: A loan or note issued by the seller/exchanger will often turn out to be “Boot” if it is part of a 1031 Exchange of real estate. The reason is that a promissory note is property received which does not meet the requirement that real estate be exchanged solely for other like-kind property (real estate). If seller financing is necessary due to circumstances, and if a delayed exchange with the use of a Qualified Intermediary is employed, there are alternatives to being taxed on the amount of the note.
1) The taxpayer can buy the note out from the exchange. By bringing personal funds in the amount of the note to the closing, the taxpayer will trade cash for the note, use the cash to purchase replacement property, and hold the note personally apart from the exchange. Instead of being taxed on the face value of the note, the taxpayer is only taxed on the income received from the note.
OR
2) The taxpayer can direct the Qualified Intermediary to sell the promissory note to a financial institution or investor and use the cash received in its place as exchange funds to acquire qualifying replacement property.
3) The taxpayer can use the promissory note in the exchange as consideration for the acquisition of replacement property. In other words, a taxpayer can take a carry-back note from the buyer of the relinquished property, as a part of that sale and later trade that note to the seller of the replacement property, as a part of that purchase. A problem with this is that in the hands of the seller of the replacement property, that note is a third-party note not eligible for installment sale reporting under IRC 453. It will be called a “third party” note because it is a note between you and the buyer of your relinquished property, now held by the seller of your replacement property, a 3rd party. That person will not be able to do 1031 Exchange with that note and will likely be taxed on its value in the tax year it is received. Accordingly, there is disincentive for the seller to take the note as part of the consideration to be received from the sale of his property. This problem is compounded if the seller is also trying to do a 1031 Exchange of his property.
Caution: These dispositions are not covered by the 1991 Regulations and are not protected by the ”safe-harbor” provisions. Therefore, if seller carry-back financing is part of the sale of the relinquished property potential tax issues are always possible under an examination by the IRS. Otherwise, the note is "Boot" to the taxpayer unless it is offset by "Boot", paid by the taxpayer, at the Replacement Property closing table. “Cash boot paid” by a taxpayer always offsets “Cash boot received.”
Vacation Homes: A vacation home or second home not held as a rental is classified as real estate held for personal use and does not qualify for 1031 treatment. However, under the rules of 280, a dwelling unit held for both personal use and rental purposes must take a use test each tax year to determine its tax classification for that tax year.
Either
1) The property is treated as real estate held primarily for personal use and treated as an asset not held for profit if the owner's personal use is more than 14 days or 10% of the total rental days, and the unit is rented for one day or more during the tax year. This property does not qualify for 1031 treatment.
OR
2) The property is treated as
TIC Investment if the owner's personal use is no more than 14 days or 10% of the rental days during the tax year and the property is rented more than 14 days during the tax year. This property may qualify for 1031 treatment.
New Construction of Replacement Property: One of the more interesting stipulations is the regulation that permits you to exchange for real property that has not yet been built. A transfer will still qualify for 1031 treatment if the new construction is identified within the 45- day period, and received within the 180-day exchange period. This property must be carefully identified. This identification should include the legal description of the underlying ground and as much other description as possible for the property to be constructed. Also, the new construction must be completed and received in substantially the same form as described in the identification documents.
You cannot exchange for services (i.e. A contractor’s obligation to do work or build on the property, etc.) Partially completed real property can be received in a like kind exchange if properly identified.
There are two ways that new construction is handled in a Delayed Exchange:
1) You contract with a builder to purchase a property that will be completed, and closed, prior to the end of the 180-day exchange period. This is the least expensive and easiest method for the exchanger.
OR 2) You can contract to do what is known as a "Build-to-Suit " Exchange. Just like a Delayed Exchange, the sale property closes first and exchange funds are used to buy replacement property. The replacement property could be vacant land or it could already be developed. Through a special agreement with the Qualified Intermediary, the taxpayer’s chosen builder draws on the exchange proceeds as certain steps of the construction are completed. All work that will be part of the exchange must be complete and the taxpayer must take ownership of the property before the 180-day exchange period expires.
In both cases, the Purchase & Sale Agreement should contain language that requires “The Builder” to bear responsibility for the “The Exchanger’s” taxes if the exchange fails due to the “Builder’s” failure to complete the construction prior to the 180th day. If “The Builder” refuses to sign such an agreement, then at least you know where you stand. If a taxpayer’s exchange is approaching its 180th day and construction will not be complete, to salvage the exchange, the taxpayer can have “The Builder” convey ownership to the taxpayer to that portion of the property that is complete. In such an instance, the value of that portion is added to the total amount of replacement property purchased for the exchange. The value of the Replacement Property must be figured on the day of transfer. Construction work completed after the day of transfer will not be treated as part of the exchange.
Related Parties: In the past, enough people have, in order to circumvent or evade proper taxation, etc. transacted slanted real estate deals between related parties, that the IRS has issued strict guidelines regarding their involvement in a 1031 Exchange. If not handled properly, selling to or buying from a related party can disqualify your 1031 Exchange. CPA’s should be prudent and use caution when a related party is involved in an exchange transaction. Related parties are treated differently and have a unique set of rules. Knowing these rules should eliminate unpleasant surprises.
