The 1031 Exchange

THE 1031 EXCHANGE EXPLAINED

WHY IS THE 1031 TAX DEFERRED EXCHANGE IMPORTANT TO A REAL ESTATE PROPERTY INVESTOR?

An investor in real estate understands how important it is to preserve wealth and assets. In the frequently changing world of taxation, the investor is fortunate to have IRC Section 1031. This tax code allows the investor to exchange from one investment property to another and defer taxes on the gain. This means that a 1031 Exchange is a rollover of equity of like properties, rather than an avoidance of tax. Thus the investor continues to build wealth through real estate investment, and maintains the hard earned equity. Any tax liability through inheritance will be limited to the gains from the date of the inheritor’s acquisition, not during the years of ownership. So in essence the taxes that are saved now are never paid.

HOW TO GO ABOUT A 1031 EXCHANGE AND GUIDELINES REGARDING THE 1031 EXCHANGE:

• Taxpayer finds a buyer and sells the property through a Qualified Intermediary.

• Taxpayer buys a replacement property through the Intermediary.

• The parties may not know each other and their properties can be in different states.

• The exchange period begins on the day the relinquished property is transferred and ends on the earlier of 180 days thereafter or the due date (including extensions) of the tax return for the taxable year in which the transfer of the relinquished property occurs.

• The taxpayer’s agent, broker, attorney, accountant or family member is excluded as a qualified intermediary.

WITHOUT A PROPERLY EXECUTED 1031 EXCHANGE:

Equity ($120,000) less tax ($14,000) = $106,000 available towards purchase of a new property.

WITH A PROPERLY EXECUTED 1031 EXCHANGE:

If the tax-deferred exchange of the property was properly executed, TAX WILL BE DEFERRED and the investor will have $120,000 to use towards the purchase of another investment property.

The concept of a tax deferred exchange is easy to understand. However, there are many details involved in an exchange that need careful consideration. Before taking steps towards a 1031 tax-deferred exchange, please consult your CPA, attorney, or tax advisor.

Rules to Identify
Replacement Property

What are the identification rules??

Three property Rule-The Exchanger may identify three (3) properties of any value; or

200% Rule-The Exchanger may identify more than three (3) properties if the total fair market value of what is identified does not exceed 200% of the sale price of the relinquished property: or

95%  Rule- If the Exchanger identifies more than three (3) properties and the total value exceeds 200% of the sale price of the relinquished property, to have a successful exchange, the Exchanger must acquire 95% of the fair market value of what was identified.

How is the identification made?

1.      The identification must be made to a party to the exchange (i.e., the Qualified Intermediary)

2.      It must be in writing.

3.      It must be “unambiguous”

4.      It must be signed by the Exchanger.

5.      It must be delivered, mailed, telecopied, or “otherwise sent” within 45 days of the close of the relinquished property.

Please refer to Myth No. l – Like for Like and Myth No. 2 Identification period for more in-depth information regarding identification.

THE 1031 EXCHANGE EXPLAINED

Popular Real Estate
  §1031 Myths

MYTH NO. 1

"A taxpayer must acquire replacement property with an investment property similar in ‘use’ to the investment property relinquished, i.e. apartments for apartments, land for land, offices for offices."

The real fact is the Internal Revenue Service has applied a very flexible interpretation to the "like-kind" requirement defining it as having reference to the nature or character of the property and not its grade or quality. Therefore developed property, of any product type, may be exchanged for a leasehold interest in real estate if there is an excess of 30 years remaining in the lease. Optional renewal periods are treated as part of the leasehold term.

 An exchange of cooperative housing corporation stock for condominium units in the same physical project will qualify where the local law provides that a cooperative housing project with leases in excess of 30 years is tantamount to a condominium. The fact that the parties held the property in different form, i.e., exchange of an interest in property held as a tenant-in-common with property held in fee simple without any co-tenants, will not affect the qualification as a tax deferred exchange.

Real Estate located outside of the United States and real estate located within the United States are not considered to be like-kind property. Therefore, exchanges involving foreign and U. S. real estate do not qualify for non-recognition-of-gain treatment under the like-kind exchange rules. The definition of United States when used in a geographical sense in the Internal Revenue Code includes only the State and the District of Columbia. United States territories such as Guam do not qualify as "like-kind" property. 

MYTH NO. 2

"In a real estate 1031 Exchange, a tax-payer may designate as many properties as he/she wishes as long as a diligent effort is made within the 180 period."

The 1991 regulations published by the Department of Treasury clarified the identification period for the delayed exchange.

The Identification Period: The "Identification period" is a 45-day period beginning on the date the taxpayer transfers the relinquished property. The period ends at midnight of the 45th day.

The Exchange Period: The "exchange period is a 180 day period beginning on the date the taxpayer transfers the relinquished property and ends at midnight on the 180th day. However, if the taxpayer is required to file his return prior to the final day of the exchange period, the date on which the tax-payer is required to file his tax return (giving consideration to extensions) becomes the final day of the "exchange period."

