1031 Tax Deferred Exchange
TAX DEFERRED EXCHANGES
The 1031 tax deferred treatment of capital gains tax is one of the best real estate investor vehicles for preserving and building real estate wealth. Section 1031 of the Internal Revenue Code allows property owners to exchange their property for other like-kind property. This makes it possible to transfer the financial gain that is realized from the sale of a property into another property without paying the capital gains tax.
Exchanging properties is not new. The “your property” for “my property” type of direct exchange (i.e., a swap) has been in practice for ages, and is not uncommon in the Hilton Head area. In June 1990 all of this became easier for real estate investors. The IRS issued regulations governing deferred (sale & purchase) exchanges. By using a qualified intermediary to handle the transaction, anyone can now turn the sale of their property, and subsequent purchase of another “like-kind” property, into an “Exchange”.
A 1031 Deferred Exchange is not difficult, but there are very strict rules and timetables that must be followed. We recommend that you consult a qualified intermediary if you are interested in performing a 1031 Exchange. For more information, contact us and we will be happy to have someone contact you directly.
INTRODUCTION
In June of 1990, the IRS issued the rules governing Delayed Exchanges. This gave everyone the opportunity to use purchase and sale techniques to structure tax deferred exchanges. The deferred exchange is an alternative to a common sale and purchase transaction. If you wish to keep your investment money in real estate, you should consider the tax advantages of a deferred exchange.
Definitions:
- Relinquished Property: This is the property you now own and are planning to sell or exchange.
- Replacement Property: This is the property or properties (there can be more than one) which you are planning to purchase.
- Non recognition of gain: IRS terminology which means you don’t have to pay the Capital Gains Tax on the transaction.
During an exchange, there are three conditions which must be met to accomplish non recognition of gain:
- The properties exchanged must qualify, and be of “like-kind”.
- There must be an actual exchange, not a transfer of property for money only.
- The time requirements must be strictly followed.
QUALIFIED PROPERTIES
The IRS classifies real estate into the following four classifications:
- Property held for personal use (Personal Property)
- Property held primarily for sale (Dealer Property)
- Property held for productive use in a trade or business (Business Property)
- Property held for investment (Investment Property)
The classification of properties exchanged determines if the property qualifies for Section 1031 treatment. Classifications 3 & 4 qualify; classifications 1 & 2 do not. It is your use of the property that determines its classification. What the other party does with the property does not affect your tax status.
“Like-Kind” Property
Like-kind refers to your use of the property and not to its grade or quality.
“1031″ property may be mixed as to type and still be like-kind. As an example, you may exchange land for a duplex, or a commercial building for a retail store, etc. Property held outside the USA and its territories does not qualify for exchange with property held within the USA.
Partnership Interests
Your interest in a partnership cannot be traded for an interest in another partnership, but a partnership as an entity can exchange real estate it owns for other like-kind real estate.
Transfer Between Spouses
There are no income tax consequences in entering into financial transactions between spouses. In addition, most transfers incident to a divorce are tax free. However, transactions with a former spouse are normally subject to tax unless they qualify for misrecognition under the provisions of Section 1031.
Sale/Lease Back As An Exchange
A lessee’s interest in a lease for real property with a term of 30 years or longer is considered like-kind to other real property. In addition, property which is subject to a lease can be, if the lease is for a term of 30 years or longer, the subject of a tax free exchange. The receipt of prepaid lease payments, whether for a 30-year lease or not, are taxed as ordinary income and will not qualify for tax-free exchange treatment.
Business Assets
The personal property assets of one business can be exchanged for like-kind assets of another business and will be held as a like-kind exchange under Section 1031. The real property is treated the same as any other exchange. The like-kind requirements for personal property are much more stringent than for real property (e.g., a truck cannot be exchanged for a car, nor can a sailboat be exchanged for a cargo ship).
Vacation Homes & Properties
This type of property does not qualify if it is used solely for personal use. However, in the Hilton Head Island area, most people rent their vacation homes and villas on the short-term rental market. This classifies the property as “income-producing” property and thereby qualifies the property because it is not used solely for personal use. The property also qualifies if it is not used for personal purposes more than fourteen days per year. (I.R.C. Section 280A)
TIME RESTRICTIONS
In 1984, Congress amended the Internal Revenue Code adding an identification and exchange period for like-kind exchanges. This signaled their approval for delayed multi-party exchanges. However, it was not until the spring of 1990 that the IRS issued preliminary regulations defining delayed exchanges. Final adoption occurred in July of 1991.
