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1031 Exchange Information
courtesy of TVPX
1. What is a 1031 Exchange?
2. What type of property qualifies?
3. What are the advantages of Exchanging vs. Selling
4. What are the disadvantages of Exchanging vs. selling property?
5. What are the misconceptions about Exchanging?
6. What are the risks?
7. 1031 Exchange Timeline
8. Do's and Don'ts
Glossary
Other Considerations
1. What is a 1031 Exchange?
1031, of the Internal Revenue Code of 1986, as amended, offers real estate investors one of the last great investment opportunities to build wealth and save taxes. By completing an exchange, the investor (Exchanger) can dispose of their investment property, use all of the equity to acquire replacement investment property, defer the capital gain tax that would ordinarily be paid, and leverage all of their equity into the replacement property. The Internal Revenue Code Section 1031 provides that no gain or loss will be recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of like kind that is to be held either for productive use in a trade or business or for investment. 1031 Exchanges are not really exchanges in the context of two-party barter. Instead, they are typical sales and purchases that involve the same exact ingredients as any other sale or purchase, without the capital gains. The only real difference is the investor is increasing his selling and buying power by electing to avoid the drain of taxes under Section 1031 regulations. No other aspects of the transaction are affected. In general terms, the replacement property will be deemed to be of a "like kind" if it is the same general type of property as the relinquished property. All types of real property are like kind to each other. The 1031 Exchange is very popular with real estate investors as it allows them to maximize their potential gains, while shielding those gains from high capital gains taxes. Investors can accomplish virtually any investment objective with exchanges including greater leverage, diversification, and freedom from joint ownership, improved cash flow, and geographic relocation and/or property consolidation. However, the 1031 Exchange process is quite complicated, and it is recommended that a professional or firm provides guidance or advice on the transaction(s) in question.
2. What type of property qualifies?
There are some basic requirements for exchanges including what type of property qualifies. Both properties in the Exchange must be "Like Kind." Like-kind simply means real property. Like-kind refers to the nature or character, not its grade or quality. Like-kind is a very broad and liberal category where just about any type of investment of business use property would qualify. Properties can be located anywhere within the United States with Exchanges taking place in one or more states. Examples of like-kind include: rental properties (single family homes, duplexes, triplexes, apartment buildings and complexes, etc.) raw land, office buildings, shopping centers and businesses. Some examples of non like-kind: stocks, bonds, notes, interest in a partnership, personal property or certificates of trust.
Both properties must be held for investment or business use. Your use of both the relinquished property and replacement property must be investment or business use; each for a minimum of one to two years. Properties must not be used for personal use for more than 14 days per year or 10% of the actual number of days the property has been rented in a given year. Replacement property cannot be purchased with the intent to sell immediately.
Any property held for productive use in a trade or business or property held for investment purposes can be exchanged for any like-kind property; property may be real property such as an apartment building, raw land, single family rental, shopping center, or leasehold interest. A shopping center may be exchanged for an apartment building or an apartment building may be exchanged for raw land; furthermore, one property can be sold and three properties acquired; or four properties can be sold and one acquired.
To qualify for a tax deferred exchange under IRC 1031 both the relinquished and the replacement properties must be held by the Exchanger for investment purposes or for "productive use in their trade or business." The Exchanger's purpose and intent in holding the property, rather than the type of property, is the critical issue. The use of the property by the other parties to the exchange (buyer and/or seller) is irrelevant.
It is important to note that the intent by the Exchanger to hold the property for personal use will prevent the property from qualifying for exchange treatment. Therefore, second homes will not qualify for tax deferred exchange treatment unless the taxpayer 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 rental property. However, the taxpayer cannot just simply rent the taxpayer's residence and expect it to automatically qualify for exchange treatment. Many taxpayers own vacation homes, which are rented out during the time when the taxpayer is not using the home. Even though under IRC 280A a vacation home may have a portion of its deductions disallowed if it is used for personal purposes under the "14-day rule," an Exchanger can argue that if the vacation home is partially used in a trade or business (renting it), the vacation home should be eligible for tax deferred exchange treatment upon it sale. However, there may need to be a bifurcation of uses as is also required for a home office use in a personal residence.
3. What are the advantages of Exchanging vs. Selling
The benefits of IRC Section 1031 exchanges can be tremendous! Investors are often able to defer thousands of dollars in capital gain taxes, both at federal and state levels. If the requirements of a valid 1031 exchange are met, capital gain recognition will be deferred until the taxpayer chooses to recognize it. This essentially results in a long-term, interest-free loan from the IRS.