1) A taxpayer can only sell relinquished property to a related party if the related party will hold that property for at least 2 years after the exchange.
2) A taxpayer can only buy from a related party if the related party will also do a complete 1031 Exchange, receiving no “boot” and both the taxpayer and the related party each hold their respective replacement properties for at least 2 years after the exchange. Per IRS guidelines, related parties are the following:
- Members of a family, including only brothers, sisters, half-brothers, half-sisters, spouse, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.)
- An individual and a corporation when the individual owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation .
- Two corporations that are members of the same controlled group as defined in 1563(a), except that "More than 50%" is substituted for "At least 80%" in that definition.
- A trust fiduciary and a corporation when the trust or the grantor of the trust owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation.
- A grantor and fiduciary, and the fiduciary and beneficiary, of any trust.
- Fiduciaries of two different trusts, and the fiduciary and beneficiary of two different trusts, if the same person is the grantor of both trusts.
- A tax-exempt educational or charitable organization and a person who, directly or indirectly, controls such an organization, or a member of that person's family.
- A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital interest, or profits interest, in the partnership.
- Two corporations, one of which is an S corporation, if the same persons own more than 50% in value of the outstanding stock of each corporation or Two S corporations if the same persons own more than 50% in value of the outstanding stock of each corporation.
- An executor of an estate and a beneficiary of such estate, except in the case of a sale or exchange in satisfaction of a pecuniary bequest.
- Two partnerships if the same persons own directly, or indirectly, more than 50% of the capital interests or profits in both partnerships, or a person and a partnership when the person owns, directly or indirectly, more than 50% of the capital interest or profits interest in the partnership.
Suggested Exchange Clause: We suggest that you insert language similar to the following clause into your corresponding Purchase & Sale agreement so that all parties are aware that the transaction will be a delayed exchange, and there will be no lack of disclosure which may obstruct the transaction. (This is merely a suggestion, as disclosure of the 1031exchange is not required to be included in the Purchase & Sale Agreement.) When “Seller” is exchanging use the clause below. When the Buyer is exchanging, reverse the placement of “Seller” & “Buyer” in the clause below.
"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 nor cause additional expense or liability to the Buyer. The Seller’s rights and obligations under this agreement may be assigned to Haven Exchange, Inc. a Qualified Intermediary, for the purpose of completing such an exchange. Buyer agrees to cooperate with the Seller and Haven Exchange, Inc. in a manner necessary to complete the exchange."
006Resources
Internal Revenue Code § 1.1031(k)-1
Law Offices of Frank D. Granato - Frank D. Granato, Attorney at Law
701 South Parker St., Suite 6000, Orange, CA 92868
Phone: (714) 547-3361 - E-mail: fGranato@earthlink.net
Federation of Exchange Accommodators Phone: (916) 388-1031
N.A.R. - National Association of Realtors Toll-Free: (800) 874-6500
Frequently Asked Questions
What should I do with the Earnest Money deposit on the sale of my Relinquished Property? The earnest money should never be deposited in your own account. It should be deposited with the title or escrow company, closing attorney or real estate brokers trust account, or with your QI. The earnest money receipt should state that the funds are to be assigned to the QI, and that you will never have possession or constructive receipt of those funds.
How do I handle the earnest money deposit for the purchase of my Replacement Property? Typically it is handled in one of two ways. 1) If your relinquished property has closed and your funds are with the QI, you can direct the QI to send the deposit out of your exchange proceeds. OR 2) You can give an earnest money deposit from your own personal funds, even before the relinquished property has closed. If you directly put some of your own personal money into the purchase transaction and if there are unused funds at the closing which are not exchange funds, then you can be reimbursed up to the amount of your “out of pocket” deposit, when that purchase closes. If the transaction fails to close the funds should be returned to your Qualified Intermediary by the closer.
Do I have to spend all of the proceeds from my relinquished property on replacement property? No, you don't. However, any amount you don't spend will be treated as cash boot received and must be taken into account when figuring your net boot received.
If I don't spend all of my proceeds when can I receive the unused amount? The IRC §1031 guidelines specify that you can receive the unused proceeds anytime after you have acquired all of the properties identified by you during the 45-day identification period. If you do not acquire all of the identified properties the unused proceeds cannot be released until the end of the 180 day exchange period or the due date of your tax return, including extensions, whichever is earlier.
If I decide not to go through with my exchange when can I get my money back? The IRC §1031 guidelines specify that if no replacement property is identified by you during the 45 day identification period the exchange ends and the proceeds can be released any time afterward. However, if you identify replacement property for your exchange that you do not acquire, the funds cannot be released until the end of the 180 day exchange period or the due date of your tax return, including extensions, whichever is earlier. Your funds will continue to earn interest for you throughout.
How long do I have to hold the replacement property before I can sell it or move in and occupy it as my primary home?