The “1031 Exchange” rules have two Time Limitations:
The period of time to identify the replacement property begins on the date of closing of the exchange property and ends 45 days later. The replacement property must be identified in writing, and delivered to the facilitator by midnight of the 45th day after the closing of the relinquished (exchange) property. In identifying, the replacement property must be unambiguously described. We recommend that you use both the legal and specific street address.
The period of time in which the replacement property must be received by the exchanger begins on the date of closing of the exchange property and ends on the date that the tax return of the taxpayer is due, including extensions, or in 180 days, whichever is earlier.
REPLACEMENT PROPERTY
The term “REPLACEMENT PROPERTY” simply means the property or properties intended to be purchased with the funds that are received from the sale of the relinquished property. Meeting the technical requirements of identification is critical. You must satisfy one of these rules:
- You may identify not more than three replacement properties of any value, or;
- You may identify any number of replacement properties so long as the total value of all property identified does not exceed twice the value of the relinquished property, or;
- You may identify as many properties as you desire so long as you close and take title on 95% of the value of such properties.
The property you wish to acquire (”replacement property”) needs to have a value equal to or greater than the relinquished property. All of the proceeds from the relinquished property sale need to be invested in the replacement property. The gain will be taxable only to the extent that these goals are partially achieved. If all the goals are accomplished, the entire gain will be deferred. In layman’s terms, all of the money you make from the sale of your property must be invested in the purchase of the new property(s) during an exchange in order to defer the capital gains.
Incidental Property
For purposes of completing a proper identification within the 45-day identification period, it should be noted that property which is incidental to Real Estate property, such as furniture, laundry machines, appliances, personal items, etc., is not treated as separate property from the real estate property if:
- In standard commercial transactions the property is typically transferred together with the real estate property, and;
- The aggregate market value of the incidental property does not exceed 15% of the market value of the real estate property.
For description purposes, the legal description or street address of the real estate property can be used to describe the entire property. There is no need to list the particular incidental property attached to it. For example: The Exchange or Replacement property is an apartment house complex worth one million dollars. The furniture, laundry machines, and other items that go with the apartment complex should not then exceed $150,000 in value, which is 15% of one million dollars. For purposes of identification the entire apartment complex, including furniture, laundry machines, etc., will be treated as one property.
NB: The foregoing discussion relates to the identification of replacement property during the 45 day identification period. However, any non-like-kind property which is received will be treated as taxable boot unless like-kind replacement personal property is acquired by the taxpayer.”
Revocation of Replacement Properties
Replacement properties can be revoked as long as it is done within the 45-day identification period. This revocation must be done in writing and should include a rescission of a purchase and sale agreement, if one was written.
Receipt of Replacement Property
Replacement property is treated as received before the end of the exchange period if you actually acquired the replacement property. That is, you closed the transaction prior to the end of the exchange period (180 days, or the due date of the taxpayers tax return, whichever is earlier), and The Replacement property acquired is substantially the same as identified during the 45- day identification period.
New Construction Replacement Property
There is an interesting regulation that permits you to exchange for real property that has not yet been built. A transfer will still qualify for Section 1031 treatment if the new construction is identified within the 45-day period, and received within the 180-day exchange period. This property must be carefully identified. This identification should include the legal description of the underlying ground and as much other description as possible for the property to be constructed. Also, the new construction must be completed and received in substantially the same form as described in the identification documents. You can not exchange for services. Partially completed real property can be received in a like kind exchange if properly identified. {IRC 1.1031(k)-1(e)(3)(iii)}
EXCHANGE OR SALE
Introduction
The intent of the delayed property exchange is that you have an actual continuation of your old property investment into your new replacement property. To qualify, you must follow the rules and requirements of Section 1031 of the Internal Revenue Code. Intent does not count. What you actually do is what determines if you qualify. Actions taken for the primary purpose of avoiding tax will usually be disqualified.
