A 1031 tax deferred exchange represents a simple, strategic method for selling one qualifying property and the subsequent acquisition of another qualifying property within a specific time frame. Although the logistics of selling one property and buying another are virtually identical to any standard sale and purchase scenario, an exchange is different because the entire transaction is memorialized as an exchange and not a sale. And it is this distinction between exchanging and not simply selling and buying which ultimately allows the taxpayer to qualify for deferred gain treatment. So essentially, sales are taxable and exchanges are not. Internal Revenue Code, Section 1031
Because exchanging represents an IRS-recognized approach to the deferral of capital gain taxes, it is important for us to appreciate the components and intent underlying such a tax deferred or tax free transaction. It is within Section 1031 of the Internal Revenue Code that we find the core essentials necessary for a successful exchange. Additionally, it is within the Like-Kind Exchange Regulations, previously issued by the Department of the Treasury, that we find the specific interpretation of the IRS and the generally accepted standards and rules for completing a qualifying transaction. Throughout the remainder of this booklet we will be identifying these rules and requirements, although it is important to note that the Regulations are not the law. They simply reflect the interpretation of the law (Section 1031) by the Internal Revenue Service. Why exchange?
Any property owner or investor who expects to acquire replacement property subsequent to the sale of his existing property should consider an exchange. To do otherwise would necessitate the payment of capital gain taxes in amounts which can exceed 20-30%, depending on the appropriate combined federal and state tax rates. In other words, when purchasing replacement property without the benefit of a
1031exchange for real estate, your buying power is dramatically reduced and represents only 70-80% of what it did previously. Basic exchange rules
Let us look at a basic concept, which applies to all exchanges. Utilize this concept to fully defer the capital gain taxes realized from the sale of a relinquished property:
- The purchase price of the replacement property must be equal to or greater than the net sales price of the relinquished property, and
- All equity received from the sale of the relinquished property must be used to acquire the replacement property.
To the extent that either of these rules is abridged, a tax liability will accrue to the Exchangor. If the replacement property purchase price is less, there will be tax. To the extent that not all equity is moved from the relinquished to the replacement property, there will be tax. This is not to say that the exchange will not qualify for these reasons; partial exchanges do in fact qualify for partial tax deferral. It simply means that the amount of any discrepancy will be taxed as boot, or non-like-kind, property.
Four common exchange misconceptions:
- All exchanges must involve swapping or trading with other property owners. (NO)
Before delayed exchanges were codified in 1984, all simultaneous exchange transactions required the actual swapping of deeds and simultaneous closing among all parties to a 1031 tax exchange. Often times these exchanges were comprised of dozens of exchanging parties as well as numerous exchange properties. But today, there is no such requirement to swap your property with someone else in order to complete an exchange. The rules have been streamlined to the extent that the current process is reflective more of your qualifying intent rather than the logistics of the property closings.
All exchanges must close simultaneously. (NO)
Although there was a time when all exchanges had to be closed on a simultaneous basis, they are rarely completed in this format any longer. In fact, a significant majority of exchanges are now closed as delayed exchanges.
Like-kind means purchasing the same type of property which was sold. (NO)
The definition of like-kind has often been misinterpreted to mean the requirement of the acquisition of property to be utilized in the same form as the exchange property. In other words, apartments for apartments, hotels for hotels, farms for farms, etc. However, the true definition is again reflective more of intent than use. Accordingly, there are currently two types of property that qualify as like-kind:
- Property held for investment, and/or
- Property held for a productive use in a trade or business.
- Exchanges must be limited to one exchange and one replacement property. (NO)
This is another exchanging myth. There are no provisions within either the Internal Revenue Code or the Treasury Regulations that restrict the amount of properties that can be involved in an exchange. Therefore, exchanging out of several properties into one replacement property or vice versa, relinquishing (selling) one property and acquiring several, are perfectly acceptable strategies.
Equity and Gain
Is my tax based on my equity or my taxable gain?
Tax is calculated upon the taxable gain. Gain and equity are two separate and distinct items. To determine your gain, identify your original purchase price, deduct any depreciation which has been previously reported, then add the value of any improvements which have been made to the property. The resulting figure will reflect your cost or tax basis. Your gain is then calculated by subtracting the cost basis from the net sales price.
Deferring All Gain
Is there a simple rule for structuring an exchange where all the taxable gain will be deferred?