There are many advantages to Exchanging versus selling. First of all, the Exchanger will have more buying power because the federal income taxes are deferred. This will enable him to leverage himself up greater than he could have, had he paid the tax liability. The additional equity to reinvest will make him a more solid buyer and help him get easier financing.
Second, investors can do exchange after exchange to create a pyramiding effect. This tax liability is forgiven upon the death of the investor as the heirs get a stepped up basis on the inherited property.
Third, the Exchanger will have greater selling power because he does not have to inflate the sales price to try to cover some of the capital gains that would normally be due upon the sale of an investment property. It will enable him to be more flexible with the selling price.
Fourth, the Exchanger can acquire a replacement property with greater income potential. He can sell raw land and acquire income-producing property. Perhaps, he wants to acquire a building with additional units or in an easier to rent location.
Lastly, the Exchanger has the opportunity to consolidate several hard to manage properties in one east to manage property or diversify several small properties into one large property. It provides an excellent opportunity to relocate or expand a current business or investment. An exchange can also help an investor acquire a less management intense property.
Besides tax reduction, 1031 Exchanges can accomplish many investment goals. Estate preservation increased buying power because of greater cash flow, increased selling power because the federal capital gain tax liability is deferred.
Defer paying capital gains taxes. Leverage. Aproperly structured exchange can provide real estate investors with the opportunity to defer all of their capital gains taxes. By exchanging, the investor essentially receives an interest-free, no-term loan from the government. Relief from property management. The lessee takes the responsibility to sublet and maintain the property allowing real estate buyers to avoid most of the day-to-day management headaches. Upgrade or consolidate property. Diversify. Own multiple properties rather than just one. Relocation to a new area. Differences in regional growth or income potential. Change property types among residential, commercial, retail, etc.
4. What are the disadvantages of Exchanging vs. selling property?
You will have a slightly lower depreciation schedule when you acquire your new properties, because the IRS will look at your new tax basis as being the same as your previous one, minus your deferred gain. With an exchange there are additional costs including intermediary fees, counsel of your accountant and/or attorney and tax preparation fees. Also, there is a reduced tax basis in the replacement property. Unforgiving time requirements in both the 45-day identification and 180-day exchange periods also provide for a disadvantage of the Exchange. Lastly, there is limited access to the use of the property's equity. The Disadvantages of a Section 1031 Exchange also include a reduced basis for depreciation in the replacement property. The tax basis of replacement property is essentially the purchase price of the replacement property minus the gain, which was deferred on the sale of the relinquished property as a result of the exchange. The replacement property thus includes a deferred gain that will be taxed in the future if the taxpayer cashes out of his investment.
5. What are the misconceptions about Exchanging?
Some of the common misconceptions that have clouded the many benefits of Section 1031 are as follows:
A 1031 exchange is just like what a repeat homeowner does under the Section 1034 rollover.
Although there are many similarities, such as the ability to defer gain, 1031 exchange regulations are more structured. 1031 exchanges must be completed within a 180-day exchange period as opposed to the two year period under the 1034 rollover. Unlike a 1034 rollover, a taxpayer must use a qualified intermediary to facilitate his 1031 exchange.
Both properties must be "like-kind". The regulations are extremely user-friendly, enabling a taxpayer to exchange any type of real property for any type of real property. For example, an investor may sell raw land and acquire a multi-unit apartment building or he may sell two single family homes (used as rentals) and acquire an office building. You can sell more than one property and acquire more than one property. Some examples of "like-kind" property are rental properties (single family home, duplexes, and triplexes, multi-units), office buildings, raw land, motels, farms, marinas, parking garages, storage facilities, warehouses, factories and interests in a co-tenancy. Examples of non-like-kind are primary residences, second or vacation homes, stocks, bonds, notes and partnership interests.
I need to find someone to swap properties. Fortunately, this has not been the case in many years. Although they are several rules attached, an exchange is much like a typical sale and purchase transaction but without the capital gain. 1031 exchanges only work for big investors. The truth is that anyone who owns investment property should consider a 1031 exchange before selling. Regardless of whether you are selling a duplex or a shopping center, you have the option of simply paying the gain and throwing away your hard earned money or affecting an exchange and preserving your estate. All investors should consult a tax adviser with knowledge on 1031 exchanges to determine the best tax strategy for their particular needs.