In the situation where the taxpayer, as part of the same exchange, transfers more than one piece of property, the regulations mandate that the time period for the "identification period" and the "exchange period" begin to run with the first transfer. 

Where the identification period or the exchange period ends on a Saturday, Sunday, or legal holiday, the identification period or exchange period is not extended. Acts of God or a natural disaster will not extend these periods or permit other properties to be identified in the event the replacement property(ies) identified is/are destroyed.

Replacement property must be identified "unambiguously in writing signed by the tax-payer and hand delivered, mailed or other-wise sent before the end of the 45-day identification period to a third party (i.e. the qualified intermediary) involved in the exchange other than the taxpayer or a related party."

Replacement properties must be identified as follows: (a) Three properties of any fair market value, or (b) any number of properties as long as their aggregate fair market value (irrespective of net equity) at the end of the identification period does not exceed 200% of the value of the relinquished properties.

The Code provides for two exceptions:

Property actually acquired by the taxpayer within the 45-day identification period is deemed to have met the identification requirement without the requirement for a specific designation notice; and

If more than three properties are identified, and the aggregate fair market value exceeds 200%, the taxpayer must purchase 95% of the property identified. A taxpayer may substitute a property for one previously identified by submitting a letter of revocation and replacement to the third party before the 45th day. For purposes of identification, incidental property is disregarded. Incidental property is considered property normally transferred with a larger property and which as a fair market value of less that 15% of the larger property. The identified property must be substantially the same as the property officially identified. Property under construction must include as much detail as is practicable at the time identification is made. It must be substantially the same property when received as was identified.

MYTH NO. 3

"Once a taxpayer has completed a §1031 Exchange with real estate, the taxpayer does not need to concern himself about the Internal Revenue Service."

When the dreaded annual IRS tax deadline is behind all great American taxpayers, a breath of relief can be taken until the all-to-well-known tax auditor knocks the exchanger’s front door.

In the first Mid-Exchange, "Myths" and "Facts" article published, we mentioned the exchange Period ended on the 180th day. However, if the taxpayer is required to file his return prior to the final day of the the exchange period, the date on which the taxpayer is required to file his tax return (giving consideration to extensions) becomes the final day of the "exchange period." In other words, the fact is any taxpayer with an April 15th return filing deadline who relinquished a property on or before December 31st of the prior year, and who did not acquire a replacement property by the tax return filing deadline of April 15th of the following year, should have filed an extension beyond the 180th day.

If an exchanger met the extension hurdle, all should be well and fine unless and until the much dreaded auditor knocks at the door. If any exchanger utilized the services of a qualified intermediary, there is a higher probability that the exchange transaction will not be scrutinized as closely as if the Qualified Intermediary Safe Harbor did not apply. However, the following audit issues are usually raised by an examining agent:

1. Are the properties like-kind? Form 8824 specifically asks for descriptions of the relinquished property and the replacement property.

2. Is the replacement property held for investment or productive use in a trade or business? Form 8824 further asks if the replacement property was sold or disposed of during the taxable year.

3. Was the exchange with a related party under §1031?

4. Was the exchange a deferred exchange? If so, was the identification period requirement and the exchange period requirement satisfied?

5. Was the amount of gain reported properly calculated?

6. Was any nontaxable boot received in the exchange?

7. Was the basis of the replacement property properly calculated?

Form 8824 and common practices suggest several routine issues will be part of an exchange audit. Deferred exchanges will be examined for compliance with the regulations, closing statements will be examined to ensure that gain is properly calculated, actual use of the relinquished and replacement property may be examined to ensure that properties are not held primarily for sale, properties are like-kind, and properties are held for productive use in a trade or business or held for investment and there is not personal use. Where partnerships are concerned, a transaction will be scrutinized more carefully.

Recent case law gives guidance for examination by the Service. In the simultaneous and deferred exchange scenario, the Service has been unsuccessful in raising the issue of substantial implementation of an exchange unless a sale has actually closed before an exchange by converting a purchase into a §1031 exchange, the Service has successfully raised the issue of substantial implementation of a sale.

Questions and Answers

Q. What property qualifies for a 1031 Exchange?
A. Relinquished and replacement properties must be property held for investment.

Q. How long do you have to find a replacement property?*
A. Identification must be received within 45 days of the close of the relinquished property.

Q. When must the replacement property close?*
A. The replacement property must close 180 days from the close of the relinquished property or the date the Exchanger must file their tax return (including extensions) whichever occurs first.
* There are no extensions for Saturdays, Sundays, or Holidays.

Q. Who controls the proceeds?
A. The proceeds must be held  and controlled by a Qualified Intermediary NOT by an agent, escrow, or related party which includes relatives.

Q. What is boot?
A. Any time there is excess money or unmatched property coming from the relinquished property there will be a taxable event.

Q. What is adjusted basis?
A. Generally it is determined by taking the sales price when acquired cost of capital improvement less depreciation (check with your CPA basis may not be the sale price).