1. What is an IRC §1031
Tax Deferred Exchange?
2. What are the requirements for a valid exchange?
3. What are the time restrictions on completing a
Section 1031 exchange?
4. Is there any limit to the number of properties
that can be identified?
5. What is the primary role of the Qualified Intermediary
(QI)?
6. Why do the proceeds from the sale go to the QI?
7. How complex is the exchange process?
8. Can a Taxpayer exchange relinquished property
into a new primary residence?
9. Can an Exchanger rent the replacement property
to a related party?
10. Can an Exchanger exchange into vacant land and
build a house?
11. Can an Exchanger buy the replacement property
first and then sell the relinquished property?
12. Are there any other requirements involved in
conducting a 1031 Exchange?
13. What is "boot"?
1.
What is an IRC §1031 Tax Deferred Exchange?
A 1031 tax deferred exchange is an investment tool where the taxpayer
transfers property held either for productive use in a trade or
business or for investment purposes and subsequently receives
another property to be held either for productive use in a trade
or business or for investment without recognizing any gain or
loss. This investment tool allows the taxpayer to protect, grow,
and diversify their assets by permitting them to sell qualifying
property, reinvest the proceeds in new qualifying property, and
defer all capital gains tax due at the time of sale.
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2.
What are the requirements for a valid exchange?
Qualifying Property – Property that has been or will
be held for income production (rental), investment or used in
a trade or business. Types of property that do not qualify for
a 1031 exchange are: stocks, bonds, partnership or LLC interests,
personal residences and stock in trade or inventory.
Proper Purpose/Qualified Use – Both
the relinquished (old) property and the replacement (new) property
must be used for productive use in a trade or business or for
investment. Property acquired for immediate resale does not qualify
for 1031 treatment.
Like Kind – Assuming the property
satisfies the qualified use test, then the property must satisfy
the “like kind” test. Real property is “like kind”
to real property. Among the types of real property that are eligible
for 1031 treatment are raw land, single-family homes, hotels,
multifamily dwellings, factories, commercial office buildings,
shopping centers, farmland, leases of 30 years or more, quarries,
and oil fields. Basically, any type of real estate may be traded
for another type of real estate as long as it satisfies the qualified
use test. “Like kind” rules for personal property are
more restrictive.
Exchange Requirement – The relinquished
(old) property must be exchanged for other property, rather than
sold for cash and the proceeds used to buy the replacement property.
Most people use Qualified Intermediaries (QI) to facilitate their
exchanges.
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3.
What are the time restrictions on completing a Section 1031 exchange?
A taxpayer has 45 days after the date that the relinquished property
closes to properly identify potential replacement properties.
The exchange must be completed within 180 days after the transfer
of the relinquished property, or the due date of the taxpayer's
federal tax return for the year in which the relinquished property
was transferred, whichever is earlier.
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4.
Is there any limit to the number of properties that can be identified?
Yes. There are three rules that limit the number of properties
that can be identified, of which the taxpayer must meet the requirements
of at least one.
The Three-Property Rule
Rule: The Exchanger may identify up to three properties
regardless of their fair market value. The Exchanger is not obligated
to purchase all three properties but must purchase at least one
of the three identified property.
Example: if selling a relinquished property for $100,000,
three replacement properties can be identified with a combined
fair market value in excess of $300,000.
The 200% Rule
Rule: The Exchanger may identify more than three properties
as long as the aggregate of the fair market value does not exceed
double (200%) of the gross sale price of the relinquished property.
Example: if a relinquished property was sold for $250,000
and four or more replacement properties are identified, their
combined fair market value cannot exceed $500,000 (200% or double
the sale price of the relinquished property.)
95% Value Rule
Rule: Any number of properties may be identified provided
that the Exchanger purchases 95% of the fair market value of the
all identified properties.
Example: If a relinquished property was sold for $100,000
and four or more replacement properties are identified with combined
fair market value of $750,000. The Exchanger must purchase at
least 95% of the fair market value of the identified properties.
This means you must purchase all the properties identified.
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5.
What is the primary role of the Qualified Intermediary (QI)?
For the proceeds of an exchange to remain tax-free, the Exchanger
cannot have constructive receipt, use of, or access to the funds
from the relinquished property at any point during the exchange
process. To guarantee this, a Qualified Intermediary, under written
agreement, acquires the relinquished property and transfers it
to the buyer. The QI then holds the sale proceeds to prevent the
Exchanger from having actual or constructive receipt of the funds.
Finally, the QI acquires the replacement property and transfers
it to the Exchanger to complete the exchange within the appropriate
time limits.
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6.
Why do the proceeds from the sale go to the QI?
