On April 25, 1991, the IRS issued deferred exchange regulation-Reg 1.1031(k)-1.
This tax code allows taxpayers to defer ALL of the capital gains taxes resulting from their sale of investment property, when they will, use a Qualified Intermediary & following the I.R.S. guidelines, use the money to buy more suitable investment property within 180 days of the close of their sale.
This means that you can reinvest the money you would otherwise have lost to capital gains tax if you will use the extra money to buy more investment property for the purpose of making more money. This can be done within and between all classes of real property anywhere in the USA. Our service team is here to help make 1031 exchange as easy and effective for you as possible.
This is why 1031 Tax-Deferred Exchange is often cited as "The Best Tax Loophole Left." When you get ready to sell that replacement property, you utilize 1031 tax deferral again. Now the amount of your tax savings has quadrupled. Bigger and better replacement properties that earn you more income can be yours. If you keep exchanging and never cash out, the difference in the size of your empire will be phenomenal! 1031 Exchange Help is a click or a phone call away.
In a 1031 Exchange, the entity beginning the exchange will be the entity concluding the exchange. The Intermediary will prepare exchange documentation reflecting the vesting information as shown on the title commitment or title report of the relinquished property. That entity must be the entity to acquire title to the replacement property.
Trustee relinquishes .................... Trustee acquires
Schmidt LLC relinquishes .................... Schmidt LLC acquires
Se Bon Partnership relinquishes .................... Se Bon Partnership acquires
Wife relinquishes ............so........ Wife acquires
The Exchanger's legal relationship to the relinquished property must be the same as the Exchanger's legal relationship to the replacement property. Exchangers must anticipate this issue as part of their advanced planning for the exchange. Business considerations, liability issues and lender requirements may make it difficult to meet this rule.
The most common exchange variation is the delayed exchange format. The delayed exchange, which became popular after the well-known Starker decision [Starker v. United States 602 F2d 1341 (9th Cir. 1979)], changes made by Congress in 1984, and the 1991 Final Regulations, can provide Exchangers the opportunity for simple and defensible exchanges by adhering to the following deadlines:
The §1031 exchanges BEGINS on the earlier of the following:
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 prorations, 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:
DO ADVANCE PLANNING for the 1031 exchange. Speak in depth with your accountant, attorney, broker, lender and Qualified Intermediary. Only a CPA/Tax Attorney familiar with 1031 AND your prior several years tax returns can be aware of everything you must consider.
DO NOT overfinance the replacement property. The IRS does not consider funds remaining due to excess financing to be loan funds. You may not receive them without disadvantageous tax consequences.
DO REMEMBER that any credit to you on a closing statement is taxable, and reduces the amount of exchange funds that will be used to purchase the replacement property.
DO NOT miss your identification and exchange deadlines. Failure to identify within the 45 day identification period or failure to acquire replacement property within the 180 day exchange period will disqualify the entire exchange. Reputable Intermediaries will not act on back-dated or late identifications.
DO keep in mind these three basic rules to qualify for complete tax deferral:
Use all proceeds from the relinquished property for purchasing the replacement property.
Make sure the debt on the replacement property is equal to or greater than the debt on the relinquished property. (Exception: A reduction in debt can be offset with additional cash, however, a reduction in equity cannot be offset by increasing debt.
Receive only like-kind replacement property.
DO NOT plan to sell and invest the proceeds in property you already own. Funds applied toward property already owned purchase goods and services , not like-kind property.
DO attempt to sell before you purchase. Occasionally Exchangers find the ideal replacement property before a buyer is found for the relinquished property. If this situation occurs, a reverse exchange (buying before selling) is the only option available. Exchangers should be aware they are considered a more aggressive exchange variation and they are considerably more costly. The Q.I. must take title to both properties and therefore is more exposed to liability. There is a double straight up swap escrow that must take place and the fee is usually calculated by adding both sales prices, and finding a closer experienced in that type of escrow may be a challenge. Additionally, there will be supplemental property tax bills, filing fees, state entity fees, dissolution fees, none of which occur in a delayed exchange.
DO NOT dissolve partnerships or change the manner of holding title during the exchange. A change in the Exchanger's legal relationship with the property may jeopardize the exchange.
The role of the Qualified Intermediary is essential to completing a successful and valid delayed exchange. The Qualified Intermediary is the glue that puts the buyer and seller of property together into the form of a 1031 Exchange. Where such an intermediary (often called an exchange facilitator) is used, the intermediary will not be considered the agent of the taxpayer for constructive receipt purposes notwithstanding the fact that he may be an agent under state law and the taxpayer may gain immediate possession of the money or property under the laws of agency.
In order to take advantage of the qualified intermediary "safe harbor" there must be a written agreement between the taxpayer and intermediary expressly limiting the taxpayer's rights to receive, pledge, borrow or otherwise obtain the benefits of the money or property held by the intermediary.
A qualified intermediary 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 taxpayer, transfers the relinquished property, acquires the replacement property, and transfers the replacement property to the taxpayer. The qualified intermediary does not actually have to receive and transfer title as long as the legal fiction is maintained.
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.
There are no licensing requirements for Intermediaries. They need merely be not an unqualified person as defined by the Internal Revenue Code in order to be qualified. The Code prohibits certain "agents" of the taxpayer from being qualified. Accountants, attorneys and realtors who have served taxpayers in their professional capacities within the prior two years are disqualified from serving as a Qualified Intermediary for a taxpayer in an exchange.
The Qualified Intermediary does not provide legal or specific tax advice to the exchanger, but will usually perform the following services:
1. Coordinate with the exchangers and their advisors, to structure a successful exchange.
2. Prepare the documentation for the Relinquished Property and the Replacement Property.
3. Furnish escrow with instructions and documents to effect the exchange.
4. Secure the funds in an insured bank account until the exchange is completed.
5. Provide documents to transfer Replacement Property to the exchanger, and disburse exchange proceeds to escrow.
6. Hold the document of Identification of Replacement Properties sent by the Taxpayer.
7. Submit a full accounting of the Exchange Funds for the Taxpayer's Records.
8. Submit a 1099 to the Taxpayer and the IRS for any growth proceeds paid. And overall, Provides Quality Service:
Although the process is relatively simple, the rules are complicated and filled with potential pitfalls. Haven Exchange, Inc. has developed a reputation as the industry leader because of our unyielding commitment to our clients. Haven Exchange, Inc. works closely with all parties involved in an exchange to ensure a smooth transaction.
