1031 Exchange – Deferring Taxes
1031 Exchange – Deferring Taxes
Section 1031 Tax Deferred Exchange Defined
Tax-deferred exchanging (aka a 1031 Exchange) is an investment strategy that should always be considered by anyone who owns investment real estate and is considering selling. This process is time-consuming and has several pitfalls; so, it should be considered well before even listing your property, and the desire to complete a 1031 Exchange should be communicated to all parties as soon as possible. You will very likely need the help of your potential Buyer!
WHAT IS A TAX DEFERRED EXCHANGE?
A tax-deferred exchange is a simple method by which a property owner trades one property for another and “temporarily” avoids taxes on the transaction. In an ordinary sale transaction, the property owner is taxed on any gains realized by the sale of the property. But in a 1031 exchange, the tax on the transaction is deferred until sometime in the future, usually when the newly acquired property is sold.
These exchanges are sometimes erroneously called “tax-free exchanges” because the exchange transaction itself is not taxed. Tax-deferred exchanges are authorized by Section 1031 of the Internal Revenue Code. The requirements of Section 1031 and other sections must be carefully met, but when an exchange is done properly, the tax on the transaction is deferred.
In exchange, a property owner (or “taxpayer”) simply disposes of one property and acquires another property of “Like-Kind” known as your Up-leg Property. The transaction must be structured in such a way that it is, in fact, an exchange of one property for another, rather than the taxable sale of one property and the purchase of another. The use of a fourth party, a Qualified Intermediary (QI), is imperative. With the help of a QI, the process can be easy, inexpensive, and safe.
MISCONCEPTIONS ABOUT EXCHANGING
People often fail to consider tax-deferred exchanging as an investment strategy because they are misinformed about the requirements of exchanging.
Myth: Exchanges require two parties who want each other’s properties.
Fact: Two-party exchanges are possible, but in reality, such two-party swaps rarely occur.
Myth: The like-kind requirement limits an exchanger’s options.
Fact: Property must be exchanged for “like-kind” property. But “like-kind: simply means that your Investment Property must be exchanged for Investment Property. Your apartment building can be exchanged for land, or a office building or single family residence – so long as it is a true investment property.
Myth: In exchange, title on the exchanged properties must pass simultaneously.
Fact: The properties do not have to close at the same time. However, in a deferred exchange, the replacement property must be identified within 45 days, and you must close escrow within 180 days after closing on the relinquished property. Not 181 day – but 180. The IRS is a huge stickler on this one. They want their taxes.
This Myth/Fact is where we shine. Let us help structure your 1031 exchange to last 6 months, maybe a year or more. Planning and communication are everything, the help of your potential buyer is key and we can help. Give us a call today 818.781.0255.
ADVANTAGES AND DISADVANTAGES OF EXCHANGING
The primary advantage of a tax-deferred exchange is that the taxpayer may dispose of property without incurring any immediate tax liability. This allows the taxpayer to keep the “earning power” of the deferred tax dollars working for him or her in another investment. Some refer to this and an “interest-free loan” from the IRS.
- And this “loan” can be increased through subsequent exchanges. There is currently no limit on the number of times that you can complete a 1031 exchange.
- And under current law-this tax liability is forgiven upon the death of the taxpayer. Upon the taxpayer’s death, the heirs get a stepped-up basis on such inherited property; that is, their basis is the fair market value of the inherited property at the time of the taxpayer’s death. Call us today and we can assist you in protecting your property in a trust or via a 1031 exchange 818.781.0255.
Potential Disadvantages as a result of a 1031 Exchange:
The Basis in the replacement property, resulting from the carry-over of the basis of the relinquished property will be quite low.
There are some increased transactional costs for entering into and completing a tax-deferred exchange. Some of those costs would be that few thousand dollars for the QI, the costs for the extra meetings with your accountant, and possibly your attorney fees too.
The taxpayer may not initially use any of the net proceeds from the disposition of the property for anything except reinvestment in real property.
SOME DEFINITIONS AND NAMES IN THE PROCESS
The Taxpayer: The taxpayer has a property and would like to exchange it for a new property. Sometimes easily confused with the “Seller”. Since you are both a Seller and a Buyer – we call you the Taxpayer or “Exchangor”
The Seller: The seller is the person who owns the up-leg property that the taxpayer wants to acquire in the exchange.
The Buyer: The buyer is the person with cash who wants to acquire the taxpayer’s property.
The Qualified Intermediary: The intermediary plays a role in almost all exchanges today. It is usually a corporation or limited liability company – or even your attorney. It neither begins nor ends the transaction with any property. It buys and then resells the properties in return for a fee. The Intermediary can not be related to the taxpayer (Don’t make this mistake – it can be quite costly).
