You must trade up or equal in value and equity to totally defer the taxable gain in your exchange. We do not undertake to calculate taxable gain in your exchange. CONSULT YOUR TAX ADVISOR.

 There are restrictions on acquiring a replacement property from a related party. Please call us if you are considering this.

 You must fund loan fees and other loan costs from non-exchange funds or these amounts may be taxable boot to you. Consult your tax advisor.

 Please consult us if you have received earnest money or options payments outside of escrow.

 

The Role of the QI

The most common exchange format, the delayed exchange, requires investors to work with an IRS approved middleman called a “Qualified Intermediary” (QI) who facilitates the exchange; and is further defined as follows:

  1. Not a related party (i.e. agent, attorney, accountant, investment banker, broker, or real estate agent, etc.);
  2. Receives a fee;
  3. Receives the relinquished property from the exchanger and sells to the buyer;
  4. Purchases the replacement property from the seller and transfers it to the exchanger.

The QI does not provide legal or specific tax advice to the exchanger, but will usually perform the following services:

  1. Coordinate with the exchanger and their advisors (i.e. attorney, accountant, etc.) to structure a successful exchange;
  2. Prepare the exchange documentation for the Relinquished Property and the Replacement Property;
  3. Furnish escrow with instructions to effect the exchange;
  4. Secure the funds in an insured bank account until the exchange is completed;
  5. Provide documents to transfer Replacement Property to the exchanger, and disburse exchange proceeds to escrow;

Provide documentation to the exchanger at completion of the exchange necessary to complete their required tax reporting.

 

What is a 1031 Exchange?

The concept of Section 1031 has been on the books since 1921 and is one of the last significant tax advantages remaining for real estate investors.  The key advantage of a Section 1031 exchange is the ability to sell a property without paying any capital gain tax, or depreciation recapture at closing, which allows the earning power of the deferred taxes to work for the benefit of the investor.

Although Section 1031 refers to “an exchange of property”, it does not require a simultaneous “swap” of properties.  One of the most significant rule changes occurred as a result of the 1979 Starker decision in which the Court of Appeals enabled the non-simultaneous or “delayed” exchange to qualify for tax deferral.  This gave investors the time necessary to find desirable replacement property. In 1991, the IRS described how to convert a sale and subsequent purchase of property (or “delayed” exchange) into a tax deferred exchange by employing what the IRS calls a “Qualified Intermediary” (also referred to as a Facilitator or Accommodator).

 

What is a QI?

A Qualified Intermediary “QI” is an entity who enters into a written agreement with the taxpayer (“exchanger”) to acquire the exchanger’s rights and/or ownership interest in the property the exchanger is selling (“relinquished property”), and transfer such ownership interest into one or more properties of “like-kind” that the exchanger chooses to buy (“replacement property”). A QI is required by tax law and provides a safe harbor for the taxpayer (exchanger).

In other words, the intermediary is “assigned in” as the seller of the property during the closing process.  It is the assignment that allows the seller to become an exchanger, and, essentially, convert an otherwise taxable sale and subsequent purchase of investment real estate into a tax-deferred exchange.

Because the intermediary is technically the seller who receives the sale proceeds, it prevents the exchanger from being in “actual or constructive receipt” of the proceeds; thus, there is nothing to tax.

 

Basic Requirements

Although Section 1031 refers to “an exchange of property”, it does not require a simultaneous “swap” of properties.  One of the most significant rule changes occurred as a result of the 1979 Starker decision in which the Court of Appeals enabled the non-simultaneous or “delayed” exchange to qualify for tax deferral.  This gave investors the time necessary to find desirable replacement property. In 1991, the IRS described how to convert a sale and subsequent purchase of property (or “delayed” exchange) into a tax deferred exchange by employing what the IRS calls a “Qualified Intermediary” (also referred to as a Facilitator or Accommodator).

A Qualified Intermediary “QI” is an entity who enters into a written agreement with the taxpayer (“exchanger”) to acquire the exchanger’s rights and/or ownership interest in the property the exchanger is selling (“relinquished property”), and transfer such ownership interest into one or more properties of “like-kind” that the exchanger chooses to buy (“replacement property”). A QI is required by tax law and provides a safe harbor for the taxpayer (exchanger).