If you go down in value, you can still do an exchange to defer a portion of your transaction, however, you will pay taxes on any "boot" you receive upon completion of the exchange. The cost of the replacement property may be reduced by the cost of broker commissions, escrow and title fees for all transactions involved in the 1031 Exchange.
See our Contact Us tab at the top of the page.
The following are examples of qualifying properties:
Bare Land..............Farmer's Land
Commercial rental..........Residential rental
Industrial property..........Doctor's own office
30-year leasehold interest...............Percentage interest in investment property
Cement truck............Cement truck
The Exchanger must hold the relinquished property for investment or for productive use in their trade or business to qualify for §1031 treatment. The Exchanger's purpose in holding the property, rather that the type of property, in the critical issue. The intent to hold the property for personal use will prevent the property from qualifying for §1031 treatment. Therefore, second homes will not qualify for §1031 treatment unless the property owner changes how they treat or use the second home. For example, a taxpayer could convert their second home to a valid exchange property and establish this intent by properly renting the property and holding it as a legitimate TIC Investment. Consultation with a tax advisor is important whenever a taxpayer changes how they intend to hold property.
The intent to hold property "primarily for sale" will prevent the property from qualifying for §1031 treatment. Most properties held by developers, builders and people who perform rehabilitation work are held primarily for sale and may not be the subject of an exchange. When these properties are sold, they are subject to ordinary income taxes rather than capital gain taxes.
Partnership interests, notes secured by real property, contract vendors' interests and foreign property (under the Revenue Reconciliation Act of 1989) do not qualify for §1031 treatment.
A key issue when addressing exchanges involving partnerships is to first determine whether the entire partnership wants to do an exchange or whether one or more of the partners elect to defer capital gain taxes under IRC §1031. As long as the partnership meets the requirements that apply to any exchange transactions (i.e. both the relinquished and replacement properties will be held for investment or income purposes,) then the entire partnership can do a valid tax deferred exchange.
The more commonly asked question is "Can one or more partners drop out of the partnership and exchange their interest for a like-kind replacement property?" Since an interest in a partnership is personal property, one possible solution is to liquidate the partnership under IRC §708 so that each partner will now own their respective interest as tenants-in-common with the other former partners.
If either the entire partnership or one or more parties to the partnership receive a direct interest in the underlying assets of a liquidated partnership interest, the next key issue to do determine is if the relinquished property was considered to be held for productive use in a trade or business or for investment purposes. Both the IRS and the Tax Court seem to utilize the substance-over-form doctrine in situations like these. In both Bolker v. Commissioner, 753 F2d. 490 (1983) and Magneson v. Commission, 760 F2d. 1039 (1985), the taxpayer's transaction qualified under IRC §1031.
Transactions of this type can be complicated and should be carefully reviewed by qualified tax and legal counsel to determine whether the facts and circumstances are strong enough to support a defensible tax deferred exchange. For example, in Chase v. Commissioner, 92 T.C. 53 (1989), the taxpayer did not properly liquidate a partnership interest prior to an exchange and was denied non-recognition treatment.
As with any other specific area of real estate law, you need to know the lingo, Joe. The following are some of the oft-used exchange terms and phrases, with their "plain-English" interpretation.
Definitions Of Some Common Terms
TAX REFORM ACT OF 1984
In the Tax Reform Act of 1984, Congress addressed the IRS's continued displeasure with the Starker decision by amending Section 1031 to allow Delayed Exchanges; but only if all of the exchange property is identified and acquired within specific deadlines (see Exchange Period). And most important in the Conference Report accompanying the 1984 Act, Congress specifically reaffirmed that a "sale" followed by reinvestment in like-kind property does NOT qualify for tax deferral under Section 1031. So to qualify for tax deferral, it is still quite essential to carefully structure an exchange to avoid actual or constructive "receipt" of proceeds of sale and to prevent characterization of the transaction as a taxable sale and reinvestment.
Basically the IRS held a hearing to try and "clean up" the Tax Reform Act of 1984 and to provide uniform terminologies, which are included herein. One of the main results for this revision is that IRS finally had a change of attitude toward Delayed Exchanges by accepting them instead of fighting them.
Relinquished Property: (Also called "Downleg" or simply Sale Property). This is the property you now own and are planning to sell or exchange. This is also sometimes referred to as the "exchange" property or the "downleg" property.
Replacement Property: (Also called "Upleg" or Purchase Property). Replacement Property is the property or properties intended to be purchased with the funds that are received from the sale of the Relinquished Property. There are limitations on how many replacement properties you may identify in the same deferred exchange, no matter how many relinquished properties you transfer. This is sometimes referred to as the "acquisition" property or the "upleg" property.
Important: The penalty for violating the permitted maximum is severe. You are treated as not having identified any property within the identification period and the entire exchange will fail.
Like-Kind Property : Like-kind refers to your use of the property and not to its grade or quality, "1031" property may be mixed as to type and still be like kind. As an example, you may exchange a condo for a duplex, or a commercial building for vacant land, etc. This term refers to the nature or character of the property, and not its grade or quality. Generally, real property is "like-kind" as to all other real property, as long as the Exchanger's intent is to hold the properties as an investment or for productive use in a trade or business. With regards to personal property, the definition of "like-kind" is much more restrictive.
Note: Property held outside the USA and its territories does not qualify for exchange with property held within the USA.
Boot: Fair Market Value on non-qualified (like-kind) property received in an exchange. (Examples: cash, notes, furniture, supplies, reduction in debt obligations.)
Constructive Receipt: A term referring to the control of proceeds by a taxpayer even though funds may not directly be in their possession.
Exchanger: The property owner(s) seeking to defer tax by utilizing a Section 1031 exchange (The Internal Revenue Code uses the term "Taxpayer")
Qualified Intermediary: The entity that facilitates the exchange for the Exchanger. Some companies use the term "facilitator," and or "accomodator" and the Treasury Regulations use the term "Qualified Intermediary."
Qualified Intermediary is the company who acts as the accommodator in the exchange.
