THE BASICS OF 1031 EXCHANGE
"Real Estate cannot be lost or stolen, nor can it be taken away. Purchased with common sense, paid for in full, and managed with reasonable care, it's the safest investment in the world"
- Franklin D. Roosevelt
Many of our Silicon Valley real estate investors are asking us how to do a 1031 exchange. Commonly referred to by the IRS as Section 1031, a Like-Kind exchange or a Starker exchange, a 1031 exchange is a very good strategy for tax deferment.
The tax deferred exchange, as defined in §1031 of the Internal Revenue Code, offers taxpayers one of the last great opportunities to build wealth and save taxes. By completing an exchange, the Taxpayer (Exchanger) can dispose of investment or business-use assets, acquire Replacement Property and defer the tax that would ordinarily be due upon the sale.
With current Silicon Valley real estate pricing as well as the low levels of real property inventory, we are seeing a number of our investors thinking about exchanging out of their current real estate investment holdings. Investors may fare well by taking their gains now and reinvesting in other types of real estate investment.
HOW TO DO A 1031 EXCHANGE
To preface, we must encourage all readers of this article to consult their CPAs, Qualified Intermediaries and/or tax attorneys prior to acting on any of the information in this article. With that out of the way, let’s discuss the 1031 exchange in greater detail.
Basically, with a 1031 exchange, you’re exchanging one property for another property that is similar in class or that is a “like-kind” property. The term “like-kind” is a bit broad but if we are wanting to exchange out of real property, we will always exchange our current real property asset for another real property asset. Although the properties do not have to be of the same value, it typically behooves investors to exchange old property for new property that is at least the same value or just a bit more so as not to incur any tax liability on the exchange.
To defer paying capital gain taxes, relief from property management, to diversify, if need to relocate, if would like to change property types. In a typical transaction, the property owner is taxed on any gain realized from the sale. However, through a Section 1031 Exchange, the tax on the gain is deferred until some future date.
Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of "like-kind", while deferring the payment of federal income taxes and some state taxes on the transaction.
The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer's investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a "paper" gain.
The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.
Who Should Exchange?
A taxpayer who has real property that may net them a gain upon the sale (generally property that has been substantially depreciated for tax purposes and/or has appreciated in fair market value.
Benefits of Exchanging vs. Selling
- Section 1031 exchange is one of the few techniques available to postpone or potentially eliminate taxes due on the sale of qualifying properties.
- By deferring the tax, you have more money available to invest in another property. In effect, you receive an interest free loan from the federal government, in the amount you would have paid in taxes.
- Any gain from depreciation recapture is postponed.
- You can acquire and dispose of properties to reallocate your investment portfolio without paying tax on any gain.
Different Types of Exhanges
Forward Exchange. Also known as a delayed exchange, in a forward 1031 exchange, the relinquished or old property is sold by assigning the rights of the Purchase and Sale Agreement (PSA) to the qualified intermediary who instructs the title company to direct deed the property to the buyer.
Reverse Exchange. A situation where the replacement property is acquired prior to transferring the relinquished property. The IRS has offered a safe harbor for reverse exchanges, as outlined in Rev. Proc. 2000-37, effective September 15, 2000. These transactions are sometimes referred to as "parking arrangements" and may also be structured in ways which are outside the safe harbor.
Simultaneous Exchange. The exchange of the relinquished property for the replacement property occurs at the same time.
Build-to-Suit (Improvement or Construction) Exchange. This technique allows the taxpayer to build on, or make improvements to, the replacement property, using the exchange proceeds. Reverse Exchange: A situation where the replacement property is acquired prior to transferring the relinquished property. The IRS has offered a safe harbor for reverse exchanges, as outlined in Rev. Proc. 2000-37, effective September 15, 2000. These transactions are sometimes referred to as "parking arrangements" and may also be structured in ways which are outside the safe harbor. Effective January 1, 2018, IRC §1031 applies only to real estate assets. It does not apply to exchanges of stock in trade, inventory, or property held for sale, such as property acquired and developed or rehabbed for purposes of resale.
Effective January 1, 2018, IRC §1031 applies only to real estate assets. It does not apply to exchanges of stock in trade, inventory, or property held for sale, such as property acquired and developed or rehabbed for purposes of resale.
What are the conditions for a valid exchange?
To fully defer the capital gain or recapture tax, the Exchanger must:
(a) acquire “like kind” Replacement Property that will be held for investment or used productively in a trade or business
(b) purchase Replacement Property of equal or greater value
(c) reinvest all of the equity into the Replacement Property, and
(d) obtain the same or greater debt on the Replacement Property. Debt may be replaced with additional cash, but cash equity cannot be replaced with additional debt. Additionally, the Exchanger may not receive cash or other benefits from the sale proceeds during the exchange.
FREQUENTLY ASKED QUESTIONS
Q - What are the general guidelines to follow in order for a taxpayer to defer all the taxable gain?
- The value of the replacement property must be equal to or greater than the value of the relinquished property.
- The equity in the replacement property must be equal to or greater than the equity in the relinquished property.
- The debt on the replacement property must be equal to or greater than the debt on the relinquished property.
- All of the net proceeds from the sale of the relinquished property must be used to acquire the replacement property.
