1031 Exchange
Internal Revenue Code section
1031
Under Section 1031 of the Internal Revenue
Code ( 26 U.S.C. § 1031),
the exchange of certain types of property may defer the recognition of
capital gains or losses due upon
sale, and hence defer any capital gains taxes otherwise due.
Summary
To qualify for Section 1031 of the Internal Revenue Code,
the properties exchanged must be held for productive use in a trade or business
or for investment. Stocks, bonds, and other properties are listed as expressly
excluded by Section 1031 of the Internal
Revenue Code. The properties exchanged must be
"like-kind", i.e. of the same nature or character, even if they differ in grade
or quality. Personal properties of a like class are like-kind properties.
Personal property used predominantly in the United States and personal property
used predominantly elsewhere are not like-kind properties.
Real properties generally are of like-kind, regardless of whether
the properties are improved or unimproved. However, real property in the United
States and real property outside the United States are not like-kind
properties.
Taxpayers may wonder whether items such as equipment used on a
property are included in the lump-sum sale of the property, and if they are able
to be deferred. Under treasury regulation §1.1031(k)-1(c)(5)(i), property that
is transferred together with the larger item of value will not exceed 15% of the
fair market value of the larger property. So for equipment with a fair market
value of $15,000, as long as the qualified like-kind property sells for
>$100,000, the equipment can be included in the exchange of property and any
gain realized can be deferred.
Cash to equalize a transaction cannot be deferred under Code
Section 1031 because it is not like-kind. This cash is called "boot" and is
taxed at a normal capital gains rate.
If liabilities assumed by the buyer exceed those of the seller
(taxpayer), the realized gain of the seller will be not only realized, but
recognized as well. If however, the seller assumes a greater liability than the
buyer the realized loss cannot offset any realized and recognized gain of
receiving boot such as cash or other personal property considered boot.
Originally, 1031 cases needed to be simultaneous transfers of
ownership. But since Starker vs. U.S. (602 F.2d 1341), a contract to exchange
properties in the future is practically the same as a simultaneous transfer. It
is under this case that the rules for election of a delayed 1031 originated. To
elect the 1031 recognition, a taxpayer must identify the property for exchange
before closing, identify the replace property within 45 days of closing, and
acquire the replacement property within 180 days of closing. A Qualified Intermediary must also be used to
facilitate the transaction.
Section 1031 Like-Kind
Exchanges
Section 1031(a) of the Internal Revenue
Code (26 U.S.C. § 1031) states the recognition rules for
realized gains (or losses) that arise as a result of an exchange of like-kind
property held for productive use in trade or business or for investment. It
states that none of the realized gain or loss will be recognized at the time of
the exchange.
It also states that the property to be exchanged must be
identified within 45 days, and received within 180 days. [1]
1031(b) states when like-kind property and boot can be
received. The gain is recognized to the extent of boot received.
1031(c) covers cases similar to those in 1031(b) except when
the transaction results in a loss. The loss is not recognized at the time of the
transaction, but must be carried forward in the form of a higher basis on the
property received.
1031(d) defines the basis calculation for property acquired
during a like-kind exchange. It states that the basis of the new property is the
same as the basis of the property given up, minus any money received by the
taxpayer, plus any gain (or minus any loss) recognized on the transaction. If
the transaction falls under 1031(b) or (c), the basis shall be allocated between
the properties received (other than money) and for purposes of allocation, there
shall be assigned to such other property an amount equivalent to its Fair Market
Value at the date of the exchange.
1031(e) stipulates that livestock of different sexes do not
qualify for like kind exchange.
1031(h)(1) stipulates that real property outside the United
States and real property located in the United States are not of like kind.
The sale of the relinquished property and the acquisition of the
replacement property do not have to be simultaneous. A non-simultaneous exchange
is sometimes called a Starker Tax Deferred Exchange (named for an
investor who challenged and won a case against the IRS). See Starker v.
United States, 602 F.2d 1341, 79-2 U.S. Tax Cas. (CCH) paragr. 9541, 44
A.F.T.R.2d 79-5525 (9th Cir. 1979).[
For a non-simultaneous exchange, the taxpayer must use a Qualified Intermediary, follow guidelines of the Internal Revenue
Service, and use the proceeds of the sale to buy more
qualifying, like-kind, investment or business property. The replacement property
must be "identified" within 45 days after the sale of the old property and the
acquisition of the replacement property must be completed within 180 days of the
sale of the old property.
Section 1031 is most often used in connection with sales of real
property. Some exchanges of personal property can qualify under Section 1031.
Exchanges of shares of corporate stock in different companies will not qualify.
Also not qualifying are exchanges of partnership interests in different
partnerships and exchanges of livestock of different sexes. However, as of 2002
IRS ruling (see Tenants in common 1031
exchange), Tenants in Common (TIC) exchanges are
allowed. For real property exchanges under Section 1031, any property that is
considered "real property" under the law of the state where the property is
located will be considered "like-kind" so long as both the old and the new
property are held by the owner for investment, or for active use in a trade or
business, or for the production of income.