A qualified intermediary is identifed as follows:
1) Not a related party to the Exchanger, (e.g. agent, attorney, broker, etc.);
2) Receives a fee;
3) Acquires the relinquished property from the Exchanger; and
4) Acquires the replacement property and transfers it to the Exchanger.
The replacement property must be identified within 45 days of the close of escrow/closing the relinquished property. This 45 day rule is very strict and is not extended if the 45th day should happen to fall on a weekend or a legal holiday.
The replacement property must be received by the taxpayer within the "Exchange Period", which ends on the earlier of 180 days after the date on which the taxpayer transferred the property relinquished, or the due date for the taxpayer's tax return for the taxable year in which the transfer of the relinquished property occurs (such as April 15th). Due to the Taxpayer's ability to extend the date of payment, the exchange period is usually 180 days.
This term is now used in place of "Non-Simultaneous Exchange" or "Starker Exchange". This is the type of an exchange where the Exchanger utilizes the exchange period described above.
Name of the taxpayer in U.S. Court of Appeal's case which authorized Delayed Exchanges. The term "Starker Exchange" is no longer used to describe a Delayed Exchange.
Property is actually deeded to the Intermediary and the Intermediary deeds to the ultimate owner.
Vested owner deeds directly to the ultimate owner. Does not eliminate the duties of the Qualified Intermediary to acquire and transfer the relinquished property and acquire and transfer the Replacement Property.
A deferred Exchange is defined as an exchange in which, PURSUANT TO AN AGREEMENT, the Exchanger transfers the relinquished property and subsequently receives the replacement property. THEREFORE, AN EXCHANGE AGREEMENT IS VITAL.
When an Exchanger is exchanging real property, like-kind is one of the real advantages of §1031 exchanges. All real property is like-kind with all other real property. Like-kind refers to how the property is held by the investor, not the type or character of property. The Exchanger must have held the relinquished property for investment or for productive use in their trade or business and intend to do the same with the replacement property. The following are examples of like-kind properties:
The IRS informed us with PLR 20040002 that a taxpayer could acquire replacement property from a related party if the related party is also doing an exchange. PLR 200616005 reaffirms this position. The Service ruled that taxpayer could sell relinquished property A to unrelated buyer through QI, and acquire replacement property B from related party S corporation without violating the related party rules of § 1031(f)(4) IF the related party was also doing an exchange out of property B into other property. The related party was thus not cashing out. The taxpayer and related party represented that they both would hold their replacement property for at least two years. This is similar to a previous PLR 200440002, which reached the same result. In this new ruling, however, the taxpayer represented that it was trying to obtain additional replacement property from an unrelated seller, and the taxpayer would pay tax on the cash received if the taxpayer was unable to find additional replacement property. The Service ruled that this taxable boot would not blow the whole related party exchange.
Below is the Private Letter Ruling for Review.
PLR 200616005 - IRC Section 1031 - Exchange of Property Held for Productive Use or Investment
IRC Section 1031
Document Date: December 22, 2005
Internal Revenue Service
Department of the Treasury
Washington, DC 20224
Release Date: 4/21/2006
Third Party Communication: None
Date of Communication: Not Applicable
Index Number: 1031.06-00
Person To Contact:
Refer Reply To: CC:ITA:B04 PLR-131347-05
Date: December 22, 2005
S Corp =
This responds to your request for a private letter ruling dated May 6, 2005, regarding § 1031 of the Internal Revenue Code.
STATEMENT OF FACTS:
Trust and S Corp are related persons within the meaning of § 1031(f)(3). Trust owns Building I and S Corp owns Building 2. Trust has transferred Building 1, including land and improvements, the tangible personal property, leases and other assets associated with Building 1, to Buyer. Trust wants to defer the recognition of the gain on the transfer of Building 1. Therefore, Trust will acquire Building 2, including land and improvements, as one of its identified replacement properties in exchange for Building 1 in a transaction intended to qualify for nonrecognition treatment under § 1031. S Corp will also engage in an exchange of Building 2 for other like-kind property in a transaction intended to qualify for nonrecognition treatment under § 1031.
To facilitate their exchanges, Trust and S Corp will enter into exchange agreements with a qualified intermediary ("QI") described in § 1.1031(k)-1 (g)(4). Pursuant to Trust's exchange agreement, QI will, for purposes of § 1031 and the regulations thereunder, be treated as the seller of Building 1 to Buyer. Moreover, QI will be treated as acquiring Building 2 from S Corp and transferring it to Trust in exchange for Building 1. Similarly, pursuant to S Corp's exchange agreement, QI will be treated as acquiring property to replace Building 2 ("S Corp's Replacement Property") and transferring it to S Corp in exchange for Building 2. S Corp's Replacement Property is, prior to its transfer to QI, owned by a party that is not related to either Trust or S Corp.
Once all the transactions are completed, Trust will own Building 2, S Corp will own S Corp's Replacement Property, and Buyer will own Building 1. Trust represents that it will not dispose of Building 2 within two (2) years of its receipt as replacement property. S Corp represents that it will not dispose of S Corp's Replacement Property received in exchange for Building 2 within two (2) years of its receipt as replacement property. For purposes of these representations, both taxpayers assert that the principles of § 1031(f)(2) apply. Trust and S Corp each seek a ruling regarding the application of § 1031(f) to their respective exchanges.
After Trust acquires Building 2, QI will still hold approximately $A of the proceeds of the sale of Building 1 to Buyer. Trust has designated and intends to acquire additional like-kind properties from unrelated third parties in the transaction that will qualify under § 1031. In the event that Trust is unable to acquire such like-kind property, these funds will be distributed by QI to Trust. Trust also requests a ruling that if it receives such cash proceeds, they will cause Trust to recognize gain on the transfer of Building I but not in excess of the amount of cash distributed outright to Trust from QI.
STATEMENT OF LAW:
Section 1031(a)(1) generally provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.
Section 1031(b) provides that if an exchange would be within § 1031(a)(1) but for the fact that cash or other non-like kind property is received in the exchange, gain is recognized but in an amount not in excess of the cash or other non-like kind property received in the exchange.
