IRC 1031 EXCHANGES
I. WHAT IS AN EXCHANGE OF PROPERTY?
The purpose of an exchange is to defer the payment of taxes on some or all
of the capital gain in the property to be exchanged. A taxpayer does not have
to look for a party to buy his/her property and acquire a replacement property
from the same individual that bought the sale property (a two-party exchange). Although
it was required at one time, a taxpayer may sell his/her property to one purchaser
and acquire replacement property from another party. An exchange is similar
to a sale and a purchase, however, the intent of an exchange, exchange documents
and a Qualified Intermediary are necessary elements to effect an IRC 1031. The
taxpayer is increasing his selling and buying power by electing to avoid the
payment of capital gains tax to the IRS.
II. WHAT IS LIKE-KIND PROPERTY?
The IRS, through Section 1031 of the Internal Revenue Code, recognized that an
exchange of like-kind property is not a taxable event. Sec. 1031(a) – Nonrecognition
of gain or loss from exchanges solely in kind – (1) In general, no gain
or loss shall be recognized on the exchange 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 either for productive use in a trade
or business or for investment. A taxpayer must acquire a property of “like-kind”
which is virtually any type of real property used for business use or investment.
A taxpayer may sell vacant land and acquire a warehouse or sell a 3-4 family rental
dwelling and acquire vacant land. The property does not have to be similar
in nature. Properties can be located anywhere within the United States. A few examples of non like-kind property are stocks,
bonds, notes, interests in partnerships, improvements to property currently owned
and choses in action. Simply put, like-kind refers to real property for real property
as long as it is held for business use or investment. Both the property being
sold and the property being purchased should be held by the taxpayer for at least
two years and should not be held with the intent of being sold immediately before
or after the exchange takes place.
III. WHAT ARE THE KEY ELEMENTS OF AN EXCHANGE?
A. Taxpayer/Exchangor cannot have actual or constructive
receipt of the sale proceeds. A Qualified Intermediary, a middleman, whom
is not an agent of the Exchangor, must hold the proceeds. An attorney,
a tax advisor, a broker, an accountant, and family members are all considered
agents of the Exchangor and are considered disqualified parties. If the
Exchangor has access to the sale proceeds and/or taxable interest accrued on
the proceeds, either directly or indirectly through an agent, the funds will
become tainted and the exchange corrupted.
B. Utilize a Qualified Intermediary prior to the close of the
sale of the Relinquished Property. ESI will prepare the necessary exchange
documents for both the Relinquished and Replacement Properties. One of
the key documents that needs to be in place prior to the sale closing is the
Exchange Agreement between ESI and the Exchangor along with the Acceptance of
Assignment and Notice to Buyer for the Relinquished Property. ESI can make
the exchange process very simple and keep the Exchangor aware of time deadlines
and ensure the Exchangor meets the strict requirements of the Code.
C. Replacement Property must be identified with the Qualified Intermediary
within 45 days of the closing of the Relinquished Property. When identifying
Replacement Property one of the following rules must be followed:
1) Three-Property Rule: Up to three properties of any value may be identified. The
Exchangor can purchase one, or all three properties.
2) Two Hundred Percent Rule: Any number of properties can be identified
so long as the aggregate fair market value of all properties identified do not
exceed 200% of the sale price of the Relinquished Property
3) Ninety Five Percent Rule: If both above rules are exceeded in the
number and value of the properties identified, it will be considered valid if
at the end of the exchange, the Exchangor has succeeded in acquiring properties
worth an aggregate of at least 95% of the fair market value of all of the properties
originally identified. For example, you may identify $1,000,000 in Replacement
Property and acquire only $950,000 in Replacement Property.
D. The transaction must be completed by the earlier of (i) 180 days from
the date of the first closing or (ii) the due date of the exchangor’s
tax return (including extensions) for the year the Relinquished Property was
IV. HOW CAN AN EXCHANGOR SECURE A QUALIFIED INTERMEDIARY’S EXCHANGE PROMISE?
A. A mortgage, deed of trust, or other security interest in property, B. A
standby letter of credit, C. A guarantee of a third party, or D. Cash
held in a qualified trust or qualified escrow.
V. WHEN CAN AN EXCHANGOR RECEIVE ANY REMAINING CASH THAT IS NOT INVESTED
IN REPLACEMENT PROPERTY?
A. After the end of the 45-day identification period, if there
were not any properties identified.
B. After you have received all Identified Replacement Properties.
C. Otherwise, after the end of the 180-day exchange period.
Exchange Solutions, Inc. handles four types of exchanges; the simultaneous exchange,
the delayed exchange (basic types) and construction exchanges and reverse exchanges
for personal and real property.
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Members of the Federation of Exchange Accommodators, Bonded and Insured