Different types of Exchanges

       Simultaneous Exchange:    The property sold and the replacement property are joined together and must be closed as one transaction or neither can close.

        Delayed Exchange:  An exchange in which the property sold and the replacement property close on different dates but not more than 180 days apart.

        Reverse Exchange:    A reverse exchange occurs when you buy your replacement property before you sell your current property.  The IRS does not characterize this as an exchange.

"Like-Kind" Property

       All real property is "like-kind" with all other real property.  "Like-kind" refers to how the property is held by the investor.  The exchanger must have held the relinquished property for investment or for "productive use in their trade of business" and the intent is to do the same with the replacement property.  You can dispose of and acquire any interest in real property other than a home or second residence.

Time Periods

       You must identify the replacement property by midnight of the 45th day following the close of the first leg.  The exchanger may identify any three potential replacement properties without regard to their fair market value.  You are not required to wait until your first leg closes to identify a property.

        The replacement property must actually close by midnight of the 180th day following the close of the first leg.

What Qualifies For A 1031 Exchange?

The classification of properties exchanged determines if the property qualifies for Section 1031 treatment.

A. The IRS's 4 classifications of Real Estate:

1. Property held for personal use. (Personal Property)
2. Property held primarily for sale. (Dealer Property)
3. Property held for productive use in a trade or business. (Business Property)
4. Property held for investment. (Investment Property)

The last two qualify for Section 1031 tax deferral, the first two do not. Both the property received and the property sold must be of "Like Kind". It is your use of the property that determines its classification. What the other party does with the property does not affect your tax status.

B. Like-Kind Property

1. Like-kind refers to your use of the property and not to its grade or quality.
2. "1031" property may be mixed as to type and still be like-kind. As an example, you may exchange land for a duplex, or a commercial building for a retail store, etc. (See page 14.)
3. Property held outside the USA and its territories does not qualify for exchange with property held within the USA.

C. Partnership Interests

Your interest in a partnership cannot be traded for an interest in another partnership.

Exception: The partnership as an entity can exchange real estate it owns for other like-kind real estate.

D. Transfer Between Spouses

There are no income tax consequences in entering into financial transactions between spouses. In addition, most transfers incident to a divorce are tax free. However, transactions with a former spouse are normally subject to tax unless they qualify for non recognition under the provisions of Section 1031.

E. Sale/Lease Back As An Exchange

A lessee’s interest in a lease with a term of 30 years or longer in real property is considered like-kind to other real property. In addition, property which is subject to a lease can be, even if the lease is for a term of 30 years or longer, the subject of a tax free exchange. However the receipt of prepaid lease payments in an exchange for a 30-year or longer lease is taxed as ordinary income and will not qualify for tax-free exchange treatment.

F. Business Assets

The personal property assets of one business can be exchanged for like-kind assets of another business and will be held as a like-kind exchange under Section 1031. The real property is treated the same as any other exchange. The like-kind requirements for personal property are much more stringent than for real property (e.g., a truck cannot be exchanged for a car, nor can a barge be exchanged for a cargo ship).

G. Vacation Homes & Properties

This type of property does not qualify if it is used solely for personal use.

It may qualify if rented, and must pass a use test each year.

Why Use A 1031 Exchange?

I. PRESERVATION OF EQUITY

A properly structured exchange provides real estate investors with the opportunity to defer 100% of both Federal and State capital gain taxes. This essentially equals an interest-free, no-term loan on taxes due until the property is sold for cash! Most often, the capital gain taxes are deferred indefinitely because many investors continue to exchange from one property to the next, dramatically increasing the value of their real estate investments with each exchange!

II. LEVERAGE

Many investors exchange from a property where they have a high equity position or one that is "free and clear" into a much more valuable property. A larger property produces more cash flow and provides greater depreciation benefits, which therefore increase an investors return on their investment.

III. DIVERSIFICATION

Exchangers have a number of opportunities for diversification through exchanges. One option is to diversify into another geographic region such as exchanging of one apartment building in Denver, Colorado for two additional apartments - one in Los Angeles, California and the other in Dallas, Texas. Another diversification alternative is acquiring a different property type such as exchanging from several residential units to a small retail strip center.