Section 1031(f) sets forth special rules for exchanges between related persons. Section 1031(f)(1) provides that if (A) a taxpayer exchanges property with a related person; (B) there is nonrecognition of gain or loss to the taxpayer in accordance with § 1031 with respect to the exchange; and (C) within 2 years of the date of the last transfer that was part of the exchange either the taxpayer or the related person disposes of the property received in the exchange, then there is no nonrecognition of gain or loss in the exchange. In other words, the gain or loss that was deferred under § 1031 must be recognized. Any gain or loss the taxpayer is required to recognize by reason of § 1031(f)(1) is taken into account as of the date of the disposition of the property received in the exchange (the second disposition).
Section 1031(f)(2) provides that certain dispositions will not be taken into account for purposes of § 1031(f)(1)(C). These include any disposition (A) after the earlier of the death of the taxpayer or the death of the related person, or (B) in a compulsory or involuntary conversion (within the meaning of § 1033) if the exchange occurred before the threat or imminence of such conversion. The excepted dispositions also include a disposition with respect to which it is established to the satisfaction of the Secretary that neither the exchange nor the second disposition had as one of its principal purposes the avoidance of federal income tax.
Section 1031(f)(4) provides that § 1031 shall not apply to any exchange that is part of a transaction, or series of transactions, structured to avoid the purposes of § 1031(f). Thus, if a transaction is set up to avoid the restrictions on exchanges between related persons, § 1031(f)(4) operates to prevent nonrecognition of the gain or loss on the exchange.
In Rev. Rul. 2002-83, 2002-2 C.B. 927, a taxpayer transfers relinquished property to a qualified intermediary in exchange for replacement property formerly owned by a related party. As part of the transaction, the related party receives cash for the replacement property. The ruling holds that because the taxpayer's use of the qualified intermediary was to avoid the application of § 1031(f)(1), the taxpayer, under § 1031(f)(4), was not entitled to nonrecognition treatment under § 1031.
In the present case, § 1031(f)(1) is not applicable to currently tax Trust's disposition of Building I because Trust is exchanging property with a qualified intermediary, who is not a related party. However, § 1031(f)(4) provides that § 1031 shall not apply to any exchange that is part of a transaction, or series of transactions, structured to avoid the purposes of § 1031(f). Thus, § 1031 will not apply if Trust's exchange is structured to avoid the "purposes" of§ 1031(f). Both the Ways and Means Committee Report and the Senate Finance Committee Print describe the policy concern that led to enactment of this provision:
Because a like-kind exchange results in the substitution of the basis of the exchanged property for the property received, related parties have engaged in like-kind exchanges of high basis property for low basis property in anticipation of the sale of the low basis property in order to reduce or avoid the recognition of gain on the subsequent sale. Basis shifting also can be used to accelerate a loss on retained property. The committee believes that if a related party exchange is followed shortly thereafter by a disposition of the property, the related parties have, in effect, 'cashed out' of the investment, and the original exchange should not be accorded nonrecognition treatment.
H.R. Rep. No. 247, 101st Cong. 1st Sess. 1340 (1989); S. Print No. 56, at 151. The Committee Reports also included the following example of when § 1031(f)(4) applies: If a taxpayer, pursuant to a pre-arranged plan, transfers property to an unrelated party who then exchanges the property with a party related to the taxpayer within 2 years of the previous transfer in a transaction otherwise qualifying under section 1031, the related party will not be entitled to nonrecognition treatment under section 1031.
H.R. Rep. No. 247, at 1341; S. Print No. 56, at 152.
In Rev. Rul. 2002-83, the Service discussed and applied § 1031(f)(4) to the following facts:
Individual A owns real property (Property 1) with a fair market value of $150x and an adjusted basis of $50x. Individual B owns real property (Property 2) with a fair market value of $150x and an adjusted basis of $150x. Both Property I and Property 2 are held for investment within the meaning of § 1031(a). A and B are related persons within the meaning of § 267(b). C, an individual unrelated to A and B, wishes to acquire Property I from A. A enters into an agreement for the transfers of Property I and Property 2 with B, C, and a qualified intermediary (QI). QI is unrelated to A and B. Pursuant to their agreement, on January 6, 2003, A transfers Property 1 to QI and QI transfers Property 1 to C for $150x. On January 13, 2003, QI acquires Property 2 from B, pays B the $150x sale proceeds from Ql's sale of Property 1, and transfers Property 2 to A.
In analyzing these facts under § 1031(f)(4), the Service quoted the legislative history cited above for the proposition that § 1031(f)(4)is intended to apply to situations in which related parties effectuate like- kind exchanges of high basis property for low basis property in anticipation of the sale of the low basis property. In such case, the original exchange should not be accorded nonrecognition treatment. Under the facts in the revenue ruling, A and B were attempting to sell Property 1 to an unrelated party while using the substituted basis rule of § 1031(d) to reduce the gain on such sale from $100x to $0. This allowed the parties to "cash out" of their investment in Property 1 without the recognition of gain. The Service concluded that the transaction was structured to avoid the purposes of § 1031(f)(1) and, therefore, A had gain of $100x on its transfer of Property 1.
The legislative history underlying § 1031(f)(2)(C) provides that any second disposition by exchanging parties will not be taken into account for purposes of § 1031(f)(1 ) if it can be established to the satisfaction of the Secretary that neither the initial exchange nor the second disposition had as one of its principal purposes the avoidance of federal income tax. In that regard, the Conference Committee Report, which adopted the Senate amendment, noted that the Senate Finance Committee Report provided that "the non-tax avoidance exception generally will apply to ... dispositions in nonrecognition transactions .... "H.R. Rep. No. 386, 101st Cong., 1st Sess. 613 (1989).
In the present case, the only disposition contemplated by the parties after Trust receives Building 2 as replacement property is the acquisition by S Corp of S Corp's Replacement Property in another exchange under § 1031, a nonrecognition transaction. Thus, because S Corp is structuring its disposition of Building 2 as an exchange for like-kind replacement property so that the gain on the transfer of Building 2 is eligible for nonrecognition treatment under § 1031(a), § 1031(f)(4)and Rev. Rul. 2002-83 are not applicable. Trust's exchange and S Corp's exchange are structured as like-kind exchanges qualifying under § 1031. There is no "cashing out" of either party's investment in real estate. Upon completion of the series of transactions, both related parties will own property that is like-kind to the property they exchanged. Moreover, neither party will have ever been in receipt of cash or other non-like kind property (other than boot received in the exchange) in return for the relinquished property. Finally, under § 1031(b), any receipt of cash by Trust from QI will result in gain to Trust not in excess of the cash received.
