Every Section 1031 Exchange transaction is different. These "Frequently Asked Questions" are intended
to answer general inquiries only.
Q - What is a tax-deferred exchange and how can it help me?
In a typical transaction, the property owner is taxed on any gain realized from the sale. However, through a Section
1031 Exchange, the tax on the gain is deferred until some future date. Section 1031 of the Internal Revenue Code provides
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. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one
or more replacement properties of "like-kind", while deferring the payment of federal income taxes and some state
taxes on the transaction.
The theory behind Section 1031 is that when a property owner has reinvested
the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any
tax. In other words, the taxpayer's investment is still the same, only the form has changed (e.g. vacant land exchanged for
apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a "paper" gain. The like-kind
exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of
another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property,
is subject to tax.
Q - What are the benefits of exchanging v. selling?
- A Section 1031 exchange is one of the few techniques available to postpone or potentially eliminate taxes due on
the sale of qualifying properties.
- By deferring the tax, you have more money available to invest
in another property. In effect, you receive an interest free loan from the federal government, in the amount you would have
paid in taxes.
- Any gain from depreciation recapture is postponed.
- You
can acquire and dispose of properties to reallocate your investment portfolio without paying tax on any gain.
Q - What are the different types of exchanges?
- Simultaneous Exchange: The exchange
of the relinquished property for the replacement property occurs at the same time.
- Delayed
Exchange: This is the most common type of exchange. A Delayed Exchange occurs when there is a time gap between the transfer
of the Relinquished Property and the acquisition of the Replacement Property. A Delayed Exchange is subject to strict time
limits, which are set forth in the Treasury Regulations.
- Build-to-Suit (Improvement or Construction)
Exchange: This technique allows the taxpayer to build on, or make improvements to, the replacement property, using the exchange
proceeds.
- Reverse Exchange: A situation where the replacement property is acquired prior to
transferring the relinquished property. The IRS has offered a safe harbor for reverse exchanges, as outlined in Rev. Proc.
2000-37, effective September 15, 2000. These transactions are sometimes referred to as "parking arrangements" and
may also be structured in ways which are outside the safe harbor.
- Personal Property Exchange:
Exchanges are not limited to real property. Personal property can also be exchanged for other personal property of like-kind
or like-class.
Q - What are the requirements for a valid exchange?
- Qualifying Property - Certain types of property are specifically excluded from Section 1031 treatment: property held
primarily for sale; inventories; stocks, bonds or notes; other securities or evidences of indebtedness; interests in a partnership;
certificates of trusts or beneficial interest; and choses in action. In general, if property is not specifically excluded,
it can qualify for tax-deferred treatment.
- Proper Purpose - Both the relinquished property
and replacement property must be held for productive use in a trade or business or for investment. Property acquired for immediate
resale will not qualify. The taxpayer's personal residence will not qualify.
- Like Kind - Replacement
property acquired in an exchange must be "like-kind" to the property being relinquished. All qualifying real property
located in the United States is like-kind. Personal property that is relinquished must be either like-kind or like-class to
the personal property which is acquired. Property located outside the United States is not like-kind to property located in
the United States.
- Exchange Requirement - The relinquished property must be exchanged for other
property, rather than sold for cash and using the proceeds to buy the replacement property. Most deferred exchanges are facilitated
by Qualified Intermediaries, who assist the taxpayer in meeting the requirements of Section 1031.
Q - What are the general guidelines to follow in order for a taxpayer to defer all the taxable gain?
- The value of the replacement property must be equal to or greater than the value of the relinquished property.
- The equity in the replacement property must be equal to or greater than the equity in the relinquished property.
- The debt on the replacement property must be equal to or greater than the debt on the relinquished
property.
- All of the net proceeds from the sale of the relinquished property must be used to
acquire the replacement property.
Q - When can I take money out of the exchange account?
Once the money is deposited into an exchange account, funds can only be withdrawn in accordance with the Regulations.
The taxpayer cannot receive any money until the exchange is complete. If you want to receive a portion of the proceeds in
cash, this must be done before the funds are deposited with the Qualified Intermediary.
Q - Can
the replacement property eventually be converted to the taxpayer's primary residence or a vacation home?
