About 1031 Exchanges
For recognizing potential like-kind replacement properties in your 1031 exchange transaction, there are very specific identification requirements. When you identify these like-kind replacement properties, they do not need to be under any contract or escrow. However to take the advantage of this wealth preserving and income producing benefit, certain conditions must be met. Here are the rules for 1031 exchange.
1) REAL PROPERTY USE: For exchanging any type of real estate, both your old and new properties must qualify the test of investment or business use.
2) 45 DAY IDENTIFICATION PERIOD: The identification period in a delayed exchange begins on the date the Exchanger transfers the relinquished property and ends at midnight on the 45th calendar day. This deadline of 45 days is very strict. No variances are allowed whether it is a weekend or a holiday. The proceeds from the sale of the abandoned property are in the custody of the qualified agent during this 45 day period.
3) 180 DAY EXCHANGE PERIOD: The basis for the 1031 states that the individual has 180 days from the date of selling his property to accept the newly acquired property.
The “Exchange Period” under 1031 is the period within which an individual receives the replacement property for his sold relinquished property. This exchange period ends at 180 days after the due date for the person’s tax return for the taxable year in which the transfer of the relinquished property occurred or the date on which the person transfers the surrendered property, whichever is earlier. A word of expert advises: Don’t wait until the deadline ends. Do it as early as you can. Many careless investors assume that they can wait until the last minute to purchase the new property after seeing their language referring to the due date for their tax return. For instance, if an individual sells its property in June, the deadline for acquiring a new property would fall before his tax return in the spring of the same year.
The utilization of 1031 exchanges may be an invaluable tool for maximizing tax savings, but it is a very complex process and often difficult to operate.
IDENTIFICATION RULES AND EXCEPTIONS
1031 EXCHANGE ID Rules
You must adhere to at least one of these given identification rules or exceptions while executing the classification of your like-kind replacement properties:
It is a safe option to think of a replacement property in mind and purchase the agreement set up before opting to start the 1031 process. “The three property rule” states that the dealer of the replacement or abandoned property can identify up to 3 replacement properties, despite their value.
THREE (3) PROPERTY IDENTIFICATION RULE
The vast majority of Investors today are using the three (3) property identification rule because this rule limits the total number of like-kind replacement properties that you can identify with your three (3) potential like-kind replacement properties. As part of your 1031 exchange, investors can get all of the three identified like-kind replacement properties, but most Investors only acquire one of the three defined properties. Usually, the second and third specified properties are kept as a backup in case they are not able to get the first like-kind replacement property.
If you are trying to broaden your investment portfolio and wish to identify more than three like-kind replacement properties, you can skip this three property identification rule and use the 200% of Fair Market Value Rule.
200% OF FAIR MARKET VALUE IDENTIFICATION RULE
You are allowed to identify more than three like-kind replacement properties until and unless the total fair market value of all your identified like-kind replacement properties does not exceed 200% of the total net sales value of your acquired property or properties sold in your 1031 exchange. You can choose any number of like-kind replacement properties. The restriction is only for the total identified value.
For example, if you sold your relinquished property(ies) for $3,000,000, then you can identify as many like-kind replacement properties as you want as long as the aggregate value of the identified like-kind replacement properties does not exceed $6,000,000 (200% of $3,000,000).
95% IDENTIFICATION EXCEPTION
The third and the last rule is the 95% rule, wherein if you identify more than three properties and their total fair market value exceeds 200% of the value of what was sold, the transaction may still be valid if 95 % of the entire cost of all properties on the list are acquired. For example, you have properties worth $ 200,000 on your list, and then you need to purchase at least $190,000 of them.
With Solid Investments, you can locate a like-kind property for a 1031 exchange, and we assure you a steady and successful transaction.
1031 EXCHANGE RULES FAQ
What kind of property is like-kind to my property?