Based on the facts and representations submitted by the taxpayer, we rule as follows:
1. Section 1031(f) will not apply to trigger recognition of any gain realized in Trust's exchange of Building I for Building 2 or S Corp's exchange of Building 2 for S Corp's Replacement Property, provided that Trust does not dispose of Building 2 within two (2) years of its receipt as replacement property and S Corp does not dispose of S Corp's Replacement Property received in exchange for Building 2 within two (2) years of its receipt as replacement property.
2. If Trust does not acquire replacement property in addition to Building 2 and receives a distribution of $A from QI, receipt of such cash will cause Trust to recognize gain on the Building I transaction, but not in excess of the $A distributed to it from QI.
These rulings relate only to the application of § 1031(0 to the exchanges described above. No opinion is expressed regarding whether the other requirements of § 1031 have been satisfied. Further, even if the other requirements of § 1031 are met, nonrecognition treatment does not apply to the extent of any boot in the form of cash or other nonlike-kind real, personal or intangible property received by Trust and S Corp in the exchanges at issue. See § 1031(b); and Rev. Rul. 67-255, 1967-2 C.B. 270. Finally, except as specifically provided above, no opinion is expressed as to the federal tax treatment of the transaction under any other provisions of the Internal Revenue Code and the Income Tax Regulations that may be applicable or under any other general principles of federal income taxation.
The rulings contained in this letter are based upon information and representations submitted by the taxpayer and accompanied by a penalty of perjury statement executed by an appropriate party. While this office has not verified any of the material submitted in support of the request for rulings, it is subject to verification on examination. This ruling is directed only to the taxpayers requesting it. Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.
A copy of this letter must be attached to any income tax return to which it is relevant. We enclose a copy of the letter for this purpose. Also enclosed is a copy of the letter showing the deletions proposed to be made when it is disclosed under § 6110. In accordance with the Power of Attorney on file with this office, a copy of this letter is being sent to your authorized representative.
Michael J. Montemurro
Branch Chief (Income Tax & Accounting)
Start with the price you paid for your property, add any capital improvements, and subtract any depreciation, . This figure is your adjusted basis. Subtract the adjusted basis and the new costs of sale from the new sales price and the remaining figure is your gain.
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.
The build-to-suit exchange (also referred to as a construction or improvement exchange) is a tax deferred exchange in which the Qualified Intermediary acquires fee ownership to the replacement property and makes improvements to it [Treas. Reg. §1.1031 (k)-1(e)]. Once the necessary improvements are completed within the exchange time period (180 days), ownership is then transferred to the Exchanger and the exchange transaction is completed. This exchange variation gives investors more flexibility, thereby providing the opportunity to either improve an existing property or even construct a new replacement property.
An Exchanger should consider a build-to-suit exchange when the aggregate value, debt or equity of the replacement property will not result in complete deferral of the capital gain tax. This situation arises when the purchase of replacement properties results in a decrease in debt or equity. Either exchange proceeds or additional debt can be used to pay for the replacement properties improvements. If additional debt is used for improvements, loan documents should be executed by the Qualified Intermediary.
The regulations require that identification, made no later than the 45th day of the exchange period, specify as much detail...regarding construction of the improvements as is practicable at the time the identification is made [Treas. Reg. §1.1031(k)-1(e)(2)(I).]. Typically, a Qualified Intermediary will request the legal description of the property along with floor plans and specifications for new construction or a complete description of the renovation.
As always, advance planning is essential. Due to the weather, local government permits and approvals, normal construction delays and labor problems, investors can be limited in the amount of improvements which can be constructed within the exchange period. The tax code provides only 180 days from closing on the relinquished property to acquire replacement property and this deadline applies to build-to-suit exchanges as well. However, not all improvements must be completed within the 180 day period. For an Exchanger to receive complete deferral of the capital gains tax, they must receive title to the replacement property which consumed all of the proceeds in the exchange account and has a fair market value of equal (or greater than) the relinquished property.
With the issuance of Revenue Procedure 2000-37 (the "Rev. Proc."), it is now possible for a taxpayer to, in essence, acquire the replacement property and use it, before it has sold the relinquished property. The Rev. Proc. gives the taxpayer the "safe harbor" presumption that its exchange qualifies under §1031, if certain criteria are met.
In a Reverse Exchange the same rules apply. Just like a normal 1031 Exchange, the proceeds from the sale of the Relinquished Property must be used to acquire the Replacement Property. For this to be possible when the Replacement Property will be acquired before the Relinquished Property has even sold requires the Exchanger to be able to produce those funds from another source and use them to purchase the Replacement Property.
This means that the exchanger must loan the LLC formed by the Qualified Intermediary expressly for their Reverse Exchange the amount of proceeds is expected to result from the sale of the Relinquished Property. The exchanger will be repaid from the Proceeds when the Relinquished Property is sold. If the amount of proceeds from the Relinquished Property exceeds the amount loaned to purchase the Replacement Property, the difference could be taxable, unless a delayed exchange is performed with the balance. Another replacement property must be identified and purchased. If you suspect this might happen, it would be wise to spell it all out as to percentages in the Exchange Agreement in the beginning.
Which type of Reverse Exchange utilized depends on whether or not the exchanger will be financing the purchase the Replacement Property in the Exchange. In a Reverse 1031 Exchange requiring financing for the purchase of the Replacement Property, the Exchange First will be utilized.
See Reverse Exchange Timeline below for a “simple” Reverse Exchange in which 1 property will be purchased and 1 sold. For demonstration purposes we will say that both the property being purchased (The Replacement Property) and the property being sold (The Relinquished Property) have a price of $2,000,000.00. Also, the Exchanger in this example currently has a mortgage of $750k on the Relinquished Property.
1) The Exchanger finds and enters into contract to purchase suitable Replacement Property, inserting Exchange Clause into the contract verbiage.