The Confusing Part: The party who acquires the taxpayer’s relinquished property is NOT the same party who owns the replacement property. The exchange is NOT a swap whereby two individuals swap properties with one another. This is KEY Because you as the Taxpayer are NOT ALLOWED TO TOUCH the Funds. Not even for one brief second. The instant you do – Poof = Taxes Due.
The Relinquished Property: The property originally owned by the taxpayer and which the taxpayer would like to dispose of in the exchange.
The Replacement Property (almost always referred to as the Up-leg Property): The new property, that is, the property that the taxpayer would like to acquire in the exchange. In order for an exchange to be completely tax deferred, the replacement property must have a fair market value greater than the relinquished property and all of the taxpayer’s equity or more must be used in acquiring replacement property.
If you acquire an up-leg property that is of lesser value, all of the remaining money will be taxed at the Taxpayers current tax rate.
The Two-Party Exchange: Two-party exchanges are rare since, in the typical Section 1031 transaction, the seller of the replacement’s property is not the buyer of the taxpayer’s property. The two-party exchange, or swap, is the purest form of exchange. As the name implies, only two parties are involved, and they exchange their properties.
The Simultaneous Exchange with Intermediary: Most exchanges today employ the services of a QI whose sole purpose in the transaction is to facilitate the exchange. In a simultaneous exchange with an intermediary, title to the relinquished property is transferred directly to the buyer. The buyer pays cash to the intermediary. The intermediary pays cash to the seller who transfers title to the replacement property directly to the taxpayer. As noted above: The taxpayer thus avoids receiving any cash during the transaction, which would be immediately taxable.
The Deferred Exchange with a Qualified Intermediary: Sometimes when the relinquished property is transferred (escrow closes/records) to the buyer, the taxpayer often does not yet know what property he or she wants to acquire. When that is the case, a deferred exchange is necessary. The structure of the deferred exchange with a QI is essentially the same as the simultaneous exchange. However, because the replacement property is not known at the time of the first transfer the two legs of the exchange take place at different times.
The taxpayer has 45 days, from the close of the first escrow to identify one or more properties he or she wishes to use as their up-leg property. Subsequently, the escrow for the up-leg property must close within 180 days of the transfer of the relinquished property. Remember – 180, not 181 or more or you owe the taxes.
Qualified Property: In general, most property, both real and personal, can qualify for tax-deferred treatment, but some are specifically disqualified. The brush the surface: stocks, bonds, or notes; securities of indebtedness, interests in a partnership or multi-member limited liability company, or certificates of trust are just some of those items disqualified.
The Purpose Requirement: Not every type of property is eligible for tax-deferred treatment. Both the relinquished property and the replacement property must be held for productive use in a trade or business or for investment. Hint: You cannot exchange into or out of your own personal residence, or property held for resale as a dealer. Vacation homes may qualify if they are rented out by the taxpayer to unrelated persons, or held primarily for investment rather than personal use. Tip: If you don’t have really good and clear documentation that your vacation home was rented out to others (not family), we recommend that you don’t try at 1031.
The “Like-Kind” Requirement: Replacement property acquired in an exchange must be “like-kind” to the property being relinquished. Like-kind means “similar in nature or character, notwithstanding differences in grade or quality.” All real property is like-kind, regardless of whether it is improved of unimproved and regardless of the type of improvement or interest. Therefore, raw land may be exchanged for land with a building. One property may be exchanged for more than one property. Hint: Real property is not like-kind to personal property.
The Holding Period: How long must I hold property in order for it to qualify for a 1031 exchange? We get this question all the time……
Here is the answer from our Tax Professionals: The holding period is one factor used to determine whether the Purpose Requirement (see above) has been met. If the replacement property is acquired and then immediately sold, say in the example of a “flip”; that might indicate the property was actually acquired for “immediate” resale and is, therefore, dealer property and consequently cannot qualify for tax-deferred treatment. A one year holding period is commonly used as a rule of thumb but has no basis in statutory or case law. Two years is more prudent.
Contact usThe Exchange Requirement: It may seem silly to mention this, but Section 1031 specifically requires that an exchange take place. This means that one property must be exchanged for another property, rather than sold for cash. Tip: Another way to look at this is: – The taxpayer must swap one property for one or more properties, and in the process not receive any money during the exchange. This is why the QI touches the money.
Time Limits: There are two critical time limits are established by Section 1031. The taxpayer is required to identify the replacement property within 45 days after the transfer of the relinquished property, AND the taxpayer must close escrow on the replacement property before the earlier of(a) 180 days after the transfer of the relinquished property, or (b) the due date of the taxpayer’s federal income tax return (including extensions) for the year in which the relinquished property is transferred. There are NO exceptions to these time limits.