Yes, but the holding requirements of Section 1031 must be met prior to changing the primary use of the property.
The IRS has no specific regulations on holding periods. However, many experts feel that to be on the safe side, the taxpayer
should hold the replacement property for a proper use for a period of at least one year.
Q - What
is a Qualified Intermediary (QI)?
A Qualified Intermediary is an independent party who facilitates
tax-deferred exchanges pursuant to Section 1031 of the Internal Revenue Code. The QI cannot be the taxpayer or a disqualified
person.
- Acting under a written agreement with the taxpayer, the QI acquires the relinquished
property and transfers it to the buyer.
- The QI holds the sales proceeds, to prevent the taxpayer
from having actual or constructive receipt of the funds.
- Finally, the QI acquires the replacement
property and transfers it to the taxpayer to complete the exchange within the appropriate time limits.
Q - Why is a Qualified Intermediary needed?
The exchange ends the moment the taxpayer
has actual or constructive receipt (i.e. direct or indirect use or control) of the proceeds from the sale of the relinquished
property. The use of a QI is a safe harbor established by the Treasury Regulations. If the taxpayer meets the requirements
of this safe harbor, the IRS will not consider the taxpayer to be in receipt of the funds. The sale proceeds go directly to
the QI, who holds them until they are needed to acquire the replacement property. The QI then delivers the funds directly
to the closing agent.
Q - Can the taxpayer just sell the relinquished property and put the money
in a separate bank account, only to be used for the purchase of the replacement property?
The
IRS regulations are very clear. The taxpayer may not receive the proceeds or take constructive receipt of the funds in any
way, without disqualifying the exchange.
Q - If the taxpayer has already signed a contract to
sell the relinquished property, is it too late to start a tax-deferred exchange?
No, as long as
the taxpayer has not transferred title, or the benefits and burdens of the relinquished property, she can still set up a tax-deferred
Exchange. Once the closing occurs, it is too late to take advantage of a Section 1031 tax-deferred exchange (even if the taxpayer
has not cashed the proceeds check).
Q - Does the Qualified Intermediary actually take title to
the properties?
No, not in most situations. The IRS regulations allow the properties to be deeded
directly between the parties, just as in a normal sale transaction. The taxpayer's interests in the property purchase and
sale contracts are assigned to the QI. The QI then instructs the property owner to deed the property directly to the appropriate
party (for the relinquished property, its buyer; for the replacement property, taxpayer).
Q -
What are the time restrictions on completing a Section 1031 exchange?
A taxpayer has 45 days after
the date that the relinquished property is transferred to properly identify potential replacement properties. The exchange
must be completed by the date that is 180 days after the transfer of the relinquished property, or the due date of the taxpayer's
federal tax return for the year in which the relinquished property was transferred, whichever is earlier. Thus, for a calendar
year taxpayer, the exchange period may be cut short for any exchange that begins after October 17th. However, the taxpayer
can get the full 180 days, by obtaining an extension of the due date for filing the tax return.
Q
- What if the taxpayer cannot identify any replacement property within 45 days, or close on a replacement property before
the end of the exchange period?
Unfortunately, there are no extensions available. If the taxpayer
does not meet the time limits, the exchange will fail and the taxpayer will have to pay any taxes arising from the sale of
the relinquished property.
Q - Is there any limit to the number of properties that can be identified?
There are three rules that limit the number of properties that can be identified. The taxpayer must meet the requirements
of at least one of these rules:
- 3-Property Rule: The taxpayer may identify up to 3 potential
replacement properties, without regard to their value; or
- 200% Rule: Any number of properties
may be identified, but their total value cannot exceed twice the value of the relinquished property, or
- 95% Rule: The taxpayer may identify as many properties as he wants, but before the end of the exchange period the
taxpayer must acquire replacement properties with an aggregate fair market value equal to at least 95% of the aggregate fair
market value of all the identified properties.
Q - What are the requirements to properly
identify replacement property?
Potential replacement property must be identified in a writing,
signed by the taxpayer, and delivered to a party to the exchange who is not considered a "disqualified person".