In other words, the intermediary is “assigned in” as the seller of the property during the closing process.  It is the assignment that allows the seller to become an exchanger and, essentially convert an otherwise taxable sale and subsequent purchase of investment real estate into a tax-deferred exchange.

Because the intermediary is technically the seller who receives the sale proceeds, it prevents the exchanger from being in “actual or constructive receipt” of the proceeds; thus, there is nothing to tax.

 

Choosing a Qualified Intermediary

A QI should be investigated for their experience, background and credentials.  They should have extensive real estate and 1031 Exchange knowledge and expertise.

Due to the complexity of the 1031 Exchange, it is in the best interest of the exchanger to hire a QI that is a Certified Exchange Specialist™.  This designation demonstrates that the QI possesses a higher level of knowledge and experience and passed the national examination administered by the Federation of Exchange Accommodators (FEA), a national organization for qualified intermediaries. A person who receives the CES™ is required to uphold a strict Code of Ethics and must meet continuing education requirements to retain this designation.

 

Dealer vs. Investor

The IRC Section 1031 Rules and Regulations specifically state “No like-kind exchanges for “dealers” in real estate, only “investors”.  Dealers in real estate may not use the like-kind exchange provisions regarding non-recognition of gain or loss on exchange of real property because they hold real property as stock-in-trade (inventory), and not for productive use in business or for investment (Section 1031(a)(2)).”

“An ‘investor’ or ‘speculator’ in real estate is usually anticipating a gradual appreciation in value of the real estate, or a rather sudden increase in value in the event of fortuitous circumstances, without doing much to cause that increase in value; whereas the ‘dealer’ in real estate is typically looking for a rapid increase in price over a relatively short time, most frequently as a result of some efforts on their part to cause the increase.  Unfortunately, these categories are only the extremes and do not cover the entire spectrum of real estate transactions.  Those that fall in between are the most difficult to characterize for tax purposes.”

Klarkowski v. Commissioner, T.C. Memo 1965-378.

 

Exchange Basics

Qualified Property

To meet the requirements of §1031, both Relinquished Property and Replacement Property must qualify. In other words, both the property you are selling and the property you are buying must be qualified property of like-kind. If not, your exchange will fail and be classified as a sale.  This is so important, that it bears repeating:

TO QUALIFY AS A LIKE-KIND EXCHANGE, THE PROPERTY MUST BE BOTH (1) QUALIFYING PROPERTY, AND (2) LIKE-KIND PROPERTY.

For income tax purposes, real estate is divided into four (4) classifications.  Classification is made as of the date the transaction is made.  The classifications are:
            
            Held for business use (§1231)
            Land held for investment (§1221)
            Held for personal use (§121)
            Held primary for sale (Dealer Property)

The first two classifications – held for business and held for investment – qualify for §1031 treatment.  The second two – held for personal use and dealer property – do not.

Some properties have more than one classification at the time of sale.  For example, a farmer sells his farm including his personal residence.  The sale or exchange is allocated between the real estate held for personal use (the personal residence) and the real estate held for use in a trade or business (the farm).  Another example is the sale or exchange of a duplex where the seller lived in one unit and rented out the other unit.

Under §1031, both business and investment property qualify.  And it does not require only business property for business property or investment property for investment property.  You can mix the classifications.  For example, you can exchange a commercial warehouse (business property) for two unimproved lots (investment property). Or, a 100 acre tract of land (investment property) for an apartment building (business property).  All could qualify.

The 45-day Identification Rule

The Internal Revenue Code requires that you identify your potential replacement properties within 45 days of the closing on the sale of your relinquished property. The 45 days are calendar days, so if the 45th day is Sunday, Labor Day or the 4th of July, that day is still the deadline for identification of new properties. There are no extensions allowed.

There are two ways to comply with the 45-day identification requirement.  The first way is to have already purchased your replacement property.  If you meet all of the exchange value requirements by using all of your sale proceeds; purchase equal or greater in value; and have replaced any debt relief from the sale; and done so within the 45 day period following closing of your relinquished property, your exchange is complete at that point.

