1031 Exchange Alliance.com

What is a 1031 tax-deferred exchange?

Under Internal Revenue Code (IRC) Section 1031, a real property owner can sell his property and then reinvest the proceeds in ownership of like-kind property and defer the capital gains taxes. To qualify as a like-kind exchange, property exchanges must be done in accordance with the rules set forth in the tax code and in the treasury regulations. The 1031 exchange can offer significant tax advantages to real estate buyers. Often overlooked, a 1031 exchange is considered one of the best-kept secrets in the Internal Revenue Code.

In a typical transaction, the property owner is taxed on any gain realized from the sale. However, through a Section 1031 Exchange, the tax on the gain is deferred until some future date.

Section 1031 of the Internal Revenue Code 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. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of “like-kind”, while deferring the payment of federal income taxes and some state taxes on the transaction.

The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer’s investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a “paper” gain.

The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.

What are the benefits of exchanging vs. selling?

A Section 1031 exchange is one of the few techniques available to postpone or potentially eliminate taxes due on the sale of qualifying properties. By deferring the tax, you have more available money to invest in another property. In effect, you receive an interest free loan from the federal government, in the amount you would have paid in taxes. Any gain from depreciation recapture is postponed. You can acquire and dispose of properties to reallocate your investment portfolio without paying on any gain.

What does “like-kind” mean?

In a 1031 Like-Kind exchange you can exchange any real property for any other real property within the United States or its possessions if said properties are held for productive use in trade or business or for investment purposes. Examples of 1031 like-kind exchange property include apartments, commercial, condos, duplexes, raw land and rental homes*. As used in IRC 1031(a), the words “like-kind” mean similar in nature or character, notwithstanding differences in grade or quality. One kind of class of property may not, under that section, be exchanged for property of a different kind or class. Examples of qualified 1031 like-kind properties and like-kind exchanges:

           • apartment building for farm/ranch

           • office building for hotel

           • raw land for retail space

           • unimproved property for commercial property

           • airplane for airplane

Examples of non like-kind properties include primary residences, stocks and bonds, notes, partnership interests, developed lots held primarily for sale and property to be resold immediately after initial purchase or completion of improvements. * Qualification for Section 1031 exchanges depends upon the extent of personal use.

Replacement property identification Criteria

3-property rule: You may identify any three properties as possible replacements for your relinquished property. More than 95% of exchanges use the 3-property rule.

200% rule: You may identify any number of properties as possible replacements for your relinquished property as long as the aggregate value of those properties does not exceed 200% of the value of your relinquished property.

95% exemption: You may identify any number of properties as possible replacements for your relinquished property as long as you end up purchasing at least 95% of the aggregate value of all properties identified

The role of the Qualified Intermediary (QI)

The QI is a 1031 exchange Intermediary or entity that can legally hold funds to facilitate a 1031 exchange. To be qualified, the 1031 exchange intermediary must not be relative or agent of the exchanging party. As an exception, a real estate agent may serve as a 1031 exchange intermediary if the current transaction is the only instance in which the agent has represented the exchanging party over the past two years.

The use of a Qualified 1031 Exchange Intermediary is essential to completing a successful 1031 exchange process. The QI performs several important functions in the 1031 exchange process including creating the exchange of properties, holding the 1031 exchange proceeds and preparing the legal documents.

1031 Timeline

Identification Period: Within 45 days of selling the relinquished property you must identify suitable replacement properties. This 45 day rule is very strict and is not extended should the 45th day fall on a Saturday, Sunday, or legal holiday.

Exchange Period: The replacement property must be received by the taxpayer within the “exchange period,” which ends within the earlier of . . . 180 days after the date on which the taxpayer transfers the property relinquished, or . . . the due date for the taxpayer tax return for the taxable year in which the transfer of the relinquished property occurs. This 180-day rule is very strict and is not extended if the 180th day should happen to fall on a Saturday, Sunday or legal holiday.

What are the 1031 exchange rules?

The real property you sell and the real property you buy must both be held for productive use in a trade or business or for investment purposes and must be like-kind.

The proceeds from the sale must go through the hands of a qualified intermediary and not through your hands or the hands of one of your agents or else all the proceeds will become taxable.

All the cash proceeds from the original sale must be reinvested in the replacement property - any cash proceeds that you retain will be taxable. The replacement property must be subject to an equal level or greater level of debt than the relinquished property or the buyer will either have to pay taxes on the amount of the decrease or have to put in additional cash funds to offset the lower level of debt in the replacement property.

Who should consider a 1031 exchange?

If you have real property that will net you a gain upon sale (generally property that has been substantially depreciated for tax purposes and/or has appreciated in fair market value), then you are exactly the person who should consider a 1031 exchange.

There are 5 tax classes of property:

         1) Property used in taxpayers trade or business.

         2) Property held primarily for sale to customers.

         3) Property which is used as your principal residence.

         4) Property held for investment.

         5) Property used as a vacation home.

Section 1031 applies to the first and fourth categories, and potentially the fifth category. Business use is defined as, “To hold property for productive use in trade or business.” Property retired from previous productive use in business can be qualifying property. Investment purpose defined as real estate, even if unproductive, held by a non-dealer for future use or increment in value is held for investment and not primarily for sale. Investment is the passive holding of property, for more than a temporary period, with the expectation that it will appreciate. Property held for sale in the immediate future is not held for investment.

I have a home office. Can I deduct expenses like mortgage, utilities, etc., but not deduct depreciation so that when I sell this house, the basis won’t be affected?

f you qualify to deduct expenses for the business use of your home, you can claim depreciation for the part of your home that is a home office. Generally, the part of your home that is a home office is depreciated over a recovery period of 39 years using the straight line method of depreciation and a mid-month convention. If you do not claim depreciation on that part of your home that is a home office, you are still required to reduce the basis of your home for the allowable depreciation of that part of your home that is a home office when reporting the sale of your home. For more information, refer to Publication 587, Business Use of Your Home.