6. What are the risks?
Often, the most difficult part of completing a 1031 exchange is identifying a desirable replacement property within the 45 day identification period. In recent years, a new and innovative approach has appeared which makes it much easier for investors to find quality replacement properties within 45 days by buying a partial ownership of a larger property along with other investors as Tenants In Common (TIC).
7. 1031 Exchange 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.
8. Do's and Don'ts
DO advanced planning for the exchange. Talk to your accountant, attorney, broker, lender and Qualified Intermediary.
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 Qualified Intermediaries will not act on backdated 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 fond for the relinquished property. If this situation occurs, a reverse exchange (buying before selling) may be necessary. While the IRS has recently provided guidance for reverse exchanges in Revenue Procedure 2000-37, Exchangers should be aware that reverse exchanges are considered amore aggressive exchange variation because some other entity must hold title to either the Exchanger's relinquished or replacement property for up to 180 days pending the completion of the exchange transaction.
DO NOT dissolves partnerships or changes the manner of holding title during the exchange. A change in the Exchanger's legal relationship with the property may jeopardize the exchange.
GLOSSARY
180 Days Total time allotted to acquire the Replacement Property. Must be one of the properties designated in the Identification period.
Accommodator : Another name for the intermediary.
Addendum: Textual matter that is added to a supplement document.
Allocation: The distribution of sales price among various classes of assets.
Amendment: A change or additions to a legal document which, when properly signed, has the same legal power as the original document.
Annuity: A contract sold by an insurance company designed to provide payments to the holder at specified intervals, usually after retirement.
Assets: The entire property of all sorts, belonging to a person, a corporation, or an estate; as, the assets of a merchant or a trading association.
Audit: An examination and verification of a company's financial and accounting records and supporting documents by a professional, such as a Certified Public Accountant.
Basis Purchase price, including commissions and other expenses: used to determine capital gains and capital losses for tax purposes.
Boot Cash: received by the seller, or the other property not of a like-kind to the relinquished property.
Built-in gain: Excess of market value over the depreciation cost of property transferred to a new entity, or when a C Corporation converts to an S Corporation.
Capital gain: The amount by which an asset's selling price exceeds its initial purchase price less depreciation.
C Corporation: A business which is taxed separately from its owners, unlike a partnership.
Deed : A written and signed document which sets out the things that have to be done or recognition of the parties towards a certain object.
Deferred: To put off; to postpone to a future time.
Depreciation: An allocation of purchase price over a future period of time.
Direct Deeding: Commonly used to pass property directly from exchangor to Buyer and then from Seller to Exchanger. The Facilitator receives an equitable interest in the property.
Estate: All assets owned by an individual at death, to be distributed according to the individual's will (or a court ruling if there is no will) Employee stock ownership plan (ESOP) A trust established by a corporation for the allocation of some of its stock to its employees over time, intended to motivate employees, and often providing tax benefits to the company. Also called stock option plan or stock purchase plan Exchange The offering of one property for another.
Exchangor: The client or taxpayer that takes advantage of the exchange process to defer paying gains taxes.
Exchange Period: The taxpayer must close on the replacement property within 180 days after the transfer of the relinquished property.
Gift tax: A graduated tax assessed against a person who gives money or an asset to another person without receiving fair compensation.
Identification: Within 45 days after the relinquished property is exchanged. Property must be identified in writing typically to the facilitator.
Intermediary: A third party who facilitates an exchange of property.
Liabilities: That which one is under obligation to pay, or for which one is liable.
Like Kind: Property that is held for productive use in a trade or business.
Limited Liability Company (LLC) : A type of company authorized only in certain states, whose owners and managers receive the limited liability of a corporation and (usually) the tax benefits of a partnership.
Limited Partnership: A business organization with one or more general partners, who manage the business and assume legal debts and obligations, and one or more limited partners, who do not participate in day-to-day operations and are liable only to the extent of their investments.
Net Leased: In recent years, more and more investors are becoming familiar with the ease of owning commercial properties that are occupied by National Tenants who are often credit rated. The tenant is obligated under this form of lease to pay for all expenses associated with the operation of the property including property taxes, maintenance, insurance etc. The investor can be assured of a management free property with a minimum of risk. Typical companies such as WalGreens, Wal-Mart, Barnes and Noble are usually net leased.
Nonrecourse: In the case of default, the lenders sole recourse is to claim the assets securing the default note.