IV. MANAGEMENT RELIEF

Many investors accumulate several single family rentals over the years. The on-going maintenance and management of what can be a far-reaching group of properties can be lessened by exchanging these properties for one property better suited to on-site maintenance and management. Exchanging into a single apartment complex with a resident manager is a good example of this strategy.

V. ESTATE PLANNING

Often a number of family members inherit one large property and disagree about what they want to do with it. Some want to continue holding the investment and some desire to sell it immediately for cash. By exchanging from one large property into several smaller properties, an investor can designate that, after their death, each heir will receive a different property which they can either hold or sell.

1031 Exchange Frequently Asked Questions

Do I have to spend all of the proceeds from my  property being sold on replacement property?

No, however you will be taxed on the amount you don’t spend, which is known as "boot" and are taxed on their face value at the capital gains tax rate.

If I don’t spend all of my proceeds when can I receive the unused amount?

You can receive unused proceeds at anytime after you have acquired each one of the properties identified in your 45 day identification. If you do not acquire all of the properties identified in the 45 day identification, then the unused proceeds cannot be released until the earlier of the due date of your tax return including extensions, or 180 days after the closing of the sale of the relinquished (exchange) property.

Can I take a note on the sale of my relinquished property ?

Yes, you can sell your relinquished property using a Note & Trust Deed to finance the sale. It is possible for the promissory Note and Trust Deed to be made out to the "Exchanger". If this is done the Note is taxable and may not be used to buy replacement property.

However if the Note & Trust Deed is made out in the name of the Qualified Intermediary. You have four choices on how to use it to buy replacement property:

1.      You can use it to acquire replacement property by trading it to the "Seller " for part of the equity in the new
property (that is spend it like it was cash).

2.      You can instruct the Qualified Intermediary to sell the note on the open market (you can negotiate this sale
or have the Intermediary do it) and add the amount realized to the exchange proceeds. This will give you all cash to negotiate your replacement purchase. It is less desirable because of the discount given on the sale of the note.

3.      A party related to the "Exchanger" such as a closely held corporation or relative can either purchase the Note from the Qualified Intermediary, or provide financing so that the Qualified Intermediary receives all cash at closing. You should consult with your tax advisor regarding structuring this type of transaction.

4.      You can wait until the end of the exchange and receive the note back from the Intermediary. This will result
in the note becoming "boot" and it will be taxable. However, you will only have to pay tax on the amount received each year.

What should I know about new construction of replacement property ?

There are two ways that new construction is handled in an exchange:

1.      You contract with a builder to purchase a property which will be completed, and closed, prior to the end of the 180 day exchange period. You can purchase the land prior to construction as one of your replacement properties, or you can purchase the land & building from the builder at the time of closing. This is the least expensive and easiest method for the exchanger.

2.      You can contract to do what is known as a "Build-out Exchange". This is where the exchanger finances all or part of the construction. Through a special agreement with the Qualified Intermediary the builder draws on the exchange proceeds as certain steps of the construction are completed. This arrangement is much more complicated and risky for the Exchanger, and the Intermediary, and increases the cost of the exchange by $1,500 or more.

In either case the purchase and sale agreement should have language in it that requires the builder to bear responsibility for the exchangers taxes if the exchange fails due to the completion of the construction later than the required 180 day exchange closing period.

When should I open escrow on my Replacement Property ?

The safest way is to wait until after your "Relinquished" property has closed. The opening of escrow ( or notification to the closing agent) may constitute identification as the escrow agent is listed by the IRS as a person involved in the exchange {1.1031(k)-1(c)(2)(ii) example}, and if it is done prior to the closing of the "Relinquished" property it can shorten the entire exchange period to 45 days. It is a dangerous practice and does not speed up the "replacement" property closing. Replacement property is identified if it is designated as replacement property in a written document signed by the taxpayer and sent to the Qualified Intermediary prior to the end of the 45 day identification period.

What are the disadvantages of 1031 exchanges?

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.

Are 1031 exchanges only for commercial buildings?

No, it works for any investment property.  It doesn't matter if it is a single family home, duplex, land, shopping centers, or other investment properties.  The property can be exchanges for another "like kind" property, which means another property held for an investment.