It must be the taxpayer’s intent at the time of the exchange to hold the replacement property for use in trade or business or for investment. The Treasury Regulations pursuant to IRC § 1031 do not stipulate a specific period of time that replacement property acquired through a 1031 must be held before it can be either sold or occupied as the exchanger’s primary home. Barring instances of hardship, most tax advisors recommend holding at least two full years, but some say only two tax years, which could be as short as 13 months depending on timing. If you do eventually occupy a 1031 replacement property as your primary home, you will need to live in the property for three years before you will be able to claim the primary home tax exemption on it, if you were to sell it.
SECURITY
Haven Exchange provides clients with a degree of safety and security for their funds that is unmatched by any of our competitors. At Haven Exchange, ALL exchange proceeds are covered by our Fidelity Bond and all funds are placed in separate, fully segregated, completely liquid, FDIC insured money market accounts at Union Bank of California. Every client receives a statement directly from Union Bank of California each month, reflecting the activity and balance, including interest earned for their individual 1031 Exchange account. For your security, two signatures followed by a changing, randomly generated encrypted security code are required for any release of your 1031 funds.
SERVICE
Exemplary 1031 Exchange Service is a requirement
What has most impressed our customers is the reliable care they receive from our knowledgeable and enthusiastic staff. I have many years experience both in escrow and 1031 exchange, but my team has really taught me something about customer service that I'm sure you will value. As much as I was able to teach them about 1031 exchange services, I feel very enriched by their contribution. Everyone at Haven Exchange is committed to providing unsurpassed service to our clients. Your success is our success.
Haven Exchange is here for you 7 days a week, from 6am to 9pm PST so we can be available when you need answers. Because of the obvious advantage to our clients, we are highly responsive in providing your 1031 Exchange documents, service and funds. This means the documents for your 1031 tax Exchange can be delivered within minutes and that we can fund your closing the same day we receive the necessary signatures, up to 2pm PST.
Even IRS agents have used Haven Exchange as their Q.I.
1031 Expert Guide~1031 Exchange Guide ~ Guide to Successful 1031 Exchanges by Haven Exchange, Inc –Your Expert Source for 1031 Solutions.
Schedule of Fees for 1031 Exchange of Real Property:
Delayed Exchange: Including one relinquished and one replacement Property $500.00
Each additional replacement property closing (If applicable) $ 175.00
Wire fee (If applicable) $30.00
Receipt, Transfer, and Reassignment of Notes (If applicable) $ 275.00
Reverse Exchange: Price determined on a case by case basis, depending on needs of the Exchanger $ 5,000+
“Build to Suit” Exchange: Price determined on a case by case basis, depending on needs of the Exchanger $ 5,000+
1031 Expert Guide~1031 Exchange Guide ~ Guide to Successful 1031 Exchanges
Written by Ben Brasier & Dorothy Zink, Haven Exchange, Inc. 2007. All Rights Reserved.
1031 Delayed Exchange - Step by Step
Step 1: Retain the services of tax counsel/CPA. Become advised by same.
Step 2: Sell the property, including an “Exchange Cooperation Clause” in the sales agreement. Make sure your escrow officer, title officer or closing attorney receives the “ EZ-Form” (on the outside back cover), completes it, and faxes it to Haven Exchange. This will order the creation of your 1031 Exchange.
Step 3: Enter into an exchange agreement with Haven Exchange, Inc., in which “Haven” is named as principal in the sale of your relinquished property and the subsequent purchase of your replacement property. Along with said agreement, an amendment to the closing/escrow instructions is signed which names Haven Exchange as the substituted seller. Normally the deed is prepared for recording as directly from the taxpayer to the true buyer. This is called direct deeding. It is not necessary to have the replacement property identified at this time.
Step 4: The sale of the relinquished property closes and the proceeds from the sale are forwarded to Haven Exchange. Exchange funds are kept with Union Bank of California in a fully guaranteed account, further protected by a third party insurance policy. The day the relinquished property closes is the day your 1031 Exchange comes to life and the timelines begin their countdown. Haven Exchange makes a courtesy call and also sends a letter to the taxpayer, advising them of the amount of proceeds, the date of the closing according to the Final Closing Statement, and the dates of the 45th and 180th days. A “Replacement Property Identification form” and “Earnest Money Deposit request form” accompanies the letter.
Step 5: The taxpayer sends written identification of the replacement property(ies), including address or legal description, to Haven Exchange, on or before Day 45 of the exchange. It must be signed by every signatory on the exchange. It may be faxed, hand delivered, or mailed. We recommend having it sent via certified mail with “Return Receipt Requested. The taxpayer will then have proof of receipt by the QI, verified by a government agency.
Step 6: Taxpayer enters into an agreement to purchase replacement property, again including the Cooperation Clause. An amendment is signed naming Haven Exchange as substituted buyer, but again the deeding is direct from the true seller to the taxpayer.
Step 7: When conditions are satisfied and the purchase is ready to close (and certainly prior to the180th day), Haven Exchange forwards the exchange funds to the closing. A final accounting is sent by Haven Exchange to the taxpayer, showing the funds coming in from one escrow, and going out to the other, all without constructive receipt by the taxpayer.
Step 8: Taxpayer files form 8824 with the IRS when taxes are filed, and whatever similar document your particular state requires.
1031 Expert Guide ~ 1031 Exchange Guide ~ Guide to Successful 1031 Exchanges.
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