Q - When can I take money out of the exchange account?
Once the money is deposited into an exchange account, funds can only be withdrawn in accordance with the Regulations. The taxpayer cannot receive any money until the exchange is complete. If you want to receive a portion of the proceeds in cash, this must be done before the funds are deposited with the Qualified Intermediary.
Q - Can the replacement property eventually be converted to the taxpayer's primary residence or a vacation home?
Yes, but the holding requirements of Section 1031 must be met prior to changing the primary use of the property. The IRS has no specific regulations on holding periods. However, many experts feel that to be on the safe side, the taxpayer should hold the replacement property for a proper use for a period of at least one year.
If the owner later on wants to take advantage of the home owner's exemption (up to $250,000 or $500,000 for a couple), there is now a five year holding period requirement.
Q - Can the taxpayer just sell the relinquished property and put the money in a separate bank account, only to be used for the purchase of the replacement property?
The IRS regulations are very clear. The taxpayer may not receive the proceeds or take constructive receipt of the funds in any way, without disqualifying the exchange.
Q - If the taxpayer has already signed a contract to sell the relinquished property, is it too late to start a tax-deferred exchange?
No, as long as the taxpayer has not transferred title, or the benefits and burdens of the relinquished property, she can still set up a tax-deferred Exchange. Once the closing occurs, it is too late to take advantage of a Section 1031 tax-deferred exchange (even if the taxpayer has not cashed the proceeds check).
Q - What are the time restrictions on completing a Section 1031 exchange?
A taxpayer has 45 days after the date that the relinquished property is transferred to properly identify potential replacement properties. The exchange must be completed by the date that is 180 days after the transfer of the relinquished property, or the due date of the taxpayer's federal tax return for the year in which the relinquished property was transferred, whichever is earlier. Thus, for a calendar year taxpayer, the exchange period may be cut short for any exchange that begins after October 17th. However, the taxpayer can get the full 180 days, by obtaining an extension of the due date for filing the tax return.
Q - What if the taxpayer cannot identify any replacement property within 45 days, or close on a replacement property before the end of the exchange period?
Unfortunately, there are no extensions available. If the taxpayer does not meet the time limits, the exchange will fail and the taxpayer will have to pay any taxes arising from the sale of the relinquished property, unless the IRS has expressly granted extensions in specified disaster area(s).
Q - Is there any limit to the number of properties that can be identified?
There are three rules that limit the number of properties that can be identified. The taxpayer must meet the requirements of at least one of these rules:
- 3-Property Rule: The taxpayer may identify up to 3 potential replacement properties, without regard to their value; or
- 200% Rule: Any number of properties may be identified, but their total value cannot exceed twice the value of the relinquished property, or
- 95% Rule: The taxpayer may identify as many properties as he wants, but before the end of the exchange period the taxpayer must acquire replacement properties with an aggregate fair market value equal to at least 95% of the aggregate fair market value of all the identified properties.
Q - What are the requirements to properly identify replacement property?
Potential replacement property must be identified in a writing, signed by the taxpayer, and delivered to a party to the exchange who is not considered a "disqualified person". A "disqualified" person is any one who has a relationship with the taxpayer that is so close that the person is presumed to be under the control of the taxpayer. Examples include blood relatives, and any person who is or has been the taxpayer's attorney, accountant, investment banker or real estate agent within the two years prior to the closing of the relinquished property. The identification cannot be made orally.
Q - What happens if the exchange cannot be completed within 180 days?
If the reverse exchange period exceeds 180 days, then the exchange is outside the safe harbor of Rev. Proc. 2000-37. With careful planning, it is possible to structure a reverse exchange that will go beyond 180 days, but the taxpayer will lose the presumptions that accompany compliance with the safe harbor.
Q - Can the proceeds from the relinquished property be used to make improvements to the improvements to the replacement property?
Yes. This is known as a Build-to-Suit or Construction or Improvement Exchange. It is similar in concept to a reverse exchange. The taxpayer is not permitted to build on property she already owns. Therefore, an unrelated party or parking entity must take title to the replacement property, make the improvements, and convey title to the taxpayer before the end of the exchange period.
Q- What is the difference between "realized" gain and "recognized" gain?
Realized gain is the increase in the taxpayer's economic position as a result of the exchange. In a sale, tax is paid on the realized gain. Recognized gain is the taxable gain. Recognized gain is the lesser of realized gain or the net boot received.
Q - I bought the property as a single person and I would like to acquire the replacement property together with my spouse?
The most conservative way is to stay consistent and complete the exchange the same way it was started and to add the spouse after the completion of the exchange. An exception can be made if there is a lender requirement that the spouse has to be added in order to qualify for a loan. If an exchange is planned well ahead of time, another solution would be to add the spouse to the title of the currently held property. Timing should be discussed with the CPA.
Q - I closed escrow on my first replacement property within the 45 day identification period. Can I now identify three more properties within my 45 day identification period?
If you are using the three property rule, the completed acquisition counts as one and you may identify only up to two additional properties.
Q - How do I identify two different properties (or percentages of ownership through a TIC) covered by ONE purchase contract?
If the properties could be sold separately at a later date, they should be identified as two properties.
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