Partnership: A type of unincorporated business organization in which multiple individuals, called general partners, manage the business and are equally liable for its debts; other individuals called limited partners may invest but not be directly involved in management and are liable only to the extent of their investments. Or more generally, a relationship of two or more entities conducting business for mutual benefit.
Personal property: All property other than land and buildings attached to land. Cars, bank accounts, wages, securities, a small business, furniture, insurance policies, jewelry, patents, pets and season baseball tickets are all examples of personal property.
Promissory notes: Written pledge to pay.
Qualified Intermediary Middleman, facilitator, accommodator: term given to a person or entity making the trade with the taxpayer. Typically hired to convert a sale/purchase into an exchange.
Qualified Property : Any like-kind property NOT stocks, bonds, partnerships, personal residences, LLC interests or stock in trade or inventory.
Real property: Another term for real estate. It includes land and things permanently attached to the land, such as trees, buildings, and stationary mobile homes.
Relinquished property : Property to be given in an exchange by taxpayer.
Replacement property: Property received in an exchange by taxpayer.
Revenue: Total dollar amount collected for goods and services provided.
Reverse Exchange: A Reverse Exchange occurs when the taxpayer closes on the replacement property prior to closing on the relinquished property.
S Corporation: A form of corporation, allowed by the IRS for most companies with 35 or fewer shareholders, which enables the company to enjoy the benefits of incorporation but be taxed in a manner similar to a partnership.
Starker Exchange: A name derived from the Starker Court Case in 1979 that is used to describe a delayed exchange. The first case that challenged exchanges of property received over a period of 2 years.
Tax-free: Not subject to taxation; tax-exempt.
The Exchange Requirement: Section 1031 requires one property must be exchanged for another property and cannot be sold for cash.
The Purpose Requirement: The taxpayer's property must be held for productive use in a trade or business or for investment in order to qualify for tax deferred treatment.
Trustee : A commercial institution such as a bank or trust company, or an individual holding assets for the benefit of others.
OTHER CONSIDERATIONS
As the travel needs of corporate executives continue to change and become more demanding, flight departments often respond by upgrading their fleets. A flight department may add additional aircraft, purchase fractional shares of aircraft to supplement an existing fleet, or they may sell aircraft that have run the course of their useful life and replace them with aircraft that are better suited to their flight needs. When selling and replacing aircraft, Time Value Property Exchange can assist as a Qualified Intermediary (QI) by structuring the disposition and purchase of aircraft as a tax-free exchange under IRC Section 1031.
IRC Section 1031 seems straightforward. Sell relinquished aircraft beginning the exchange, identify replacement aircraft within 45 days, and close on the replacement aircraft within 180 days. However, to successfully structure and complete an exchange of aircraft, there are many critical details that need to be considered:
Sales Tax — Are you exempt? Do you need to plan in order to minimize or avoid sales tax altogether? What are the options?
Other taxes — What other state taxes may effect the cost of your exchange?
Deposits — How are they held? Are you in constructive receipt of sales proceeds disqualifying you from non-recognition of gain? How should you avoid this?
Timing — Do you have exchange timing issues? Are you buying before selling? What are your options?
We would like to thank TVPX for their invaluable information concerning 1031 exchanges. If you have any additional questions, please contact Seaport Village Realty Inc. Osterville at 508-428-4443.