A: Property held for productive use in a trade, business or for investment can be exchanged for like-kind property. Usually, all real estate properties are like kind to each other. For example, a hotel can be exchanged for an office building or industrial building can be exchanged for a multi-family property. The state law of the jurisdiction in which the property is held decides the definition of the interest in real estates, like mineral interests or water rights. Our business concentrates on all exchanges of real estate as well as personal property. We are experienced in handling all the exchanges related to real estate as well as other tangible personal property like livestock or airplanes can be exchanged.
Q: How can I get a fully deferred exchange?
A: 1031 tax deferred exchanges allow real estate investors to delay capital gain taxes on the sale of property held for productive use in trade, business or investment. To get a fully tax deferred exchange, the trader must trade equal or up in fairness and debt. The basic idea behind this rule is to convince the trader to use the entire profits from the relinquished property as down payment on the replacement property. The trader also needs to substitute any debt paid at the time of sale of the relinquished property with an equal or greater debt on the replacement property. If the trader receives any cash at the time of the purchase of the replacement property or the sale of the relinquished property, then this cash would be referred as “cash boot” and tax will be authorized to the extent of gain. This rule does not rely on the trader’s cash position in the relinquished property. Despite of the principal pay-down, capital improvements on the relinquished property or the size of the exchanger’s down payment, if the trader receives cash as part of the exchange, then it is considered as “cash boot”. You can get an estimate of the fair market value of the relinquished property by subtracting the ordinary and customary transaction costs of the sale from the selling price. The general transaction costs such as exchange service fees, brokerage fees, recording fees and the title insurance fees are limited to the costs directly related to the sale of the relinquished property.
Q: Is it possible to have a partially tax deferred exchange?
A: If any of the rules of fully tax deferred exchange is violated, then its outcome is automatically a partially tax deferred exchange. A gain is likely to be recognized when the exchanger trades in either equity or debt. Hence, a partially deferred tax exchange is considered if the exchange portion of the transaction is otherwise valid.
Q: What are the various types of boots?
A: Boot is any property acquired by the taxpayer in the exchange which is not like-kind to the relinquished property. The boot is distinguished as “cash boot” or “Mortgage boot”.
Cash Boot – Cash Boot is any cash received by the taxpayer. It can also be in the form of property. The tax will be recognized to the amount of gain in the transaction. For instance, if the QI gets an endless supply of the surrendered property and the exchanger chooses to get $10,000 in real money at closing, the exchanger will pay tax on $10,000 while the trade is finished with the rest of the assets held by the QI.
Mortgage Boot – It is consists of liabilities assumed or given up by the taxpayer. If the trader is not able to purchase a replacement property of greater or equal value than the relinquished property, then most probably he would receive “mortgage boot”.
For instance in a case of the receipt of “mortgage boot”, if the exchanger surrenders a property esteemed at $100,000 and stores $50,000 with his QI and pays a mortgage of $50,000 and if he replaces a property esteemed at $90,000 with $50,000 cash down, and a substitution mortgage of $40,000 the exchanger will pay a charge on $10,000. An exchanger can likewise get another property, which will be considered as a boot. For instance, if the exchanger gets vehicles, craftsmanship, or any valuable thing as a replacement of the trade, that other non-like kind property will be considered as boot and taxed on the fair market value designated to it.
Q: Is it advisable to refinance a property immediately before the exchange?
A: By refinancing, exchangers usually hope to pull money out of their sale transaction to use for purposes other than investing in new 1031 property. It is proposed by the recent tax authority that refinancing of the abandoned property before sale with receipt of cash by the exchanger may not be considered “cash boot” under certain limited circumstances. This course of action is not justified. In the event the exchanger needs money for a genuine independent business purpose, it is strongly recommended that the exchanger refinances the replacement property after possession and when the independent need for cash arises.
Q: How and for how long do I have to identify, what constitutes to sufficient identification, is there any scope for it?
