Do you have some questions about 1031 exchanges?
Here are some answers to common asked questions!
What does the term 1031 refer to?
1031 is the number assigned to the Internal Revenue Code Section that provides for the tax deferred exchange of real and personal property.
What does the term Starker refer to?
It refers to the landmark 1979 federal case entitled, Starker v. U.S. 602 F2d 1341 (9 th Cir 1979) wherein the court substantiated the validity of the delayed exchange process. Prior to the Starker case, the courts had never sanctioned an exchange whereby the relinquished property was sold and - at a later date - the replacement property was purchased.
What are “Safe Harbors”?
This term refers to the rules established by the 1994 Treasury Regulations for tax deferred exchanges which provide that - if followed - the IRS will allow the exchange to qualify.
Why is the tax deferred exchange a popular financial planning tool?
If done correctly, investors defer tax due in connection with the sale of real or personal property, enabling them to access their equity to consolidate, diversify, leverage or relocate their investments.
Why use a Qualified Intermediary?
Use of a Qualified Intermediary is sanctioned as a safe harbor by the IRS.
What is like kind? Real or personal property of the same nature or quality is like kind. Generally, real property is like kind to all other real property, except foreign real property, as long as it is held for investment or the productive use in a trade or business. Personal Property must be either the same General Asset Class or Product Class.How do I properly identify my replacement property?
Property is properly identified only if you unambiguously described it in a written document signed by you and hand delivered, mailed, telecopied, or otherwise sent to the person obligated to transfer the replacement property to you (i.e. the Qualified Intermediary or the seller of the replacement property) or to any other person “involved in the exchange” other than you or a person disqualified under Treas. Reg. Section 1.1031(k)-1(k). Real property generally is unambiguously described if it is described by a legal description, street address, or distinguishable name (e.g. the Mayfair Apartment Building). If at the end of the identification period - 45 days - you identified more properties than permitted by IRC Section 1031 (k)-1(b)(1) it is treated as if no replacement property has been identified and the exchange will be disallowed.
What are the 45 and 180 day deadlines?
Beginning with the close of the Relinquished Property, you have 45 days to identify the properties you intend to purchase and 180 days (or the due date for your tax return - whichever is earlier) to complete the acquisition of those properties. In addition, the 45 day identification period and the 180 day exchange period are calendar days. If the 45 th day or 180 th day falls on a weekend or holiday, the deadlines still apply. There are no extensions for Saturdays, Sundays, or legal holidays.
Is there any way to get an extension on the 45 day or 180 day deadlines?
No extensions are allowed on the 45 day deadline. Your identification must be received, signed, in writing, on or before midnight of the 45th day. With respect to the exchange period, it ends on the earlier of the 180th day or the due date (including extensions) of you tax return for the taxable year in which the transfer of the relinquished property occurs. Thus, if the exchange period is cut short by the earlier occurrence of your tax filing date, you may file for an extension in order to get the full 180 day exchange period.
What is Boot?
Broadly defined, boot is considered:
- “Cash boot” - money received (or not reinvested) by you during an exchange. If you carry a note for your buyer, the note is also considered cash boot.
- “Mortgage boot” occurs when you pay off a loan on the sale of the relinquished property but do not either get a loan for equal or greater value when you buy the replacement property or invest additional cash equal to your debt relief. In other words, if you choose not to get a loan on the replacement property, it is perfectly acceptable to simply come up with the additional cash required to purchase the replacement property.
- Any type of replacement property received that is not like kind.
If I own a property with another investor, can I exchange my equity if he doesn't want to?
Yes. You would want to clearly allocate each investor's interest in the property before you sell. The investor who wishes to exchange may do so, and the other investor may receive cash (taxable). It is, however, very important that the investors be clear on their intentions before entering into an exchange agreement with a Qualified Intermediary. Once a Relinquished Property is closed where all investor parties are under one exchange agreement, they do not have an option of dividing proceeds and buying separate Replacement Properties.
What is a partial tax exchange?
If the equity in your investment property is $150,000 and you wanted to use only $100,000 to purchase your replacement property and take $50,000 out to buy a new car, you would have a partially tax deferred exchange. The $50,000 cash you took to purchase the car is considered taxable cash boot.
May I take out my basis and reinvest only the gains?
No. Both basis and gains must be reinvested to defer taxes. The IRS does not allow you to allocate a portion of the money as basis and a portion as gain. Any money received by you will be considered boot and taxed at a capital gain rate.
Can a carry-back note, drawn in the name of the Exchanger, be assigned to the Qualified Intermediary as part of an Exchange?
No. Once the Note is received in your name, it will be taxable boot. Alternatively, to use the note as part of the 1031 exchange, the note and deed of trust must be drawn in the Qualified Intermediary's name.
What is the net value of the property?
Simply stated, the net value is your sales price less your closing costs. You are responsible for reinvesting both the cash and the loan amount when you purchase the replacement property. (See section on Boot.)
How does the note become part of the exchange?
The note must be drawn in the name of the Qualified Intermediary. During the 180 day exchange period, you have several options in using the note as part of the exchange:
- Sell the note to a buyer and liquidate it to cash that is then added to the exchange proceeds and applied to the purchase price of the replacement property;
- Obtain the agreement of the replacement property seller to accept the note as part of the purchase price to be paid for the replacement property;
- Accept only a short-term note (i.e. due in less than 6 months) that will be paid off in full prior to the acquisition of the replacement property. Payments received are added to the exchange funds and used to purchase the replacement property.
I own a piece of property that has my own primary residence as well as a rental unit, would it still qualify for an exchange?
Yes, so long as you remain consistent with your past tax returns. Consult with your tax advisor to determine the percentage of the value of the property you have attributed to investment. You may exchange that portion of the value.
How long must I hold a property for investment before I can move into it for my own residence?
The IRS has never established any rule for a required holding period for investment property to qualify under IRC Section 1031. If you are considering converting investment property to a principal residence, we strongly recommend that you consult with your tax advisor.
What does the term “disqualified party” refer to?
The 1994 Treasury Regulations provide that certain persons/entities are disqualified from acting as a Qualified Intermediary. Disqualified persons include anyone who can be considered your agent, anyone who is a related person as defined in the Code, or anyone who bears a relationship as your agent as described in the Code. Your agents include anyone who has acted as your employee, attorney, accountant, investment banker, real estate agent or broker within the previous two years.
Can I exchange with a related party?
Yes, subject to certain restrictions - namely a two year holding requirement — you may sell property to or swap property with a related party. If you engage in an exchange with a related person, you are entitle to non-recognition of gain only if the replacement property is held by you for at least 2 years and the relinquished property is held by the related person for at least 2 years after the date of the last transfer in the exchange transaction. Related persons include members of your family and descendents, corporations, tax-exempt organizations and partnerships that are controlled or owned by you. The grantor, fiduciary and beneficiary of a trust are also considered related parties. It is not advisable to buy property from a related party.
Do I have access to my money during the exchange?
During the exchange transaction your exchange proceeds are placed in an exchange trust account so that you do not have actual or constructive receipt of the funds. If you have not identified property, you may not receive the exchange funds until after the expiration of the 45 th day. If, however, you have identified property but you later decide not to exchange you may not have access to the funds until the expiration of the 180 day exchange period. (Some limited exceptions apply.)
What are exchange expenses?
Certain expenses incurred in selling the property, which include but are not limited to the real estate commission, exchange fees, legal fees and transfer taxes, may be paid with exchange proceeds thereby reducing the amount that must be reinvested in the replacement property.
If you are interested in a 1031 exchange or if you just have a question that wasn't listed here feel free to contact me anytime!
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