In order to obtain full benefit, the replacement property must be
of equal or greater value, and all of the proceeds from the relinquished
property must be used to acquire the replacement property. The taxpayer cannot
receive the proceeds of the sale of the old property; doing so will disqualify
the exchange for the portion of the sale proceeds that the taxpayer received.
For this reason, exchanges (particularly non-simultaneous changes) are typically
structured so that the taxpayer's interest in the relinquished property is
assigned to a Qualified Intermediary prior to the close of the sale. In this
way, the taxpayer does not have access to or control over the funds when the
sale of the old property closes.
At the close of the relinquished property sale, the proceeds are
sent by the closing agent (typically a title company, escrow company, or closing
attorney) to the Qualified Intermediary, who holds the funds until such time as
the transaction for the acquisition of the replacement property is ready to
close. Then the proceeds from the sale of the relinquished property are
deposited by the Qualified Intermediary to purchase the replacement property.
After the acquisition of the replacement property closes, the Qualifying
Intermediary delivers the property to the taxpayer, all without the taxpayer
ever having "constructive receipt" of the funds.
The prevailing idea behind the 1031 Exchange is that since the
taxpayer is merely exchanging one property for another property(ies) of
"like-kind" there is nothing received by the taxpayer that can be used to pay
taxes. In addition, the taxpayer has a continuity of investment by replacing the
old property. All gain is still locked up in the exchanged property and so no
gain or loss is "recognized" or claimed for income tax
purposes.
Boot
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 relinquished 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).
Boot limitations
Exchangers are advised to follow the following
guidelines:
1. Always to trade "across" or up, but never trade
down in order to avoid receipt of boot, either as cash, debt reduction or both.
The boot received can be off-set by qualified costs paid by the
Exchanger.
2. Always to bring cash to the closing of the
replacement property to cover loan fees or other charges which are not qualified
costs. (See above)
3. Not to receive property which is not
like-kind.
4. Not to over-finance the replacement property,
since financing should be limited to the amount of money necessary to close on
the replacement property in addition to exchange funds which will be brought to
the replacement property closing.
Time limits
The §1031 exchange begins on the earliest of the
following:
the date the deed records, or
the date possession is transferred to the buyer,
and ends on the earlier of the following:
180 days after it begins, or
the date the Exchanger's tax return is due, including extensions, for the
taxable year in which the relinquished property is transferred.
The identification period is the first 45 days of the exchange
period. The exchange period is a maximum of 180 days. If the Exchanger has
multiple relinquished properties, the deadlines begin on the transfer date of
the first property. These deadlines may not be extended for any reason.
A deadline that falls on Thanksgiving, Christmas, or New
Year's Day does not permit
extension.
Identified replacement property that is destroyed by
fire, flood, hurricane, etc. after expiration of the 45 day Identification
Period does not entitle the Exchanger to identify a new property.
Mistakenly identifying condominium A, when
condominium B was intended, does not permit a change in identification after the
45 day Identification Period expires. Failure to comply with these deadlines may
result in a failed exchange.
IRS rules control the length of time that the
replacement property must be held before it may either be sold or used to enter
into a new tax deferred exchange. In highly appreciating markets, people may
take the opportunity of selling their personal residence (where no capital gain
is due below $250,000 for a single person or $500,000 for a married couple) and
moving into a former rental property for a specified time period in order to
turn it into their new personal residence, and thus avoid capital gains
taxes.
In order to qualify for this exchange, certain rules
must be followed:
Both the relinquished property and the replacement property must be held
either for investment or for productive use in a trade or business. A personal
residence cannot be exchanged.
The asset must be of like kind. Real
property must be exchanged for real property, although a broad definition of
real estate applies and includes land, commercial property and residential
property. Personal
property must be exchanged for personal property. (There are some
complicated rules surrounding this — for example, livestock of opposite sex are
not considered like kind property for the purpose of a 1031 exchange, and
property outside the United States is not considered of "like kind" with
property in the United States.)
The proceeds of the sale must be re-invested in a like kind asset within 180
days of the sale. 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 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
Fair Market Value (FMV) of all of the exchanged properties as of the initial
transfer date.
Difficulties involved in meeting
limits
Frequently, the most difficult component of a 1031
exchange is identifying a replacement property within the first 45 days
following the sale of the relinquished property. The IRS is strict in not
allowing extensions.
A 1031 exchange is similar to a traditional
IRA or 401(k) retirement plan. When someone
sells assets in tax-deferred retirement plans, the capital gains that
would otherwise be taxable are deferred until the holder begins to cash out of
the retirement plan. The same principle holds true for tax-deferred exchanges or
real estate investments. As long as the money continues to be re-invested in
other real estate, the capital gains taxes can be deferred. Unlike the
aforementioned retirement accounts, rental income on real estate investments
will continue to be taxed as net income is realized.
An alternative to a 1031 exchange for someone who wants to defer
capital gains tax, but who does not want to continue to hold property is a
structured sale. This method offers both
buyer and seller many benefits and is regarded as ideal for those looking to
retire from or exit from the real estate or business market.
How a 1031 exchange is
accomplished
The following sequence represents the order of steps
in a typical 1031 exchange:
Step 1. Retain the services of tax counsel/CPA.