In the event you haven’t closed on a replacement property and met all of the exchange value requirements within 45 days, you must identify your new property.  By midnight of the 45th day, you must compile a list of properties that you’re thinking about purchasing to replace the property you just sold.  The list must be specific: it must show the property address, the legal description, or other means of specific identification.

The 3-Property Rule - You can identify up to three potential replacement properties without regard to fair market values of the properties. 

The 200 Percent Rule – You may identify any number of properties as long as their fair market value does not exceed 200 percent of the total fair market value of all Relinquished Property (ies).

EXAMPLE – On January 1st you sell your only relinquished property for $100,000.  On or before February 14th you want to identify four potential replacement properties: four condominiums selling for $75,000 each.

In doing so you will have violated the 45-day rule because the four properties identified exceed 200% of the value of the property sold.

The 180-day Exchange Rule

Section 1031 requires that you purchase one or more new properties by the 180th day after the closing of the old property.  You must purchase one or more properties on your 45-day identification list.

Qualified Intermediary

A requirement of Section 1031 Exchanges is that you must use a Qualified Intermediary (“QI”). The QI cannot be someone with whom you have had a business or family relationship. You must use an independent organization whose only contact with you is to serve as QI.  The Exchanger or a disqualified person cannot qualify as qualified intermediaries for their own exchange.  A person is a disqualified person if the person is an agent of the exchanger.  For example, your attorney, accountant, broker or brother are all disqualified.

The QI does not provide legal or specific tax advice to the exchanger, but will usually perform the following services:

  1. Coordinate with the Exchangers and their advisors to structure a successful exchange.
  2. Prepare the required documentation for the Relinquished Property (1st Leg) and Replacement Property (2nd Leg).
  3. Provide specific instructions to escrow to affect the exchange.
  4. Secure the funds in an insured bank account until needed for disbursement to escrow to acquire the replacement property. 
  5. Prepare, manage and provide a complete accounting of the transaction to the Exchanger and/or their tax advisor at completion of the exchange.

If and when you determine that you want to undertake a 1031 Exchange, you must involve the QI prior to closing of the sale of your relinquished property.

 

Holding Requirements

There is no safe holding period for property to automatically qualify as being “held for investment”. The amount of time a taxpayer holds the property is not the only determining factor, but it does play an extremely important role in demonstrating intent.  The easiest way to demonstrate intent to hold a property is to do just that – hold it.  And, the longer the better.

In one private letter ruling (PLR 8429039), the IRS stated that a minimum holding period of two years would be sufficient.  Although a private letter ruling does not establish legal precedent for all taxpayers, there are many advisors who believe two years is a conservative holding period, provided no other significant factors contradict the investment intent.

Tax advisors frequently recommend that taxpayers hold the subject property for a minimum period of at least one year.  A holding period of one year means the taxpayer will mostly likely reflect the investment property in two tax filing years, listing rental income, expenses and depreciation, which provide a solid case to prove the intent to hold.

 

Identifying Replacement Property

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 thereafter.  To qualify for a §1031 tax deferred exchange, the tax code requires identifying replacement property in the following manner:

  • In a written document signed by the Exchanger;
  • Hand delivered, mailed, faxed, or otherwise sent;
  • Before the end of the identification period to;
  • Either the person obligated to transfer the replacement property to the Exchanger (generally the “Qualified Intermediary”) or any other person involved in the exchange other than the taxpayer or a disqualified person.

The replacement property must be unambiguously described (i.e. legal description, street address or distinguishable name).  The type of property should be described in a personal property exchange.

 

Identification Rules

Although Exchangers can identify more than one replacement property, the maximum number of properties that can be identified is limited based on the following:

  1. Three properties without regard to their fair market value (“Three Property Rule”);
  1. Any number of properties so long as their aggregate fair market value does not exceed 200% of the aggregate fair market value of all relinquished properties (“200% Rule”);

Any number of properties without regard to the combined fair market value, as long as the properties acquired amount to at least ninety-five percent (95%) of the fair market value of all identified properties (“95% Exception”).

 

“Like-Kind” Property

IRS code, Section 1031 states 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 if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment.”