2) Exchanger must calculate the amount of Proceeds they expect to net from the sale of their Relinquished Property and be able to bring those funds, as a loan, to the closing. The loan is to be repaid within 180 days, when the sale of the Relinquished Property closes. In our example the sale price is $2mil, the mortgage is $750,000.00, and let’s say $150,000.00 in costs will be paid by the Exchanger, so the proceeds should be in the neighborhood of $1.1mil. In our example the Exchanger chooses use personal savings as well as take out an equity line on his primary home to generate the $1,100,000.00.
3) The Exchanger makes arrangements for financing as normal (i.e. Exchanger shops around and applies for a mortgage.) In applying for the mortgage the Exchanger in this example will be using the $1.1 mil as a down payment on the Replacement Property.
4) The Exchanger completes “Due Diligence” with regard to the Replacement Property.
5) The Exchanger makes arrangement with Haven Exchange for a Reverse Exchange.
6) Haven Exchange creates the LLC in the same state as the Replacement Property.
7) At closing The LLC does a double escrow; one in which the LLC acquires the replacement property from the seller, and another with the Exchanger wherein the LLC executes a Note borrowing the $1.1mil from the Exchanger in order to acquire the Replacement Property, and simultaneously conveys the Replacement Property to the Exchanger in exchange for the Relinquished Property. This is the escrow to be funded by the exchanger’s new lender.
8) The Relinquished Property is then to be sold within the following 180 days and the Proceeds from that sale are used to pay off the Note owed by the LLC to the Exchanger. This completes the Reverse Exchange. When the Exchanger receives the amount of the Proceeds as loan repayment it is not a taxable occurrence.
In a "safe harbor" so-called Reverse Exchange, the taxpayer locates the property it wants to acquire as its Replacement Property. The taxpayer will first enter into a purchase contract to buy the new property. It will then enter into an Exchange Agreement with the Qualified Intermediary (QI), with an underlying agreement with an Exchange Accommodation Titleholder (or "EAT"), formed by the QI expressly for the reverse exchange and assign the purchase contract to the EAT.
The EAT becomes the contract purchaser for the new property. The taxpayer and the EAT enter into a "Qualified Exchange Accommodation Agreement" in which the EAT agrees that, if the taxpayer (and/or some third-party lender) loans the amount of proceeds expected to result from the sale of the old property to the EAT, the EAT will use the funds to purchase the new property. The EAT will then lease the property to the taxpayer on a ‘net lease’ basis, for a nominal lease payment. Then, when the taxpayer has sold the old property, the EAT will transfer the new property to the taxpayer at the price which the EAT paid for the new property, and in exchange for the old property. When the old property closes, the proceeds are used to repay the sum loaned to the EAT for the purchase of the new property. This completes the taxpayer’s exchange and is not a taxable event, but loan repayment.
The taxpayer has the benefit of getting the immediate use of the new property, without any interruption in its business activities. The taxpayer has the added benefit of selling its old property in a manner which brings the best price. This is the essence of a "safe harbor" Reverse Exchange. The basic criteria are that the taxpayer and the EAT must enter into a written agreement which sets forth their rights and obligations.
After the EAT has taken title to the new property, the taxpayer has to (i) identify the old property ("relinquished property") within 45 days after the EAT has purchased the new property and (ii) sell the old property, and complete the exchange by acquiring the new property ("Replacement Property") within 180 days after the EAT has purchased the new property. There is no requirement that the EAT put up its own money since the purchase of the new property can be financed 100% by the taxpayer and/or its lenders. There is also no requirement that the lease-back be on an "arms-length" arrangement.
If, for some reason, the taxpayer cannot meet either the 45-day or 180-day time limitation, then the presumption of the IRS "safe harbor" is lost. That does not mean, however, the taxpayer cannot get the benefits of tax-deferral using a Reverse Exchange structure.
Where the ‘safe harbor’ presumption is not available, the EAT’s relationship with the taxpayer has to be structured so there is some element of "arms-length", principal-to-principal relationship. Unlike the "safe harbor" structure, the EAT must have enough "at risk" to be deemed, for tax purposes, the taxpayer’s agent. Commonly, in these non-safe harbor situations, the EAT will invest 5%-10% of its own funds to acquire the new property and the agreement will only give the taxpayer an agreed purchase price for a short period of time (12-18 months). Further, the EAT will not have the right to "put" the new property it has acquired to the taxpayer, so if the taxpayer does not exercise its purchase option, the EAT will have to find another way to dispose of the new property. Finally, if the new property will undergo significant modifications between the time the EAT acquires it and the time it is transferred to the taxpayer, the EAT will have to be involved, at least in some capacity, in the construction process.
A typical non-safe harbor transaction is one where a taxpayer wants to purchase an aircraft with certain configuration (engine and/or interior), and the seller of the aircraft will not provide these modifications to the aircraft prior to transfer of title. Similar situations occur where machinery or equipment has to be specialized to meet certain needs (e.g., an offshore oil-drilling rig). Another situation is where the item has to be modified, or built from the ground up, and the person who is responsible for doing the actual construction does not want to have, or cannot have, ownership responsibility or liability (e.g., certain restrictions by governmental agencies, such as the FCC, may prohibit such activities).
In all Reverse Exchanges, the EAT is required to be treated as the taxpayer with respect to the property it holds. This means the EAT must file tax returns to properly report ownership (and capital improvements). It is also advisable for each Reverse Exchange transaction to be structured with a different single-purpose entity ("SPE"), so that any circumstance which adversely affects one property (e.g., a casualty during the retrofitting process), does not affect any other taxpayer, and the property which such other taxpayer is using to complete its separate, unrelated, "reverse" exchange.
Thus, it is critical that the transaction be carefully structured on two levels: First, at the level of the organization and operation of the EAT, and, Second, at the level of the relationship between the taxpayer and the EAT to ensure that either the IRS "safe harbor" requirements are met, or that the EAT is sufficiently "at risk" in the transaction to be deemed a principal, and not the agent of the taxpayer.
Last spring, Milford, Conn., resident Chris Hiza wanted to replace two rental properties he owned with other rental units that he thought would appreciate more in the long term. But instead of selling his two three-family rentals, paying taxes on the gains, and then using what was left to buy the new rentals, he made a 1031 exchange. This transaction allowed him to roll all the proceeds from selling the old properties into buying the new ones -- without taxes being taken out of the gains.