Exchange Requirements
Section 1031 requires an actual exchange of properties. If you simply sell your property and reinvest the money in another property, you will not qualify for exchange treatment, even though it is a simultaneous close. This type of transaction will result in “Constructive Receipt”. Constructive receipt occurs when you have the funds in a position in which you may draw on them, direct their usage, or give notice of intention to withdraw. In other words, you must not have control of the funds. If you have any type of control on the funds or control over the person holding the funds, you will be considered to have constructive receipt. One of the primary ways that you avoid constructive receipt is with a written contractual agreement with a qualified intermediary.
You are not in constructive receipt if your control over this money is subject to a substantial limitation or restriction. You are in constructive receipt at the time such limitations or restrictions lapse, expire, or are waived. Additionally, you are in constructive receipt if the money is accepted by your agent.
Safe Harbors
Although there is more than one type of safe harbor, the only practical safe harbor for most exchangers is a qualified intermediary. The other two safe harbor arrangements call for establishing special trusts or special security and guarantee arrangements, which are quite complicated and usually are beyond the range of the average exchanger (ask your attorney). Qualified intermediaries act on your behalf in accordance with a specific written contract. The qualified intermediary, for a fee, facilitates the deferred exchange by entering into an agreement to exchange the properties. Under this agreement, the qualified intermediary sells the relinquished property, acquires the replacement property, and transfers the replacement property to the exchanger.
The following persons may not serve as a qualified intermediary for the exchanger:
- Related parties such as a spouse, ancestors, descendants, siblings
- Exchanger’s employees or employer
- Exchanger’s attorney, accountant, investment banker, broker, or agent
- Related corporations or trusts where 10% or more of the stock or ownership is owned directly or indirectly by the Exchanger. {Treas. Reg. 1.1031(k)-1(k)}.
The Qualified Intermediary does not provide legal or specific tax advice to the exchanger, but will usually perform the following services:
- Coordinate with the “Exchangers” and their advisors to structure a successful exchange
- Prepare the documentation for the exchange and replacement properties
- Furnish escrow with instructions to effect the exchange
- Secure the funds in an insured bank account until the exchange is completed
- Provide the documents to transfer the replacement property to the Exchanger, and disburse the exchange proceeds to escrow
PROPERTY BASIS
For the purposes of a 1031 exchange, basis is the term we give to the price which was originally paid for the relinquished property, less any depreciation, plus any costs to improve that property. For example, let’s say you bought a villa on Hilton Head ten years ago for $250,000 and that you’ve depreciated the villa at $8,000 per year for the last ten years. Let’s also say you spent $20,000 to remodel the villa two years ago. To calculate the basis, you take the purchase price ($250,000), less the depreciation ($80,000) plus the cost of the remodel ($20,000) for a total basis of $190,000.
The basis of the replacement property becomes the same as the basis of the relinquished property, plus any amount paid in excess of the adjusted sale price of the relinquished property. The adjusted sales price is the price the property sold for, less the selling cost, and less any other cost to make the property ready to sell. Example: You sell a property for $100,000 with a basis of $20,000, and you buy a replacement property for $150,000. You paid $50,000 more for the new property, so the basis on your new property is now $70,000. Also any expenses which you pay to acquire the replacement property are added to the new basis, including commissions, closing costs, inspections, etc.
Basis is used as the base point for the calculation of capital gain on a transaction. Capital gain is described as the difference between the basis and the adjusted sales price of a property.
Do not confuse capital gain with equity. There is no comparison between the two. Equity is the amount of money you have in your pocket after you sell property and all debts (mortgage) and closing costs (attorney fees, commissions, etc.) are paid off. As an example let’s consider the property that you bought for $250,000 ten years ago, which now has a basis of $190,000. If you sold that property for $500,000, and paid out $25,000 in sales and other costs to prepare the property for market, you have equity of $475,000. However your capital gain on this property is the difference between your basis of $190,000 and your adjusted sales price of $475,000, or $285,000. If you do not do a 1031 Exchange, you could be obligated to pay a capital gains tax of $77,000(!) - ($80,000 depreciation X 25% = $20,000 plus $285,000 X 20% = $57,000).