The use of the QI is a safe harbor established by the IRS in order
to avoid taxable receipt of funds. The QI must be an independent
entity that is not a Disqualified Person or an agent of the Exchanger
for purposes of a 1031 exchange. A Disqualified Person may be
the actual Exchanger or the Exchanger’s accountant, attorney,
real estate professional, financial planner, employees, partners
or close relative.
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7.
How complex is the exchange process?
Entering into a 1031 exchange with an experienced qualified intermediary,
such as 1031ae couldn't be easier. Simply contact 1031ae and our
exchange consultants will walk you through the process. We will
prepare all necessary documentation and coordinate with your closing
agent. All you need to do is continue conducting your own investigations
and negotiations for purchasing your replacement property. The
experienced staff at 1031ae will contact the closing agent to
ensure that the closing complies with the requirements of the
Code and Regulations.
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8.
Can a Taxpayer exchange relinquished property into a new primary
residence?
No. The law is very clear that a tax-deferred exchange involves
investment real estate (see question 2) being exchanged for other
investment real estate. However, people sometimes change their
minds and occupy properties they had originally intended only
for rental purposes. If a Taxpayer eventually occupies the replacement
property, it is important that they be able to show the investment
intent at the time the exchange was conducted. This is an area
that Taxpayers should discuss with their own tax advisor.
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9.
Can an Exchanger rent the replacement property to a related party?
Yes. However, the rent must be fair market rent for the property.
Moreover, all the rental payments must be documented and reported
on the tax return as income. Otherwise, the IRS may rule that
the property is merely a second home, which does not qualify for
a tax-deferred exchange
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10.
Can an Exchanger exchange into vacant land and build a house?
Yes. However, most Exchangers want the replacement property to
include the value of the newly built house rather than just the
value of the land. This can pose timing problems because of the
180-day requirement to close on the replacement. Therefore, it
requires advance planning. For additional information, visit Construction
Exchange under Exchange Strategies.
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11.
Can an Exchanger buy the replacement property first and then sell
the relinquished property?
Yes, but only through a reverse exchange. Reverse exchanges occur
when the Exchanger wants to acquire replacement property before
the relinquished property sells. The IRS issued Revenue Procedure
2000-37 that governs how reverse exchanges are to be transacted
in order to minimize tax risks.
While more complex than delayed exchanges, reverse exchanges are
transacted quite frequently today in our ever-changing economy.
It is not unusual to find the desirable replacement property before
selling the relinquished property. It even seems to be a more
secure method to insure the successful completion of a tax-deferred
exchange.
Additional planning is required when an Exchanger is contemplating
a reverse exchange and typically their tax advisor will be involved
with structuring the transaction. Because there are several ways
a reverse exchange may be structured, additional planning is required.
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12.
Are there any other requirements involved in conducting a 1031
Exchange?
Yes. The general rule of thumb in order to defer all taxable gain:
• The value of the replacement property must be equal to
or greater than the value of the relinquished property.
• All the net proceeds from the sale of the relinquished
property must be used to acquire the replacement property.
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13.
What is "boot"?
Boot is defined as any non-like kind property received by the
Exchanger in the exchange and is taxable. Receiving cash or other
boot in an exchange does not terminate the exchange. If, in addition
to the replacement property, the Exchanger receives money or some
other kind of boot, the Exchanger may have taxable gain. The good
news is that the Exchanger is only taxed on gain that comes from
the money and other boot received.
Cash Boot:
Cash Boot consists of any funds received by the Exchanger, either
actually or constructively. If an Exchanger does not spend all
of the proceeds from the sale of the relinquished property, he/she
will have actual receipt of the balance not spent and pay taxes
on that amount.
Mortgage Boot or Debt Relief:
Mortgage Boot occurs when the Exchanger does not acquire debt
that is equal to or greater than the debt that was paid off; therefore,
they were relieved of debt. If the Exchanger does not acquire
equal or greater debt on the replacement property, they are considered
to be relieved of debt, which is perceived as taking a monetary
benefit out of the exchange. Therefore, the debt relief portion
is taxable, unless it is offset by adding equivalent cash to the
transaction. Thus, an Exchanger must buy of equal or greater value
while spending the net (after costs) equity. It is absolutely
acceptable to take cash out of the exchange and pay taxes on that
amount only.
**IMPORTANT: If the Exchanger wants cash
out of the exchange, the Intermediary must be notified immediately.
The cash out must come directly out of the closing of sale of
the old property and not from the Qualified Intermediary. Once
the exchange proceeds are in the Qualified Intermediary’s
account, the Exchanger cannot access the funds until the end of
the exchange.
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