A: The replacement properties must be recognized within 45 days after the bringing on the deal to a close the sale of the relinquished property. This necessity is entirely implemented, regardless of the possibility that the 45th day may be a holiday. Identification proof must be taken in writing, signed and dated by the exchanger and received by the QI no in between 45 days after the sale of the surrendered property. The replacement property must be positively recognized. Normally an email address or a legal record is enough. It is advised to be careful when a trader knows about his property in whole and then decides to close only a part of the whole. If questioned, this may be an insufficient identification for an effective trade.
Q: Within what time I need to buy my replacement?
A: After the exchange of the surrendered property, the replacement property must be acquired, and its closing must be completed within 180 days.
Q: Can I implement a multiple leg exchange?
A: Yes, multiple leg exchange can be easily implemented when various relinquished properties are exchanged for a single replacement properties. You can exchange one relinquished property with different replacement properties. Make sure from the starting that the exchange is a part of unified exchange agreement because the 45-day identification rule and 180-day replacement rule will be commenced from the date of the sale of the first relinquished property. It is better to structure these series of exchanges rather than preferring multiple leg exchange, due to its timing issue.
Q: Can I exchange less than 100% of my interest?
A: Yes, an undivided Tenant in Common (TIC) interest or fractional part of the relinquished property can be exchanged, and/or a fractional part of the replacement property may be received.
Q: What is the best method to take title to the replacement property?
A: The best method to take title to the replacement property is in the same name as the relinquished property. Even married couples have to follow this rule strictly.
Q: How is a related party defined? Is it desirable to do an exchange with them?
A: A Related party includes the members of a family, including only brothers, sisters, half-brothers, half-sisters, spouse, ancestors (parents, grandparents, etc.), lineal descendants (children, grandchildren) and business entities. In a related party, the exchanger owns, at least, a 10% interest. There is a special rule for an exchange with related parties which states that if an exchange occurs involving related party, then all exchanged properties must be held by the related party and the trader for two years after the date of the previous transfer, or the exchange will not be suited for tax deferral. In a deferred exchange, if tax avoidance is not an issue then the trader can procure property from the related party.
Q: Does my replacement property accepts any tax basis?
A: No, your replacement property only carries the tax basis forwarded by your relinquished property. If there is any increase in the mortgage or there is any further cash investment by the exchanger, the tax basis is increased in the replacement property. You cannot use a depreciation allowance on the replacement property again if it is once used. Both investors and brokers often misunderstand it, so they see this rule as a negative outcome of 1031.
Q: Can a business entity do an exchange?
A: Yes, a business entity can do an exchange if the title to the replacement property remains same as the relinquished property. If you are involved in more than one partnership, make sure you do not exchange partnership interest of one with the other. For example, a share of stock in one company should not be exchanged for a share of stock in another company. However, Under 1031 legal entities can perform exchanges.
Q: Is it possible to get title to replacement property before giving up title to relinquished property?
A: Since reverse 1031 exchanges are allowed. But title to both the properties at the same time is not permitted. Consider, holding title to one of the properties. For any detail related to it, Contact Us!
Q: Is there any way to exchange funds for paying the mortgage on the property I already own?
A: No, there is no way out for this. The IRS does not support this kind of exchanges and is against 1031 exchange rules.
Q: Can fix up on replacement property be done by the exchange funds?
A: It is suitable to get the fix up done by the owner of the replacement property before purchasing it. Otherwise for performing the fix-up on the replacement property prefer using other funds rather than the exchange funds. If the fixup is accomplished before acquiring the title, then you can use exchange funds.
Q: Can exchange funds be used for building improvements on replacement property?
A: Yes, you can succeed in your goal by having a “Special Purpose Entity”. By having Special Purpose Entity, you can build the improvements and acquire the replacement property under the rules and regulations of 1031 exchanges. Consider contacting your QI if you are required to perform construction exchange.
Q: As a closing agent, what can I do when I am informed that a party to the transaction plans to do a 1031 Tax Deferred Exchange?