Become advised by same.
Step 2. Sell the property, including the Cooperation
Clause in the sales agreement. "Buyer is aware that the seller's intention is to
complete a 1031 Exchange through this transaction and hereby agrees to cooperate
with seller to accomplish same, at no additional cost or liability to buyer."
Make sure your escrow officer/closing agent contacts the Qualified Intermediary
to order the exchange documents.
Step 3. Enter into a 1031 exchange agreement with
your Qualified Intermediary, in which the Qualified Intermediary is named as
principal in the sale of your relinquished property and the subsequent purchase
of your replacement property. The 1031 Exchange Agreement must meet with IRS
Requirements, especially pertaining to the proceeds. Along with said agreement,
an amendment to escrow is signed which so names the Qualified Intermediary as
seller. Normally the deed is still prepared for recording from the taxpayer to
the true buyer. This is called direct deeding. It is not necessary to have the
replacement property identified at this time.
Step 4. The relinquished escrow closes, and the
closing statement reflects that the Qualified Intermediary was the seller, and
the proceeds go to your Qualified Intermediary. The funds should be placed in a
separate, completely segregated money market account to insure liquidity and
safety. The closing date of the relinquished property escrow is Day 0 of the
exchange, and that's when the exchange clock begins to tick. Written
identification of the address of the replacement property must be sent within 45
days and the identified replacement property must be acquired by the taxpayer
within 180 days.
Step 5. The taxpayer sends written identification of
the address or legal description of the replacement property to the Qualified
Intermediary, on or before Day 45 of the exchange. It must be signed by everyone
who signed the exchange agreement, and it may be faxed, hand delivered, or
mailed either to the Qualified Intermediary, the seller of the replacement
property or his agent, or to a totally unrelated attorney. Send it via certified
mail, return receipt requested. You will then have proof of receipt from a
government agency.
Step 6. Taxpayer enters into an agreement to purchase
replacement property, again including the Cooperation Clause. "Seller is aware
that the buyer's intention is to complete a 1031 Exchange through this
transaction and hereby agrees to cooperate with buyer to accomplish same, at no
additional cost or liability to seller." An amendment is signed naming the
Qualified Intermediary as buyer, but again the deeding is from the true seller
to the taxpayer.
Step 7. When conditions are satisfied and escrow is
prepared to close and certainly prior to the 180th day, per the 1031 Exchange
Agreement, the Qualified Intermediary forwards the exchange funds and growth
proceeds to escrow, and the closing statement reflects the Qualified
Intermediary as the buyer. A final accounting is sent by the Qualified
Intermediary to the taxpayer, showing the funds coming in from one escrow, and
going out to the other, all without constructive receipt by the
taxpayer
Qualified
intermediary
The Qualified Intermediary (also known as an Accommodator)
should be a corporation that is in the full-time business of facilitating 1031
exchanges. The role of a QI is similar to, but not identical to, the role of an
escrow company. The Qualified Intermediary is essential to completing a
successful and valid delayed exchange. The Qualified Intermediary does not
provide legal or specific tax advice to the exchanger, but will usually perform
the following services:
- Coordinates with the exchangers and their advisors, to structure a
successful exchange.
- Prepares the documentation for the Relinquished Property and the Replacement
Property.
- Furnishes escrow with instructions and documents to effect the exchange.
- Secures the funds in an insured bank account until the exchange is
completed.
- Provides documents to transfer Replacement Property to the exchanger, and
disburse exchange proceeds to escrow.
- Holds the document of Identification of Replacement Properties sent by the
Taxpayer.
- Submits a full accounting of the Exchange Funds for the Taxpayers Records.
- Submits a 1099 to the Taxpayer and the IRS for any growth proceeds paid.
Anyone who is related to the taxpayer, or who has had
a financial relationship with them within the two years prior to the close of
escrow of the exchange can not be used as the QI. This means that the taxpayer
cannot use their current attorney, certified public accountant or real estate agent. A corporation or other entity to act as Qualified
Intermediary owned by your CPA, CPA firm, real estate agent or attorney is
likewise disqualified.
A Qualified Intermediary should be bonded and insured
against errors and omissions and employee dishonesty. Relevant educational
background such as tax, law or finance is desired. Nevada is the only state that
requires a QI to be licensed.
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. 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.
The QI holds the proceeds from the sale of the
relinquished property beyond the actual or constructive control of the
Exchangor. The Qualified Intermediary also prepares the necessary
documents to accomplish a tax deferred exchange.
Questions to
ask a Qualified Intermediary
Where will the exchange funds be held? (If held in a bank, are you aware
that FDIC coverage is only for $100,000 per account?
In what type of account are the funds invested?
Are separate accounts set up for each client?
What are the requirements for the withdrawal of any exchange proceeds? (Is
the Qualified Intermediary authorized to move funds without the Taxpayer's
written approval?)
Is the notarized signature of the Exchanger required for moving funds at all
times? (What written documents specify this requirement?)
Can a written 3rd Party Guaranty be provided to all Exchangers?
(Is this backed by a recognizable entity with an established track record and
sufficient assets to cover a potential loss of exchange proceeds?
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