Yes, the gain will be totally deferred if you: 1) Purchase a replacement property which is equal to or greater in value than the net selling price of your relinquished (exchange) property, and
2) Move all equity from one property to the other.
Definition of Like-Kind
What are the rules regarding the exchange of like-kind properties? May I exchange a vacant parcel of land for an improved property or a rental house for a multiple-unit building? Yes, “like-kind” refers more to the type of investment than to the type of property. Think in terms of investment real estate for investment real estate, business assets for business assets, etc.
Simultaneous Exchange Pitfalls
Is it possible to complete a simultaneous exchange without an intermediary or an exchange agreement?
While it may be possible, it may not be wise. With the Safe Harbor addition of qualified intermediaries in the Treasury Regulations and the recent adoption of good funds laws in several states, it is very difficult to close a simultaneous exchange without the benefit of either an intermediary or an exchange agreement. Since two closing entities cannot hold the same exchange funds on the same day, serious constructive receipt and other legal issues arise for the Exchangor attempting such a simultaneous transaction.
The addition of the intermediary Safe Harbor was an effort to abate the practice of attempting these marginal transactions. It is the view of most tax professionals that an exchange completed without an intermediary or an exchange agreement will not qualify for deferred gain treatment. And if already completed, the transaction would not pass an IRS examination due to constructive receipt and structural exchange discrepancies. The investment in a qualified intermediary is insignificant in comparison to the tax risk associated with attempting an exchange, which could be easily disqualified.
How long must I wait before I can convert an investment property into my personal residence?
A few years ago the Internal Revenue Service proposed a one-year holding period before investment property could be converted, sold or transferred. Congress never adopted this proposal so therefore no definitive holding period exists currently. However, this should not be interpreted as an unwritten approval to convert investment property at any time. Because the one-year period clearly reflects the intent of the IRS, most tax practitioners advise their clients to hold property at least one year before converting it into a personal residence.
Remember, intent is very important. It should be your intention at the time of acquisition to hold the property for its productive use in a trade or business or for its investment potential.
Involuntary ConversionWhat if my property was involuntarily converted by a disaster or I was required to sell due to a governmental or eminent domain action?
Involuntary conversion is addressed within Section 1033 of the Internal Revenue Code. If your property is converted involuntarily, the time frame for reinvestment is extended to 24 months from the end of the tax year in which the property was converted. You may also apply for a 12-month reinvestment extension.
Facilitators and Intermediaries
Is there a difference between facilitators?
Most definitely. As in any professional discipline, the capability of facilitators will vary based upon their exchange knowledge, experience and real estate and/or tax familiarity.
Facilitators and Fees
Should fees be a factor in selecting a facilitator?
Yes. However, they should be considered only after first determining each facilitator's ability to complete a qualifying transaction. This can be accomplished by researching their reputation, knowledge and level of experience.
Personal Residence Exchanges
Do the exchange rules differ between investment properties and personal residences? If I sell my personal residence, what is the time frame in which I must reinvest in another home and what must I spend on the new residence to defer gain taxes?
The rules for personal residence rollovers were formerly found in Section 1034 of the Internal Revenue Code. You may remember that those rules dictated that you had to reinvest the proceeds from the sale of your personal residence within 24 months before or after the sale, and you had to acquire a property which reflected a value equal to or greater than the value of the residence sold. These rules were discontinued with the passage of the 1997 Tax Reform Act. Currently, if a personal residence is sold, provided that residence was occupied by the taxpayer for at least two of the last five years, up to $250,000 (single) and $500,000 of capital gain is exempt from taxation.
Exchanging and Improvements
May I exchange my equity in an investment property and use the proceeds to complete an improvement on a vacant lot I currently own?
Although the attempt to move equity from one investment property to another is a key element of tax deferred exchanging, you may not exchange into property you already own.
May I exchange into a property which is being sold by a relative?
No. An Exchangor may sell to a related party; however, the related party is subject to a two-year holding period.
Partnership or Partial Interests
If I am an owner of investment property in conjunction with others, may I exchange only my partial interest in the property?
Yes. Partial interests qualify for exchanging within the scope of Section 1031. However, if your interest is not in the property but actually an interest in the partnership which owns the property, your exchange would not qualify. This is because partnership interests are excepted from Section 1031. But don't be confused! If the entire partnership desired to stay together and exchange their property for a replacement, that would qualify.