Alternative and Multiple Properties: The Taxpayer may identify up to three properties, without regard to their fair market value, aka the “The Three-Property Rule”. More than three properties, without regard to their fair market value of all these properties, can be identified if the total fair market value of all these properties at the end of the 45-day identification period does not exceed 200% of the total fair market value of all properties relinquished in the exchange, aka “The 200%Rule”.
Hint: If you violate any of these rules, the penalty is severe.
New Construction as Replacement Property: If the taxpayer wants to include new construction as replacement property, then the construction must be done prior to the date that the taxpayer acquires title to the replacement property. Any construction occurring after the taxpayer acquires title does not qualify as like-kind replacement property in the exchange.
Method: Generally, the QI will acquire title to the replacement property, use the exchange funds for the construction, and then transfer title of the now improved property to the taxpayer before the expiration of the 180-day time period. All the funds from the first transaction must be used for the construction, the Taxpayer may not access any of the funds, or even take control of them in any way.
Constructive Receipt of Funds: If the taxpayer actually receives the proceeds from the disposition of the relinquished property, then the transaction will be treated as a sale and not as an exchange. This can be as simple as the money move through your account, or even an account you have control over. The crucial question in every non-simultaneous exchange is whether the taxpayer’s control over the proceeds from the disposition of the relinquished property is “substantially limited or restricted”. As there are a number of complicated rules a taxpayer must follow; give us a call at 818.781.0255 and we will put in touch with one of our trusted accounting partners.
Reverse Exchanges: If the Taxpayer has found his or her replacement property and must close on it prior to the time that the relinquished property is ready to close, then the transaction becomes a “reverse exchange”. The current IRS Code does not allow or prohibit reverse exchanges and the IRS has created a safe harbor for reverse exchanges that use one of the two “parking” procedures below.
Relinquished Property Parked:
In the first structure, the exchange occurs with the taxpayer acquiring the replacement property and conveying the relinquished property to the Exchange Accommodation Titleholder (“EAT”), using an exchange intermediary.
In the second structure, the EAT acquires the replacement property. The EAT may construct improvements on the property if needed. When the taxpayer’s relinquished property is ready to close, then the taxpayer will exchange the relinquished property for the replacement property through an exchange intermediary.
Unique Mechanics:
In reverse exchanges, the EAT can not be the taxpayer of a disqualified person (basically a person related to the taxpayer, including an entity in which the taxpayer owns 10% or more, or the taxpayer’s attorney, CPA, real estate or employee) and must be subject to federal income tax. The EAT must hold title to the property at all times from the date of acquisition by the EAT until the property is transferred. The taxpayer and the EAT must enter into a written agreement and the EAT must be treated as the beneficial owner of the property for all federal income tax purposes. The EAT may lease the parked property to the taxpayer or the taxpayer may manage it.
There are several more Mechanics: Please call us so we can put you in touch with our Accounting or CPA partners, so you can be made fully away of all these unique and intricate mechanics.
Combination Exchanges: A reverse exchange can be combined with a deferred exchange. For example, the taxpayer can exchange into a 50% undivided interest in a replacement property in a deferred exchange. The EAT can then acquire the remaining 50% undivided interest in that replacement property and hold it for up to 180 days while the taxpayer sells a second relinquished the property to exchange for the parked portion. Take your ulcer medication and cross your fingers… these are really tricky.
Basis: The starting point for determining the tax consequences in any transaction. In most cases, a taxpayer’s “basis” in the property is the cost of the property.
Adjusted Basis: The next step in determining the specific tax consequences in exchange is to establish the “adjusted basis” of the relinquished property. To do so, take the basis (the cost of the property), add the cost of any capital improvements made to the property (during the taxpayer’s ownership), and subtract any depreciation taken on the property during that same time period.
Note: Most folks are referring to the Adjusted Basis when they ask you about “your basis” in a property you are thinking of selling. But now you know there is an actual difference.
Realized Gain: Realized Gain is the difference between the total consideration (cash and anything else of value) received for a property and the adjusted basis. Transaction costs such as commissions and recording costs are deducted from realized gain.
Recognized Gain: Recognized Gain is that portion of the “realized gain” which is taxable. Realized gain is not taxable until it is recognized. Gain is usually, but not always, recognized in the year in which it is realized.
Boot: In an exchange of real property, any consideration received other than real property is “boot.” There are two types of boot: “cash boot” and “mortgage boot.” Cash boot is cash or anything else of value received. Mortgage boot is any liabilities assumed in the exchange.
Contact us