If you have borrowed some money on this property, you will need to repay this loan at the time of closing. This will result in the relief of debt, which is the same as the receipt of cash according to IRS rules. Let’s assume you have borrowed $200,000 on the property. Your equity on the adjusted sale price is now $275,000, but you have an obligation to pay capital gains tax of $77,000. It is in this area that you must be extremely careful not to trap yourself with a regular sale. You are almost bound to exchange in a case like this unless you have the additional funds to pay the taxes. In larger transactions with larger dollars and leveraging, the situation only gets worse.
Figuring Basis Where the Property is Subject to A Mortgage
The primary rule to consider when the relinquished property has a mortgage is this: the relief of debt is considered the same as the receipt of cash by the IRS. This rule applies whether the mortgage is assumed by the other party, or whether it’s paid off. The basis calculation remains the same, regardless of the equity. The easiest rule to follow when considering replacement property is this: You need to purchase replacement property with a total value equal to, or greater than, the adjusted sale price of the relinquished property. And you need to use all of the proceeds being held by the qualified intermediary. You can add either cash or borrowings to the exchange proceeds to accomplish this.
Example
I sell a property for $100,000 which I have mortgaged for $40,000. The exchange proceeds are $60,000 and I have a relief of debt of $40,000. I buy a new property for $160,000 by paying the $60,000 of proceeds, $25,000 from savings, and the balance from proceeds of a new loan for $75,000. This results in a complete tax deferred exchange.
Boot and Taxable Gain
Cash, notes, and unlike property in an exchange is called boot. Receiving boot as part of an exchange does not defeat the non-taxable provisions of Section 1031. However if you receive boot, you probably will have taxable gain. If the other party assumes any of your liability as part of the exchange, it will be treated as if you received cash.
Example 1
| Sale Price | $500,000.00 |
| Selling Costs | -$50,000.00 |
| Original Price | $250,000.00 |
| Depreciation | -$80,000.00 |
| Improvements | $30,000.00 |
| Adjusted Sale Price | $450,000.00 |
| Less Basis | -$200,000.00 |
Instead of paying the $78,500 in Capital Gains tax, the “Exchanger” can use these funds to purchase replacement property. Leaving this money in real estate holdings through a delayed exchange, and leveraging a conservative four times, the exchanger could grow the original investment to well over $300,000 of purchasing power!
Example 2
Adjusted Sale Price | ||
| Sale Price | $835,000.00 | |
| Selling Costs | -$65,000.00 | |
| Adjusted Sale Price | $770,000.00 | |
Property Basis | ||
| Original Price | $475,000.00 | |
| Depreciation (6 years) | -$103,636.36 | |
| Improvements | $55,000.00 | |
| Adjusted Basis | $426,363.64 | |
Tax Computation | ||
| Adjusted Sale Price | $770,000.00 | |
| Less Adjusted Basis | -$426,363.64 | |
| Current Taxable Gain | $343,636.36 | |
| Tax on Gain (25%) | $85,909.09 | |
| Depreciation Recapture (20%) | $20,727.27 | |
| Total Capital Gains: | $106,636.36 | |
Available Cash Through Exchange | ||
| Sale Price | $835,000.00 | |
| Less Sales Cost and Exchange | -$67,000.00 | |
| Adjusted Sale Price | $768,000.00 | |
| Less Mortgage | -$320,000.00 | |
| Net Available Cash | $448,000.00 | |
| Leveraged Four Times | $1,792,000.00 | |
Available Cash Through Sale | ||
| Sale Price | $835,000.00 | |
| Less Sales Cost and Exchange | -$65,000.00 | |
| Adjusted Sale Price | $770,000.00 | |
| Less Taxes | -$106,636.36 | |
| Less Mortgage | -$320,000.00 | |
| Net Available Cash | $343,363.64 | |
| Leveraged Four Times | $1,373,454.55 | |
FREQUENTLY ASKED QUESTIONS
Do I have to spend all of the proceeds from my relinquished property on replacement property?
No you do not, however you will be taxed on the amount you don’t spend. Unused proceeds are known as “boot” and are taxed on their face value at the capital gains tax rate.
If I don’t spend all of my proceeds when can I receive the unused amount?
You can receive unused proceeds at anytime after you have acquired each one of the properties identified in your 45 day identification. If you do not acquire all of the properties identified in the 45 day identification, then the unused proceeds cannot be released until the earlier of the due date of your tax return including extensions, or 180 days after the closing of the sale of the relinquished (exchange) property.