The term "1031" refers to a section of the IRS code that allows real-estate investors to defer taxes on gains from the sale of investment properties as long as they put the money into buying other investment properties of equal or greater value. The seller must identify the property he wants to buy within 45 days of the sale of his existing property and complete the purchase within 180 days. A third-party intermediary normally handles the transaction.
In Mr. Hiza's case, selling the two rentals in West Haven, Conn., without forking over federal and Connecticut state taxes on the sales allowed him to buy four three-family rental homes in a desirable part of New Haven.
"The 1031 exchange was a way to trade up for the longer term and shelter the gains," says Mr. Hiza, 43. "Since we would have had a 24% combined tax rate, this leveraged up our purchase by 24% per property. That's a lot of money."
More real-estate investors are using the 1031 exchange provision to buy and sell investment property, with the majority of sales consisting of one- to four-family rental properties and worth about $500,000 to $700,000, say tax and real-estate experts. But many owners make mistakes that cause the IRS to disqualify the exchange because they don't understand the rules governing these transactions. Mr. Hiza's 1031 exchange was successful because he planned ahead and researched properties he wanted to buy before selling his former units. This allowed him to complete his transaction within the required period.
"Don't get into the 45-day crush," he says. "If you want to do it, start looking now for replacement property, get prequalified for financing and have Realtors, attorneys and intermediaries you can work with."
Here are some of the most common mistakes real-estate investors make when attempting 1031 exchanges, say intermediaries, attorneys and investment advisers.
Assuming they can do a 1031 exchange on a personal residence. While a variety of assets, such as boats or cattle, can qualify for 1031 exchanges, only real estate can be exchanged for real estate, and the only real estate that qualifies for an exchange is investment property. This includes rentals, property used in a business or land held for investment purposes. A building purchased to renovate and sell and land purchased for construction of homes or commercial buildings won't qualify since the owner doesn't intend to hold it for a period of time for investment reasons, says Denis Caron, vice president and Connecticut counsel for LandAmerica Exchange Co., a Richmond, Va.-based qualified intermediary company.
Trying to do an exchange on a property after selling it. "I can't tell you how often I get calls from people who say, 'I sold my property yesterday and want to do an exchange,' " says Mr. Caron, who's based in Cromwell, Conn. "I tell them to call me next time before they sell the property because it's too late now."
Sellers must set up an exchange agreement with a qualified intermediary before they sell their property, he says. Qualified intermediaries are disinterested parties with no current relationship to a taxpayer. This would exclude your current attorney, accountant, financial adviser or agent. The intermediary holds the proceeds from the sale for the taxpayer until the replacement property is acquired.
Not choosing a reputable intermediary. Intermediaries don't need to be licensed or certified, so it's buyer beware when choosing them. In addition to intermediary firms, many title companies and banks now serve as qualified intermediaries. Select an intermediary that's knowledgeable, experienced and trustworthy and will deposit your money in a trust account in a reputable bank, says Bruce D. Savett, principal and founder of Granite Peak Partners Inc., a Santa Barbara, Calif., real-estate adviser and investment company.
John P. Napoli, an attorney with Seyfarth Shaw LLP in New York City, makes sure that intermediaries for his clients set up separate trust accounts for each seller, with the seller named as the beneficiary. He notes that money held by an intermediary is not federally insured unless it is in a bank. "There have been cases where qualified intermediaries have gone bankrupt, and people have lost their money," he says. "You have to go on the reputation of the intermediary."
Not holding an investment property long enough. The IRS isn't specific about how much time you need to hold on to a property received in an exchange before selling it. However, quickly selling a property you bought through a 1031 exchange indicates that you didn't plan to hold it to generate investment income. A good rule of thumb, says Mr. Savett, is to hold a property during two tax years. As an example, a rental bought under a 1031 exchange in May 2004 and held at least until May 2005 would have been owned during two tax years. Mr. Savett encourages all investors considering a 1031 exchange to check with their tax adviser.
Not understanding the 45-day rule for identifying new property to purchase and the 180-day rule for buying it. The 45-day and 180-day periods are the most specific part of the code relating to 1031 exchanges. Sellers have until midnight on the 45th day after they've sold a property to identify up to three properties they may purchase with the proceeds from their sale. They have until midnight on the 180th day after the sale to buy at least one of these new properties.
The typical way to identify a property is to notify your intermediary in writing of the properties you want to acquire. At this point, you don't need to have a contract to buy any of the properties. However, to defer your taxes on your gain, you must be specific about each piece of property you identify and the property you buy must come from this list, says Mr. Caron.
The IRS has questioned taxpayers who haven't been specific enough about the property they want to buy, says Mr. Napoli. "One taxpayer identified 100 acres somewhere and took title to only 75 acres in the exchange," he says. This taxpayer won the subsequent IRS audit about the exchange. However, a taxpayer who only bought 50 of the 100 acres might not have because the property he bought differed so much from what he identified, says Mr Napoli.
Don't assume that the 45 and 180 days are limited to normal business days and exclude weekends. Weekends also are included in the time period, and if the 45th day falls on a Saturday, Sunday or holiday, you must have your paperwork completed by the prior business day or you'll be disqualified.
Only Congress or the IRS can extend these deadlines and have done so in cases of widespread emergency or disaster, says Mr. Caron. "It was done after [Sept. 11, 2001], the hurricanes in Florida and the fires in San Diego county," he says, "but never on a case-by-case basis."
Not giving yourself enough time to research properties to purchase. Many investors don't think through why they want to sell a property and what they want to buy, says Mr. Savett. "In a market where things have gotten expensive, often people sell a property because they think it is a good time," he says, "but they haven't thought enough about what they can buy."
Typically, 45 days isn't enough time for an investor to search out a new property and do the research on it to determine if it's a sound investment, he says. Often they end up designating and buying property that's too expensive, requires too much debt, won't appreciate or doesn't meet their needs.
"Determine what you want to do before you sell, check the current market and determine if your buying assumptions are accurate and, instead of accepting an offer on your property and closing quickly, find a buyer who will let you have a long escrow period or extend the date of the sale so you can look for properties that fit your investment strategy and qualify for the tax savings of a 1031 exchange," Mr. Savett suggests.
"I'd rather take my gain and put it in the bank instead of rolling that gain and buying a bad property," he says. "However, with ample planning, you can have both a quality investments and tax savings."