Thus, it is imperative that the relinquished property and the replacement property both be held for “productive use in a trade or business or for investment”.

The term “like-kind” property has been given a broad interpretation by numerous IRS revenue rulings and private letter rulings.  Through these rulings, authorities have validated exchanges between and amongst several different types of investment property, including bare land, commercial property, industrial buildings, retail stores, apartments – even leasehold interests exceeding 30 years.

 

Reverse Exchange

What if an Exchanger wants to buy a new (replacement) property before selling their old (relinquished) property? If the new property is purchased in the Exchanger’s name before the old property is sold, the transaction will not qualify for a 1031 Exchange.  Revenue Procedure 2000-37 which provides the guidelines for Reverse Exchanges makes it clear that the Exchanger cannot own both properties at the same time.

The ownership process in a reverse exchange is described as a “parking arrangement” because ownership of either the replacement property or the relinquished property is “parked” with the QI who takes on an additional role, that of an Exchange Accommodation Titleholder or “EAT”.

Parking the Replacement Property:  The EAT acquires the replacement property with funds provided by the Exchanger. Within 180 days the Exchanger sells their relinquished property through a “delayed exchange” format and the EAT then transfers ownership in the replacement property to the Exchanger.

Parking the Relinquished Property:  The Exchanger conveys the intended relinquished property to the EAT and then the Exchanger acquires the replacement property under a “simultaneous exchange” format.  EAT remains in title to the relinquished property during the 180 day exchange period until such time as it is sold to a purchaser.

 

 

Improvement Exchanges

Improve an Existing Property or Build New

What is an Improvement Exchange?

An exchange in which the replacement property will have improvements made to it before it is acquired by the Exchanger is known as an “Improvement” or “Construction/Build-to-Suit” Exchange. The improvements might be minor, in the case of a remodel, or they might be major, like constructing a building to required specifications. The ability to refurbish, add capital improvements, or build-to-suit, while using tax deferred dollars, can create tremendous investment opportunities for an Exchanger.

When can an Improvement Exchange be used?

The improvement exchange is commonly utilized to the benefit of 1031 Exchangers in the following situations:

  • The property to be acquired in the exchange is not of equal or greater value to property being sold. In this case, the improvement exchange can eliminate a taxable situation by adding capital improvements to a property. 
     
  • To build a new investment from the ground up. This example maximizes the investment opportunity in a given area by enabling an Exchanger to build their own property. This keeps the Exchanger from being subject to property that is on the market and to seller’s terms. 
     
  • The new investment is of equal or greater value but it needs refurbishments. The Improvement Exchange can be utilized to refurbish the replacement property.

Requirements of an Improvement Exchange?

An Exchanger must meet three basic requirements in order to defer all of their gain in an improvement exchange as follows:

Number One: spend the entire exchange equity on completed improvements or down payment by the 180th day;

Number Two: receive substantially the same property they identified by the 45th day; and

Number Three: the replacement property must be equal or greater value when deeded back to the Exchanger. The final value of the replacement property is the combination of the original purchase price plus the capital improvements made to the property.

It is important to note that the improvements need to be in place prior to the Exchanger taking title to the replacement property. However, the new replacement property does not necessarily have to be fully completed within the 180 day exchange period. A certificate of occupancy is not required.

Potential Obstacles

The main obstacle in this type of 1031 exchange is that the Exchanger cannot take title to the replacement property. The QI must take title to the property while the improvements are being done. When there is a lender involved, issues may arise as a result of the QI holding title to the property. In most cases they can be overcome and a successful exchange can be accomplished.

If a taxpayer intends to leverage replacement property immediately after an exchange, the taxpayer should make certain that the debt in fact is not incurred until after the exchange. As a practical matter, this means that the debt financing should be evidenced by a separate closing with a separate settlement statement from the title company. Although the acquisition and the financing can occur in back-to-back transactions, the two transactions should be distinct and separate, andtitle to the replacement property should be clearly vested in the taxpayer before debt is placed on the property. To be certain that these timing requests are met, tax advisors frequently arrange for the debt to be placed on the replacement property the day after it is acquired.