A: If you are informed, either in written or verbally that a party to the Agreement wants to do an exchange, first thing you need to do is include the “language” in your closing escrow directions so that Buyer accepts to cooperate with Seller, or the Seller agrees to cooperate with Buyer, or the Buyer and Seller makes a mutual decision. Remember, if you have put “exchange intent language” in your closing escrow instructions and are consequently notified that the party will not be doing an exchange, then don’t forget to plan an amendment eliminating that clause as it may look like you have closed or forgotten to do the exchange.
Q: When do I need to mention to the Exchange Intermediary Company about my involvement in a transaction?
A: Once you are completed with the sale and purchase contingencies such as physical inspection, title review or environmental assessments you will contact American Equity Exchange. If your escrow is quickly closed, inform us immediately and don’t wait for the contingency. Otherwise, after contingencies are eliminated, you need to immediately furnish our office with a copy of the Title Commitment, Buy-Sell Agreement, and info about closing agent on the transaction.
Q: What is the procedure followed by Qualified Intermediary after receiving the Buy-Sell Agreement & Title Commitment from the Closing Agent?
A: Qualified Intermediary prepare the exchange agreement and replacement of either seller or buyer in the escrow, after receiving Purchase and Sales Agreement as well as title commitment. After then, the exchange file is set up to coincide with your escrow depending upon its structure. Then the documents are forwarded to the closing agent for the signatures.
From this point, the substitution of buyer or seller is the Qualified Intermediary. So from now onward any subsequent amendments that require the party’s signature need to be shown to American Equity Exchange in addition to the original parties. You are risking your exchange transaction if the qualified intermediary is not mentioned in it.
So Don’t forget to replace the exchanger’s name with the Qualified Intermediary and let the exchanger merely have the “acknowledge receipt” of all subsequent instructions. This rule is applied if you are canceling or replacing your escrow instructions.
Q: As a Closing Agent, how can I manage the expected closing statements?
A: The Qualified Intermediary will represent either as the Buyer or Seller. Send us the estimate for the approval with a copy of the exchanger’s acknowledgment of the same on the bottom. Once we receive your acknowledgment, we will sign it and send you back.
Furthermore, we must get the final closing statement shortly after the escrow closing showing our name as principal together with any other documentation demanded in our instruction letter. Without these items, the exchange file cannot be completed as per the 1031 exchange rules.
Q: As the closing agent, how can I keep the record of the money received and/or distributed from the closing escrow transaction?
A: In this whole scenario, your Buyer is the only one doing an exchange that means that American Equity Exchange is already in the acquisition of exchange funds. Consider contacting our office for knowing whether the initial deposit is coming from the buyer or from us as Intermediary. To complete the purchase the buyer needs to come up with the money in addition to the exchange proceeds. You need to show the receipt and your original Closing Escrow Instructions if American Equity Exchange is giving you the initial deposit. In case, if you are receiving an initial deposit directly from the Buyer, he will be shown as the Buyer until American Equity Exchange has been replaced in as Buyer at a later date.
CAUTION: In this event, you need to clarify to IRS that buyer did not have any constructive receipt of funds by showing a line item as “return of the initial deposit to Exchangor” in closing statement Keep in mind these following points:
- All proceeds or refunds that you formulate in your escrow must be made payable to American Equity Exchange, even if they are after the close of escrow, else you will risk the exchange.
- Once American Equity Exchange is substituted in as either buyer or seller, American Equity Exchange is the principal.
- You always need to keep our office informed about every detail or any changes made.
Q: How do we supervise the situation in which the Seller is doing an Exchange, and they will be carrying back a note and report of trust or mortgage?