Can I take a note on the sale of my relinquished property?
Yes, you can sell your relinquished property using a Note & Trust Deed to finance the sale. It is possible for the promissory Note and Trust Deed to be made out to the “Exchanger.” If this is done, the Note is taxable and may not be used to buy replacement property. However, if the Note & Trust Deed is made out in the name of the qualified intermediary, you have four choices on how to use it to buy replacement property:
- You can use it to acquire replacement property by trading it to the “Seller ” for part of the equity in the new property (that is spend it like it was cash).
- You can instruct the qualified intermediary to sell the note on the open market (you can negotiate this sale or have the intermediary do it) and add the amount realized to the exchange proceeds. This will give you all cash to negotiate your replacement purchase. It is less desirable because of the discount given on the sale of the note.
- A party related to the “Exchanger,” such as a closely held corporation or relative can either purchase the Note from the qualified intermediary, or provide financing so that the qualified intermediary receives all cash at closing. You should consult with your tax advisor regarding structuring this type of transaction.
- You can wait until the end of the exchange and receive the note back from the intermediary. This will result in the note becoming “boot” and it will be taxable. However, you will only have to pay tax on the amount received each year.
What should I know about new construction of replacement property?
There are two ways that new construction is handled in an exchange:
- You contract with a builder to purchase a property which will be completed, and closed, prior to the end of the 180 day exchange period. You can purchase the land prior to construction as one of your replacement properties, or you can purchase the land & building from the builder at the time of closing. This is the least expensive and easiest method for the exchanger.
- You can contract to do what is known as a “Build-out Exchange”. This is where the exchanger finances all or part of the construction. Through a special agreement with the qualified intermediary the builder draws on the exchange proceeds as certain steps of the construction are completed. This arrangement is much more complicated and risky for the Exchanger, and the Intermediary, and increases the cost of the exchange by $1,500 or more.
In either case the purchase and sale agreement should have language in it that requires the builder to bear responsibility for the exchangers taxes if the exchange fails due to the completion of the construction later than the required 180 day exchange closing period.
When should I open escrow on my Replacement Property?
The safest way is to wait until after your “Relinquished” property has closed. The opening of escrow (or notification to the closing agent) may constitute identification as the escrow agent is listed by the IRS as a person involved in the exchange {1.1031(k)-1(c)(2)(ii) example}, and if it is done prior to the closing of the “Relinquished” property, it can shorten the entire exchange period to 45 days. It is a dangerous practice and does not speed up the “replacement” property closing. Replacement property is identified if it is designated as replacement property in a written document signed by the taxpayer and sent to the qualified intermediary prior to the end of the 45 day identification period.
Can I combine multiple relinquished properties into one replacement property?
Yes you can combine multiple relinquished properties into one replacement property. The rule here is that the first relinquished property to close starts the clock running for all the rest. All the relinquished properties to be combined must be closed within 45 days of the first one to close. The same replacement property is then identified for each relinquished property to be combined. Treas. Reg. 1.1031(k)-1(b)(2)(ii).
If the replacement property is a rental property, how long does it have to remain a rental before it can be converted into a primary residence?
There are no hard rules here. What the IRS requires is that you show intent to use the replacement property as a rental. Most tax attorneys feel that if the property shows up as a rental on two or more consecutive tax returns you will have shown intent.
If the replacement property is sold how are the capital gains taxes calculated?
The capital gains tax is calculated the same as in any other sale, assuming that you have not converted it to residential use, and that you are not going to do another 1031 exchange. The trick here is to be able to establish the basis on the new property at the time of sale. The basis on the new property is the sum of the basis transferred from the old property, plus the difference between the sale price of the old relinquished property and the new replacement property, minus the deprecation on the new replacement property.
IRS section 1031 can be an extremely complicated transaction to perform, depending on individual circumstances. RealEstateHiltonHead.net is not a qualified intermediary, nor do we practice as an intermediary in Real Estate transactions. If you have questions about what has been discussed in this document, please contact us and we will be more than happy to have a qualified intermediary contact you to discuss your individual situation. There is no cost or obligation.