Mr. Hiza agrees. He started researching his options and knew what properties he hoped to buy before selling his former units. "I made it clear I wasn't going to buy something I didn't want just to make the deadline," he says.
-- Ms. Capell is a senior correspondent for CareerJournal.com.
"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 or cause additional expense 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." and the opposite for the replacement property:
"Seller hereby acknowledges that it is the intent of the Buyer to effect an IRC § 1031 tax deferred exchange which will not delay the closing or cause additional expense to the Seller. The Buyer'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. Seller agrees to cooperate with the Buyer and Haven Exchange, Inc. in a manner necessary to complete the exchange."
Yes, if there are more than two properties involved. If two Exchangers want each others properties a qualified intermediary is not required. If three or more properties are involved, someone either has to go through the chain of title to make the exchange work or a qualified intermediary must prepare the documents required by the IRS to show the trade.
You cannot trade real property for improvements, they are not like-kind. Also, if you own both properties at the same time there can be no trade. Though there have been some recent encouraging court cases, if at all possible do not acquire the replacement property until the improvements have been made. There are ways make the improvements tax deductible -- call for details.
The same entity that relinquishes property must acquire property to qualify for an exchange. If some of the partners simply want cash and do not intend to exchange, they can be cashed out when the sale closes and the partnership can remain intact and acquire property. However, if various partners want to go their separate ways but still want to exchange, then the only real option is for the partnership to deed the appropriate percentages to the various partners, before the sale closes. There is a risk in this, however, in that §1031 is for property HELD for productive use in business, trade or for investment purposes. If the partnership deeds to the individual partners, has the property then been "held" by the individuals? Again, talk with your CPA or tax advisor.
Borrowing or pledging the funds would represent the Exchanger’s control of the money, which would make it taxable and would disqualify the exchange.
Yes, but any interest earned by the Exchanger can only be disbursed upon completion of the exchange. Otherwise the Exchanger would be benefiting from the funds, which would constitute "constructive receipt" of the funds and the Exchange would be spoiled. The Qualified Intermediary will issue a 1099 statement for the tax year during which the interest was actually paid to the Exchanger.
Buy as many as you can afford and can close within the time period. Sell as many as you can provided they can all close within the time periods set by the closing of the first sale.
If you sell a property that you own solely, and your spouse does not have an interest in the old property but does acquire new property with you, the IRS could give you credit for only one-half of the purchase! Depending on the values of the properties involved and whether or not you live in a community property state, this could result in a significant tax bill. It may be advisable to add your spouse to title on the relinquished property prior to opening escrow.
In order to meet the regulations for a tax deferred exchange, the Exchanger's access to the funds MUST be restricted. Regulations require that a proper exchange agreement warrant that the Exchanger will NOT receive any proceeds prior to the 46h day. If the Exchanger fails to identify any replacement property within 45 days he may receive the funds on the 46th day. If the Exchanger identifies property and then fails to acquire it, unless that property has been destroyed, he may receive his funds on the 181st day.
No funds can be disbursed to the Exchanger while held by Qualified Intermediary until the 46th day, if no replacement property has been identified, or if all that was identified has been acquired by the Exchanger. If property was identified but not acquired, unless the identified property has been destroyed, funds cannot be disbursed to the Exchanger until the 181st day.
Vacation homes fall under very strict guidelines to determine if they are actually investment property. If you've rented the property out while you owned it, it may qualified for tax deferral. In addition, if you have not personally used the property, you might be able to convince the IRS it was purely held for investment. Talk with your CPA.
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:
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.
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.
Any agent of the Exchanger's is disqualified by the IRS to act as a qualified intermediary as well as any related party. If in doubt about whether or not someone is an agent or related party, they probably are. If there is a relationship by contract or blood, there is probably a relationship that could disqualify the exchange. See Related Party. With Intermediary fees so reasonable, why risk the possible tax consequences?
The 45-Day Rule for Identification :
The first timing restriction for a delayed Section 1031 exchange is for the taxpayer to either close on Replacement Property or to identify the potential Replacement Property within 45 days from the date of transfer of the exchanged 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 hand-delivered, mailed, faxed, or otherwise sent to the 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.
Restrictions are imposed on the number of Replacement Properties which can be identified as potential Replacement Properties. 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 exchanged 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.
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 exchanged properties as of the initial transfer date.
Although the Regulations only require written notification within 45 days, it is recommended practice for a solid contract to be in place by the end of the 45-day period. Otherwise, a taxpayer may find himself unable to close on any of the properties which are identified under the 45-day letter. After 45 days have expired, it is not possible to close on any other property which was not identified in the 45-day letter. Failure to submit the 45-Day Letter causes the Exchange Agreement to terminate and the Intermediary will disburse all unused funds in his possession to the taxpayer.
Caution: If the exchanger is selling two relinquished properties and buying one larger replacement property, then the timing begins when the first relinquished property closes. The replacement property must be identified as such for BOTH relinquished properties within 45 days from the first relinquished property closed escrow, whether or not the second relinquished property is even sold.
A seller carry-back can be treated as an installment sale or may be deferrable upon certain conditions (call for an in-depth review). The important thing to remember is that the method of handling a carry-back will have important tax ramifications to the Exchanger and the options must be discussed and an action determined BEFORE THE SALE CLOSES.
The cooperation clause is designed to clearly show the Exchanger’s intent to exchange. It is possible to accomplish an exchange by adding this statement after the initial acceptance of the offer, before the sale closes.
Or, to simply have the buyer sign the Assignment of the Purchase Contract prepared by the Qualified Intermediary (which is the extent of cooperation required). Certainly for negotiation purposes, it’s best to get an agreement to cooperate early in the transaction.
Funds can be disbursed to escrow for earnest money for common expenses such as preliminary title reports, appraisals and credit reports when the Qualified Intermediary has been Assigned into the transaction in place of the Exchanger.
Funds must be requested by escrow, not the Exchanger to avoid the issue of the Exchanger’s control of the funds. If the Exchanger advances any of these funds THROUGH ESCROW they can be reimbursed to him at the close of the escrow without triggering any taxes. It is to be noted, however, that loan fees are considered "boot", and if exchange funds are used to pay them, it is a taxable event.