What is a 1031 tax deferred exchange?
Under Section 1031 of the Internal Revenue Code, owners of real estate held for investment or use in a trade or business can swap their property tax-free for “like-kind” real estate. Exchanges are made for people wanting to stay invested in real estate, increase their leverage and to avoid paying hefty taxes upon the sale of property.
- Rental Houses
- Retail Properties
- Raw Land
- Office Buildings
Non Qualifying Properties
- Personal Residences
- Dealer Property
- Partnership Interests
Reason to Exchanges
- Restoring Depreciation that will soon expire – by exchanging one property for another of greater value.
- To upgrade size and/or quality of investment. An exchange can be utilized to combine the equity of one or more properties into a larger singular investment.
- To change investment location. An exchange can be executed in anticipation of market trends to maximize appreciation potential.
7 Steps for a Successful 1031 Tax Deferred Exchange
Step 1: Consult with your tax and financial advisors to determine if a tax deferred exchange is appropriate for your circumstances and compatible with your investment goals.
Step 2: Listing the Relinquished Property for sale with a licensed real estate broker. During the first step the Exchanger will list the Relinquished Property with a real estate broker. The broker/agent will disclose the intent to complete an exchange in the listing agreement.
Step 3: Offer, Counter Offer and Acceptance. The Exchanger enters into a contract with the Buyer for the sale/exchange of the Relinquished Property. The broker/agent discloses the Seller/Exchanger’s intent to exchange into the Purchase Agreement and Receipt for Deposit.
Step 4: Open escrow for the Relinquished Property and coordinate with the Facilitator. The Facilitator prepares the exchange agreement and coordinates with the escrow holder to close escrow as Phase I of a tax deferred exchange. Important: The exchange agreement must be in place and signed by all parties prior to close of escrow. Additionally, all earnest money deposits should be placed with the title company.
Step 5: Replacement Property Identification. After closing escrow for the sale of the Relinquished Property, the Exchanger must identify all Replacement Property within 45 days from day after close of escrow.
Step 6: Contracting for the Replacement Property. After closing on the Relinquished Property the Exchanger has 180 days to acquire the Replacement Property. With the help of his or her agent the Exchanger enters into contract to purchase the Replacement Property from the Seller. In the contract to purchase the agent discloses the Exchanger’s intent to complete the exchange and obtains the Seller’s cooperation.
Step 7: Open escrow for the Replacement Property. The Facilitator prepares the Phase II Exchange Agreement and coordinates with the Replacement Property Escrow holder. The funds held in trust by the Facilitator are placed in escrow and the Replacement Property is purchased by the Facilitator from the seller. The Facilitator then transfers the Replacement Property to the Exchanger and the transaction is closed as Phase II of a delayed exchange.
Identification of Replacement Property
Regardless of the number of relinquished properties transferred by the Exchanger as part of the same exchange, the maximum number of replacement properties that the Exchanger can identify is as follows:
3 Property Rule: Three properties without regard to the fair market values of the replacement properties.
200 Percent Rule: Any number of properties as long as their aggregate fair market value as of the end of the identification period does not exceed 200 percent of the aggregate fair market value of all the relinquished properties as of the date the relinquished properties were transferred by the Exchanger.
95 Percent Rule: Any number of replacement properties identified before the end of the identification period and received before the end of the exchange period, but only if the Exchanger receives before the end of the exchange period identified replacement property the fair market value of which is at least 95 percent of the aggregate fair market value of all identified replacement properties.
Glossary of Terms
Accommodator: A principal involved in the exchange transaction who agrees to assist the exchanger to effect a tax-deferred exchange. Same as Facilitator or intermediary.
Accommodating Party: In an exchange of properties there is always a person or entity that steps in to accommodate or facilitate the exchange transaction. Depending on how the transaction is structured, the accommodating party may incur additional liability in their efforts to assist in the exchange.
Acquisition Property: Replacement property
Actual Receipt: When the Exchanger actually receives the funds from the sale of the Relinquished Property. Receipt of cash by the Exchanger before he receives the Replacement Property may be enough to destroy the tax deferred treatment of the transaction.
Adjusted Basis: Generally speaking the adjusted basis is equal to the purchase price plus capital improvements less depreciation. Transactions involving exchanges, gifts, probates and receiving property from a trust can have an impact on calculating the property’s adjusted basis. The taxpayer’s C.P.A. or tax advisor is the party to look to for these types of questions.
Boot: Boot is any type of property received or given up in an exchange that does not meet the like kind requirement. Generally speaking, receiving boot will trigger the recognition of gain and taxes. If the Exchanger receives boot, they will be taxed. Boot added or given up by the Exchanger does not necessarily trigger a taxable event. In a real property exchange, boot received is any type of property received by the exchange which is not real property held for investment or productive use in a trade or business.
Cash Boot: Cash Boot consists of cash and nonqualifying property. A car, a boat or receipt of the beneficial interest in a promissory note are all examples of Cash Boot.
Mortgage Boot: Mortgage Boot consists of the secured debt given up and received as part of the same exchange. If the exchanger increases the amount of debt on the Replacement Property verses the Relinquished Property, they have given mortgage boot. If the exchanger decreases the amount of debt on the Replacement Property verses the Relinquished Property, they have received mortgage boot. Generally speaking, mortgage boot received triggers the recognition of gain and it is taxable, unless offset by Cash Boot added or given up in the exchange.
Constructive Receipt: Even if the Exchanger does not actually receive the proceeds from the disposition of the Relinquished Property, the exchange will be disallowed if the Exchanger is treated as having constructively received the funds.
Delayed Exchange: Also called non-simultaneous, deferred and Starker. A delayed exchange is a tax deferred exchange where the Replacement Property is Received after the transfer of the Relinquished Property. In a delayed exchange the Exchanger must identify all potential Replacement Properties within 45 days from the transfer of the Relinquished Property and the Exchanger must Receive all Replacement Properties within 180 days or the due date of the Exchanger’s tax return whichever occurs first.
Like-Kind Property: Refers to the nature of the property the Exchanger gives up or receives as part of the same tax deferred exchange transaction. In order to qualify as like kind the property given up or received must be held for productive use in a trade or business or held for investment to qualify as like-kind.
Realized Gain: Refers to a gain that is not necessarily taxed. In a successful exchange the gain is realized but not recognized and therefore not taxed.
Recognized Gain: Refers to gain which is subject to tax. When someone disposes of property at a gain or profit in a taxable transfer such as a sale, the gain is not only realized, but recognized and subject to tax.
Relinquished Property: The property given up by the exchange to start the 1031 exchange transaction. This property usually passes through an accommodator before transferring to the ultimate Buyer.
Reverse Exchange: An exchange where the Exchange acquires or gains control of the Replacement Property before disposing of the Relinquished Property.
Simultaneous Exchange: Also referred to as a concurrent exchange. A simultaneous exchange is an exchange transaction where the Exchanger transfers out of the Relinquished Property and Receives the Replacement Property at the same time.
Transfer Tax: A tax usually assessed by a city or county on the transfer of property. It may be based on equity or value. When structuring a multi-party exchange an exchange agreement will usually call for direct deeding to eliminate additional transfer tax.
A taxpayer must identify replacement property within 45 days after the transfer of the relinquished property, and acquire the replacement property within the earlier of 180 days of the relinquished property closing, or the due date of the taxpayer’s tax return. This means that 1031 escrows that close after Oct. 18 will not have the full 180 days to acquire the replacement property unless the taxpayer files an extension.
Contact your CPA or tax attorney for advice.