Another caveat, those individuals or groups owning partnership interests, who desire to complete an exchange, and have for tax purposes made an election under IRC Section 761(a), can qualify for deferred gain treatment under Section 1031. This can be a tricky issue! See elsewhere in this publication for more information. Then, only undertake this election with proper tax counsel and only with the election by all partners!
Are reverse exchanges considered legal?
Although reverse exchanges were deliberately omitted from Section 1031, the Internal Revenue Service issued Revenue Procedure 2000-37 in September 2000 which provides a safe harbor for reverse exchange transactions.
Why are the identification rules so time restrictive? Is there any flexibility within them?
The current identification rules represent a compromise which was proposed by the IRS and adopted in 1984. Prior to that time there were no time-related guidelines. The current 45-day provision was created to eliminate questions about the time period for identification and there is absolutely no flexibility written into the rule and no extensions are available. /p>
In a delayed exchange, is there any limit to property value when identifying by using the Two Hundred Percent Rule?
Yes. Although you may identify any three properties of any value under the Three Property Rule, when using the Two Hundred Percent Rule there is a restriction. It is when identifying four or more properties, the total aggregate value of the properties identified must not exceed more than 200% of the value of the relinquished property.
An additional exception exists for those whose identification does not qualify under the Three Property or Two Hundred Percent rules. The Ninety-five Percent Exception allows the identification of any number of properties, provided the total aggregate value of the properties acquired totals at least 95% of the properties identified.
Should identifications be made to the intermediary or to an attorney or escrow or title company?
Identifications may be made to any party listed above. However, many times the escrow holder is not equipped to receive your identification if they have not yet opened an escrow. Therefore it is easier and safer to identify through the intermediary, provided the identification is postmarked or received within the 45-Day Identification Period
- If you would like more information on a 1031 Exchange or if you are in need of "Like Kind Products" Please call Michael Keegan at 1-800-390-8083.
1031 Exchanges Involving Your Personal Residence by Gary Gorman
1031 exchanges involve property you hold for investment, not your personal residence. So why write an article about doing a 1031 exchange on your personal residence? Everyone knows that your personal residence does not qualify for a 1031 exchange! Or does it?
When you sell a residence you've lived in for two of the last five years, $500,000 of the gain is tax free if you're married; ($250,000 if you are single). This is your personal residence, which does not have anything to do with 1031 exchanges, right? It might. You know the two-of-the-last-five-years rule, but did you ever ask yourself what the property was used for during the other three years?
Let's say Fred and Sue buy a house that they live in during years one and two. At the end of year two, they move out and turn the house into a rental property and rent it out for years three, four and five. When they sell it at the end of year five, does the property qualify for the personal residence exclusion? Yes, because Fred and Sue lived there for two of the five years preceding the sale. Does it also qualify for a 1031 exchange? Yes, because it was investment property for the last year-and-a-day before they sold it.
When two IRS code sections overlap, like the sale of a personal residence and Section 1031 do in this example, the IRS lets you pick the code section that gives you the biggest benefit. So which should you pick? In this example, Fred and Sue should treat the transaction as the sale of a personal residence because doing so will allow them to take up to $500,000 of their gain off the table tax free -- they'll never have to pay tax on this money again. If they treated the sale as a 1031 exchange, they would end up paying tax on the gain someday even though the gain would be deferred right now.
What if the gain from the sale of their house exceeds their personal residence exclusion? Then Fred and Sue are allowed to maximize their exclusion and can roll the rest of the gain over in a 1031 exchange. For example, assume that they sell the house for a gain of $600,000. They first apply their personal residence exclusion of $500,000, which leaves a gain of $100,000. Then they may rollover the $100,000 in a 1031 exchange to avoid being taxed on any of it.
Now let's take a different example showing a different interplay of these two code sections: Let's say Fred and Sue are selling a four-plex that they've owned for more than two years. During the time they owned it, they lived in one unit as their residence and rented out the other three units. In situations like this, they have a transaction that is a combination of both code sections -- they have both the sale of their personal residence (for one fourth of the sale), and a 1031 exchange (for three fourths of the sale). In effect, they have two transactions with this one sale.
So just because you are selling a residential property, there may still be a 1031 exchange angle that will help you defer the tax.
- If you would like more information on a 1031 Exchange or if you are in need of "Like Kind Products" Please call Michael Keegan at 1-800-390-8083.