EXCHANGE BASICS AND FAQ’S
IRS 1031 EXCHANGES
WHAT IS AN EXCHANGE OF REAL PROPERTY?
The purpose of an exchange is to defer the payment of taxes on some, or all, of the capital gain in the real property to be exchanged. Although required at one time, a taxpayer does not have to look for a party to buy his/her real property and acquire a replacement from the same individual (a two-party exchange). Today the vast majority involve a taxpayer who intends to sell his/her real property to one purchaser and acquire a replacement from another party.
An exchange is the same as a sale and a purchase, however, the intent of an exchange, exchange documents, and a Qualified Intermediary are necessary elements to execute an IRC Section 1031. The taxpayer increases their selling and buying power by electing to defer the payment of capital gains tax to the IRS.
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 essentially, any type of real property used for business use or investment. For example, 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.
Examples of non-like-kind property are personal property, stocks, bonds, notes, interests in partnerships, improvements to property currently owned and choses in action. Only real property qualifies for 1031 purposes. Taxpayers cannot exchange their primary residence, vacation homes for personal use, or any personal-use property used by family members that do not pay rent, have a lease agreement, and where income on a taxpayer’s return is not recognized.
Simply put, like-kind refers to real property for real property if 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 tax periods and should not be held with the intent of being sold immediately before or after the exchange takes place.
WHAT IS THE SAME TAXPAYER REQUIREMENT?
Any individual, tenant-in-common, partnership, limited liability company, S-Corp. or C-Corp. can elect to exchange. However, the same party selling/exchanging their Relinquished Property must be the same party purchasing the Replacement Property. There are circumstances that allow the taxpayer to create disregarded entities (DRE’s), holding companies, etc., that do not violate this rule.
CAN A TAXPAYER EXCHANGE REAL PROPERTY WITH A RELATED PARTY?
Yes, but there are strict rules that do not always allow a taxpayer to exchange with a relative. These rules need to be discussed with your Qualified Intermediary and your tax advisor.
WHAT ARE THE KEY ELEMENTS OF AN EXCHANGE?
1. Taxpayer/Exchangor cannot have actual or constructive receipt of the sale proceeds. A Qualified Intermediary, whom is not an agent of the Exchangor, must hold the proceeds. An attorney, tax advisor, broker, accountant, and family members are all considered agents of the Exchangor and are 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.
2. 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 makes the exchange process very simple and keeps the Exchangor aware of time deadlines to ensure the Exchangor meets the strict requirements of the Code.
3. Replacement Property must be identified with a qualified party and best 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:
- Three-Property Rule: Up to three properties of any value may be identified. The Exchangor can purchase one, two, or all three properties.
- Two Hundred Percent Rule: Any number of properties can be identified so long as the aggregate fair market value of all properties identified does not exceed 200% of the sale price of the Relinquished Property.
- 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.
4. 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 sold.
HOW CAN AN EXCHANGOR SECURE A QUALIFIED INTERMEDIARY’S EXCHANGE PROMISE?
- A mortgage, deed of trust, or other security interest in property,
- A standby letter of credit,
- A guarantee of a third party, or
- Cash held in a qualified trust or qualified escrow.
WHEN CAN AN EXCHANGOR RECEIVE ANY REMAINING CASH THAT IS NOT INVESTED IN REPLACEMENT PROPERTY?
- After the end of the 45-day identification period, if there were not any properties identified.
- After the end of the 45-day identification period and after you have received all identified Replacement Properties.
- Otherwise, after the end of the 180-day exchange period.
Exchange Solutions, Inc. handles all four types of exchanges: the simultaneous exchange, the delayed exchange (basic types), construction exchanges and reverse exchanges for real property. Call for your free consultation today!
Dial 516-771-2400 to speak with a representative.