A: In this circumstance, you must talk clearly with the Seller, their tax advisor, and our office about the proper structure of the transaction. You ought to show American Equity Exchange as your Beneficiary if the trust deed or mortgage is part of the Exchange. We will handle the assignment of same through our exchange file to the seller or to whomsoever it will ultimately be assigned. Sometimes it is a possibility that the mortgage or trust deed may roll into the seller’s “replacement property”. It is very important for your closing statement to reflect the percentage interests and for you to do a correction in your closing escrow if the mortgage or trust deed is no more a part of the exchange. (maybe because the seller accepts installment sale treatment for the trust deed or mortgage).
Q: What should be the Qualified Holding period for a property if purchased over 1031 exchange?
A: Although many people believe that it should be two years at minimum, no such hard and fast rule is there in this matter. The resident has to plan to hold the property for investment or income producing scheme when he gets the control over the building. In case, there is any legal plan to achieve the holding conditions, the qualified use period may be less. It would be better that the taxpayers ask their tax advisors on such matters.
Q: How much of the exchange value does it cost to get complete non-recognition of capital gain?
A: Well, you need to spend equal or greater the amount of the exchange value so as to get full non-recognition of capital gain.
Q: When selling a portion of your property can it be vested uniquely compared to when buying a piece of property?
A: No, you cannot. If you are doing a 1031 exchange, it is mandatory that the vesting of the property must be same as the vesting of the one at the time of relinquish.
HANDLING TAX BASIS IN A 1031 EXCHANGE
A section in which we get a bunch of inquiries, is about the right approach or handling of basis in a 1031 exchange. Various questions asked are: “What happens to the basis, when I send my old property?”, “What are the updates of the reduction already taken by me?”, “Will 1031 exchange help me in freshening up my depreciated old property?”, “If I think of buying the New Property worth $100,000, can I depreciate the whole $100,000?” Such questions compare with what happens to the basis of the property when you do a 1031 exchange.
The initial step that determines the basis of your New Property is the basis of your Old Property. Let us explain to you with an example. Suppose Alice and Ben are selling their duplex which they bought in 1994 for $50,000 and they have taken $10,000 as depreciation on the duplex since they bought it. Their tax basis in the duplex is $40,000 ($50,000 minus $10,000). They are selling it for $100,000 and have found a condominium to buy as their replacement property as per their 1031 exchange. What is the basis in their condominium? And how is the discount handled on the condominium?
You need to notice that they bought the condominium for the same price at which they sold their duplex. This is a significant fact because the purchase price of the New Property is one of the basic facts that affect this answer. The answer is they “bought for equal,” the basis in the new condominium is $40,000 – the same as it was for the old duplex. In a 1031 exchange, the basis rolls forward from the Old Property (the duplex) to the New (the condominium). What’s more important, on their future reduction schedules is the purchase date for the condominium is 1994 (it is the date of the original purchase of the duplex), and the reduction schedule carries over as if they were still deteriorating the duplex.
The only reason for this is that according to IRS, you still own the original property, except that the address and legal description of the property are now that of the condominium as per the 1031 exchange. In a 1031 exchange, the purchase date, holding period and depreciation schedule continue unchanged by the exchange; the basis in the condominium is the same as it was for the duplex.
Now, let’s change our presumptions and see what happens if instead of buying the condominium for the same price they sold the duplex, they would have bought an office building for $160,000. In other words, they got up by $60,000. Their basis in the office is now $90,000 which is the order of the “rollover basis” of $40,000 from the duplex and the $60,000 buy up from the office. Their reduction schedule shows the continuous depreciation of the duplex (as if they still owned it) and the purchase of the office portion as of the date they closed on the office purchase.
What happens if they thought to buy down? Instead of the office building, let’s say Alice and Ben buy a rental house, for $80,000. They sold the duplex for $100,000 and now they are buying down to $80,000. As the basis always rolls over, so their basis in the rental house is $40,000 – the same as of the duplex. Because they bought down, the amount of the buy down ($20,000) is taxable. That’s why we always say that “the gain comes first in a 1031 exchange.”