Can You Explain How the IRS looks at my Basis?

If you buy real property, certain fees and other expenses become part of your cost basis in the property.

Real estate taxes. If you pay real estate taxes the seller owed on real property you bought, and the seller did not reimburse you, treat those taxes as part of your basis. You cannot deduct them as taxes.If you reimburse the seller for taxes the seller paid for you, you can usually deduct that amount as an expense in the year of purchase. Do not include that amount in the basis of the property. If you did not reimburse the seller, you must reduce your basis by the amount of those taxes. Settlement costs. You can include in the basis of property you buy the settlement fees and closing costs for buying the property. You cannot include fees and costs for getting a loan on the property. (A fee for buying property is a cost that must be paid even if you bought the property for cash.)The following items are some of the settlement fees or closing costs you can include in the basis of your property.

         Abstract fees (abstract of title fees).

         Charges for installing utility services.

         Legal fees (including title search and preparation of the sales contract and deed).

         Recording fees.

         Surveys.

         Transfer taxes.

         Owner’s title insurance.

         Any amounts the seller owes that you agree to pay, such as back taxes or interest, recording or mortgage fees, charges for improvements or repairs, and sales commissions.

         Settlement costs do not include amounts placed in escrow for the future payment of items such as taxes and insurance.

The following items are some settlement fees and closing costs you cannot include in the basis of the property.

         Fire insurance premiums.

         Rent for occupancy of the property before closing.

         Charges for utilities or other services related to occupancy of the property before closing.

         Charges connected with getting a loan. The following are examples of these charges.

         Points (discount points, loan origination fees).

         Mortgage insurance premiums.

         Loan assumption fees.

         Cost of a credit report.

         Fees for an appraisal required by a lender.

         Fees for refinancing a mortgage.

If these costs relate to business property, items (1) through (3) are deductible as business expenses. Items (4) and (5) must be capitalized as costs of getting a loan and can be deducted over the period of the loan.

Points. If you pay points to obtain a loan (including a mortgage, second mortgage, line of credit, or a home equity loan), do not add the points to the basis of the related property. Generally, you deduct the points over the term of the loan. For more information on how to deduct points, see Points in chapter 5 of Publication 535.

Points on home mortgage. Special rules may apply to points you and the seller pay when you obtain a mortgage to purchase your main home. If certain requirements are met, you can deduct the points in full for the year in which they are paid. Reduce the basis of your home by any seller-paid points. For more information, see Points in Publication 936, Home Mortgage Interest Deduction.

Assumption of mortgage. If you buy property and assume (or buy subject to) an existing mortgage on the property, your basis includes the amount you pay for the property plus the amount to be paid on the mortgage.

What is a “Starker”? or Why is a 1031 Called a Starker?

A term used to describe delayed, non-simultaneous, exchanges. Starker vs. United States (1979) established the delayed exchange concept.

What is the definition of “Boot”?

Cash or mortgage relief received in an exchange, the result of which is a taxable gain.

Is there an extension allowed to either the 45-day period or the 180 period?

The IRS does not allow extensions for either the 45-day period or the 180-day period.

If the exchangor’s 45th or 180th day falls on a weekend or holiday do I get the benefit of the following business day? No. The IRS calculates this timeline based on calendar days. There are no extensions given.

Why can’t I simply instruct my escrow officer to hold the proceeds from the sale of the property I am selling in escrow until I instruct them to acquire the replacement property?

This creates several critical problems for the exchange: First, since the taxpayer has the right to change the escrow instructions and withdraw the proceeds, he or she will be considered in constructive receipt of the proceeds. Similarly, in an escrow context, the taxpayer is a principal and the escrow officer is legally deemed to be an agent of the taxpayer. Consequently, sales proceeds received by the escrow officer are deemed to have been received by the taxpayer as well, even if the taxpayer relinquishes the power to give escrow instructions.

May my CPA, Attorney, Real Estate Agent, or other advisor act as my QI?

Generally Not. A QI may not be an agent of the taxpayer. The IRS precludes any person or entity from acting as an intermediary if he or she has performed any non-exchange related business service for the taxpayer within two years from the date of transfer of the relinquished property.

Do I have to reinvest ALL of my cash/equity?

No. However, any cash (equity) that is not reinvested in real estate will be taxable (and is known as cash boot).

Can I purchase my replacement property first?

Yes; this requires that you do a reverse exchange however. The reverse exchange ‘may’ be an option provided you have the ability to structure the reverse exchange according to the safe harbor guidelines.

How long do I have to own my property before I can exchange it?

The longer the better. Unfortunately, there is no safe holding period for property to automatically qualify for an exchange. Keep in mind, the property only need to be “held for investment” for it to be eligible for an exchange. Time of ownership is ONLY one factor at which the IRS looks at when determining if the property was “held for investment”. In one private letter ruling (PLR 8429039), the IRS stated that a minimum holding period of two years would be sufficient. Although a private letter ruling does not establish legal precedent for all investors, there are many advisors who believe two years is a conservative holding period, provided no other significant factors contradict the investment intent.

Other advisors recommend that Exchangers hold property for a minimum of at least twelve months. The reason for this is twofold: (1) A holding period of 12 or more months means the investor will usually reflect it as an investment property in two tax filing years. (2) In 1989, Congress had proposed a one year holding period for both the relinquished and replacement properties. Although this proposal was never incorporated into the tax code, some believe it represents a reasonable minimum guideline.