A "disqualified" person is any one who has a relationship with the taxpayer that is so close that the person is
presumed to be under the control of the taxpayer. Examples include blood relatives, and any person who is or has been the
taxpayer’s attorney, accountant, investment banker or real estate agent within the two years prior to the closing of
the relinquished property. The identification cannot be made orally.
Q - Are Section 1031 Exchanges
limited only to real estate?
No. Any property that is held for productive use in a trade or business,
or for investment, may qualify for tax-deferred treatment under Section 1031. In fact, many exchanges are "multi-asset"
exchanges, involving both real property and personal property.
Q - What is a "multi-asset"
exchange?
A multi-asset exchange involves both real and personal property. For example, the sale
of a hotel will typically include the underlying land and buildings, as well as the furnishings and equipment. If the taxpayer
wants to exchange the hotel for a similar property, he would exchange the land and buildings as one part of the exchange.
The furnishings and equipment would be separated into groups of like-kind or like-class property, with the groups of relinquished
property being exchanged for groups of replacement property.
Although the definition of like-kind
is much narrower for personal property and business equipment, careful planning will allow the taxpayer to enjoy the benefits
of an exchange for the entire relinquished property, not just for the real estate portion.
Q -
What is a reverse exchange?
A reverse exchange, sometimes called a "parking arrangement,"
occurs when a taxpayer acquires a Replacement Property before disposing of their Relinquished Property. A "pure"
reverse exchange, where the taxpayer owns both the Relinquished and Replacement properties at the same time, is not allowed.
The actual acquisition of the "parked" property is done by an Exchange Accommodation Titleholder (EAT) or parking
entity.
Q - Is a reverse exchange permissible?
Yes. Although the Treasury
Regulations still do not apply to reverse exchanges, the IRS issued "safe harbor" guidelines for reverse exchanges
on September 15th, 2000, in Revenue Procedure 2000-37. Compliance with the safe harbor creates certain presumptions that will
enable the transaction to qualify for Section 1031 tax-deferred exchange treatment.
Q - How does
a reverse exchange work?
In a typical reverse (or "parking") exchange, the "Exchange
Accommodation Titleholder" (EAT) takes title to ("parks") the replacement property and holds it until the taxpayer
is able to sell the relinquished property. The taxpayer then exchanges with the EAT, who now owns the replacement property.
An exchange structured within the safe harbor of Rev. Proc. 2000-37 cannot have a parking period that goes beyond 180 days.
Q - What happens if the exchange cannot be completed within 180 days?
If the reverse
exchange period exceeds 180 days, then the exchange is outside the safe harbor of Rev. Proc. 2000-37. With careful planning,
it is possible to structure a reverse exchange that will go beyond 180 days, but the taxpayer will lose the presumptions that
accompany compliance with the safe harbor.
Q - Can the proceeds from the relinquished property
be used to make improvements to the replacement property?
Yes. This is known as a Build-to-Suit
or Construction or Improvement Exchange. It is similar in concept to a reverse exchange. The taxpayer is not permitted to
build on property she already owns. Therefore, an unrelated party or parking entity must take title to the replacement property,
make the improvements, and convey title to the taxpayer before the end of the exchange period.
Q-
What is the difference between "realized" gain and "recognized" gain?
Realized
gain is the increase in the taxpayer's economic position as a result of the exchange. In a sale, tax is paid on the realized
gain. Recognized gain is the taxable gain. Recognized gain is the lesser of realized gain or the net boot received.
Q - What is Boot?
Boot is any property received by the taxpayer in the exchange which
is not like-kind to the relinquished property. Boot is characterized as either "cash" boot or "mortgage"
boot. Realized Gain is recognized to the extent of net boot received.
Q - What is Mortgage Boot?
Mortgage Boot consists of liabilities assumed or given up by the taxpayer. The taxpayer pays mortgage boot when he
assumes or places debt on the replacement property. The taxpayer receives mortgage boot when he is relieved of debt on the
replacement property. If the taxpayer does not acquire debt that is equal to or greater than the debt that was paid off, they
are considered to be relieved of debt. The debt relief portion is taxable, unless offset when netted against other boot in
the transaction.
Q - What is Cash Boot?
Cash Boot is any boot received
by the taxpayer, other than mortgage boot. Cash boot may be in the form of money or other property