A 1031 Exchange is a valuable tool used by the owners of investment property to defer the income tax and/or capital gains tax due upon the sale of their investment property, when they replace it with like-kind property also to be held for productive use in a trade or business or for investment. Each transaction has its own set of challenges which need to be overcome in order for it to qualify for non-recognition of gain under IRC Section 1031 and Revenue Procedure 2000-37. Transaction specific issues such as ownership structures, timing, financing, state taxes, and negotiations with buyers and sellers are critical considerations in determining the best structure for a particular taxpayer?s 1031 Exchange.There following are basic descriptions of the two basic kinds of 1031 Exchange structures. Keep in mind there are many different sub variations of each type of transaction depending on circumstances:1. Straightforward Exchange:A Qualified Intermediary (QI) will prepare documents for the taxpayer?s review and execution prior to the closings on the sale of the old property (?Relinquished Property?) and the purchase of the new property (?Replacement Property?). The taxpayer will then assign its right to sell the Relinquished Property, as well as its right to purchase the Replacement Property to the QI, although a deed will pass directly between the buyer and the seller. The sale proceeds from the Relinquished Property will be transferred directly from the buyer or closing agent to the QI, which should hold each taxpayer?s funds in a separate account in strict accordance with the requirements for handling exchange proceeds set forth in IRC Section 1031 and 468B. When the taxpayer is ready to close on the purchase of the Replacement Property, the QI will wire the funds directly to the closing agent to be applied against the purchase price. If the taxpayer?s 1031 Exchange is not completed within 180 days, the funds will be released to the taxpayer in accordance with the Regulations.2. Reverse Exchange:A Reverse Exchange allows taxpayers to receive the tax benefit from a 1031 Exchange when a Straightforward Exchange is not feasible. The sale of the Relinquished Property to a third party in a 1031 Exchange always needs to occur before the purchase of the Replacement Property by the taxpayer. Under Revenue Procedure 2000-37, the Internal Revenue Service has provided a ?Safe Harbor? to address situations where taxpayers need to acquire their Replacement Property before they are able to sell their Relinquished Property. In a Reverse Exchange, an Exchange Accommodation Titleholder (?EAT?) is employed to hold title to either the taxpayer?s Relinquished Property (?Exchange First?) or the Replacement Property (?Exchange Last?) for up to 180 days or until the Relinquished Property is sold to a third party buyer, whichever is earlier.2a. Exchange First:In an ?Exchange First? Reverse Exchange transaction, the ?Exchange? is the first event to occur. In these cases, the EAT acquires the taxpayer?s Relinquished Property with borrowed funds just prior to the taxpayer acquiring the Replacement Property from a third party seller. The proceeds of the sale of the Relinquished Property are paid to the QI as the qualified intermediary, and the QI immediately applies the proceeds toward the purchase price of the Replacement Property. Once the transfers are complete, the EAT leases the Relinquished Property back to the Exchanger until a real third party buyer is located. Once a buyer is found, the EAT sells the Relinquished Property directly to the buyer and pays off the loans incurred to acquire the Relinquished Property from the Exchanger. The Exchange First method is the less common version of a reverse exchange on Real Estate. The structure more commonly used in a real estate reverse exchange is the ?Exchange Last? method.2b. Exchange Last:In an ?Exchange Last? Reverse Exchange transaction, the ?Exchange? is the last event to occur. Stepping into the taxpayer?s shoes as the buyer of the Replacement Property, the EAT borrows the funds from the taxpayer, a third party lender, or both, to acquire the Replacement Property and subsequently leases the Replacement Property to the taxpayer until the Relinquished Property is sold. Once a buyer for the Relinquished Property is found, the Exchange takes place and is structured much like a Straightforward Exchange. The taxpayer sells the Relinquished Property directly to a third party buyer, and acquires the Replacement Property from the EAT.In either case, there are critical tax reporting requirements which must be adhered to.Case Study:A Taxpayer planned to sell real property for $5.2 Million and to purchase raw land as Replacement Property for $4.0 Million. To defer taxable gain due from the sale, they wanted to structure the transactions as an Exchange under IRC Section 1031. The timing was such that the sale could occur before the purchase, and if the taxpayer opted for a typical ?Forward? Exchange, they would pay tax on the difference of $1.2 Million.Either of the following two alternatives can be employed to solve this problem:1. Structure a Straightforward Exchange and purchase additional Replacement Properties valued at $1.2 Million or more to complete the Exchange; or, 2. Structure a Revere Exchange and employ an Exchange Accommodation Titleholder (EAT) to acquire the Replacement Property on behalf of the taxpayer, and then make $1.2 Million or more of capital improvements to increase its value while owned by the EAT. When the value of the Replacement Property exceeds $5.2 Million, the EAT would transfer the Replacement Property to the taxpayer to complete the Exchange after the relinquished property is sold if it wasn?t already.In either situation, the exchange must be properly documented and completed within 180 days. We?d like to than the professionals at TVPX for providing the preceding information on 1031 exchanges. 1031 Exchanges are complicated transactions and should not be entered into lightly. Consulting with your CPA and/or tax advisor is extremely important prior to entering into a 1031 exchange, and using a Qualified Intermediary with a successful track record that is bonded and insured is equally important.TVPX is a nationally recognized leader in 1031 Tax Deferred Exchanges of real property and personal property, providing a superior level of service, whether the simplest or the most complex exchange structure is required.In order to provide their clients with additional assurance and protection, TVPX is bonded and carries errors and omissions insurance. www.TVPX.comTEL: +1 978.610.12342352 MAIN STREETSUITE 201CONCORD, MA 01742
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