Real Property: Understanding the Basics of a 1031 Exchange

A 1031 Exchange refers to the section of the Internal Revenue Code Section that provides for the tax deferred exchange of real and personal property.

The 1031 Exchange Clause: “Buyer is aware that Seller intends to perform an IRC Section 1031 tax deferred exchange. Seller requests Buyer’s cooperation in such an exchange and agrees to hold Buyer harmless from any and all claims, costs, liabilities, or delays in time resulting from such an exchange. Buyer agrees to an assignment of this contract to _________________ by the Seller.”

Why Do a 1031 Exchange?

With a 1031 Exchange investors can trade up, consolidate, diversify, leverage or relocate their investments and not be penalized by having to pay either capital gains or recapture (the amount deducted while owning the property is taxable if the property is sold). The taxes are deferred until the investor does a non 1031 Exchange sale or the property goes to the investors estate. When the property passes into an estate there is a step-up in basis to the then current market value.

1031 Exchanges can be both a powerful wealth building tool and a way of adjusting investment portfolios to more accurately reflect life style choices and circumstances. An example would be an apartment owner wanting to trade into NNN Properties or Tenant in Common properties that require little to no management.

Other investment objectives are to adjust the amount of risk and volatility of one type of property to another, increase cash flow or to take the maximum amount of cash out of a real estate asset without triggering any taxes by using a Zero.

Zeros are also used by investors selling highly leveraged properties, investors who have given up a property in foreclosure and for estate planning purposes when no immediate cash flow is desired. Typical leverage for Zeros range from the high 80% for fee simple properties to the low 90% for leaseholds.

Another type of real estate exchange is a 1033 Exchange. These occur when there is an involuntary taking of the tax payer's property either by a government, casualty loss such as a fire or natural disaster. The rules for 1033 exchanges are similar to a 1031 exchange but do vary in some significant respects. Refer to 1033 Exchange for a more complete explanation.

What are the general guidelines for a 1031 Exchange?

       The value of the 1031 Exchange replacement property must be equal to or greater than the value of the relinquished property less any selling expense.

       The equity in the 1031 Exchange replacement property must be equal to or greater than the equity in the relinquished property.

       All of the net proceeds from the sale of the 1031 Exchange relinquished property must be used to acquire the 1031 replacement property.

       Constructive receipt of sales proceeds is prohibited during the 1031 Exchange process.

       Deadlines for identifying and closing on the 1031 replacement property must be followed.

What are 1031 Accommodators and Qualified Intermediary (QI)?

A 1031 Accommodator is the same thing as a Qualified Intermediary. Frequently 1031 Accommodators are referred to as a QI (short for Qualified Intermediary). The role of the QI or 1031 Accommodator is similar to but not identical to that of a real estate escrow company. Unlike the escrow company the 1031 Accommodator handles the paper work and transfer of title for 1031 Exchanges.

The seller/taxpayer of the 1031 Exchange property enters into a written agreement with the 1031 Accommodator. The duties of the 1031 Accommodator include transferring the relinquished property to the buyer, and transferring the 1031 replacement property to the taxpayer pursuant to the 1031 Exchange agreement. The 1031 Accommodator holds the proceeds from the sale of the relinquished property beyond the actual or constructive control of the seller of the 1031 Exchange property.

The 1031 Accommodator or QI also prepares the necessary 1031 Exchange documents to accomplish a tax deferred 1031 Exchange. This includes documenting the proper identification of the 1031 replacement property(s) within the 45 day time limit.

Anyone who is related to the taxpayer, or who has had a financial relationship with the taxpayer within the two years prior to the close of escrow of the exchange cannot be used as the 1031 Accommodator or QI. This means that the taxpayer cannot use their current attorney, certified public accountant or real estate agent as their 1031 Exchange Accommodator.

A 1031 Accommodator or QI should be properly bonded and insured. Relevant educational and experience in tax, law or finance are highly desirable. 1031 Exchange funds should be kept in a segregated account (not comingled with other monies) and placed in liquid highly secure investment instruments. Currently Nevada is the only state that requires a 1031 Accommodator or Qualified Intermediary (QI) to be licensed.

What is 1031 Exchange Boot?

1031 Exchange boot is any property received by the taxpayer in the exchange which is not like-kind to the relinquished property. 1031 Exchange boot is characterized as either "cash" boot or "mortgage" boot. Realized Gain is recognized to the extent of net boot received.

What is 1031 Exchange Like Kind?

Real or personal property of the same nature or quality is like kind in a 1031 Exchange. Generally, 1031 Exchange real property is like kind to all other real property as long as it is held for investment or productive use in a trade or business. Foreign real property can be exchanged for foreign real property while US properties can only be exchanged for US properties. Personal Property must be either the same General Asset Class or Product Class for a 1031 Exchange.

What are the 1031 Exchange 45 and 180 Day Deadlines?

The 1031 Exchange clock starts with the close of the property being sold. From the close date there are 45 days to identify the 1031 Exchange properties to be purchased and 180 days to complete the purchase (or the due date for your tax return-whichever is earlier). Both periods are calendar days. If the 45th or 180th day falls on a weekend or holiday, the deadlines still apply. There are no extensions for legal holidays or Saturday or Sunday.

What Constitutes Proper 1031 Exchange Identification of 1031 replacement property?

1031 Exchange Property is properly identified only if you clearly describe it in a written document signed by you and hand delivered, mailed, faxed to the person obligated to transfer the 1031 replacement property to you (called 1031 Accommodator, Qualified Intermediary or QI) or to any other person "involved in the exchange" other than you or any one disqualified under Treasury Regulation 1.1031 (k)-1(K). The 1031 replacement property description needs to be unambiguous. Among other things an acceptable 1031 replacement property description needs to identify the property using the legal description, street address or distinguishable name. If more 1031 Exchange properties than are permitted are identified it will be treated as if no 1031 replacement property was identified and the 1031 Exchange will be disallowed.

To Defer Taxes How Much Must be Invested?

The minimum amount to be invested in a 1031 Exchange must be equal to or greater than the sales price on the property being sold less any selling expenses. If there is debt on the 1031 Exchange property being sold that amount needs to be replaced by new debt or cash from the investor's pocket.

How Many 1031 Exchange Properties May Be Identified as 1031 Replacement Properties?

1031 Exchange Investors can use any one of the following three rules governing identifying 1031 Exchange Replacement Properties:

       Three 1031 replacement property Rule: Any three properties of any value.

       200% 1031 replacement property Rule: Any number of 1031 Replacement Properties not to exceed 200% of the sold property.

       95% 1031 replacement property Rule: Any number of 1031 Replacement Properties of any value. 95% of identified properties must be closed in 180 days or the exchange will be disallowed.

Can Multiple Owners of a Single Property do a 1031 Exchange into Different Properties?

If the intent of varies owners of a single properties contemplating a 1031 Exchange is to go their separate way it is important to first review with legal counsel the manner in which the 1031 Exchange property title is held before selling. Once any title issues are resolved the property can be sold using a 1031 Exchange. In such a circumstance one investor can do a 1031 Exchange while another can receive cash and pays taxes. It is very important that the investors be clear on their intentions before entering into a 1031exchange agreement with a 1031 Accommodator (also known as Qualified Intermediary or QI). Once the property being sold is closed and all 1031 Exchange investors have entered into an 1031 Exchange agreement with their 1031 Accommodator the exchangers lose their options to divide the proceeds and buy separate 1031 replacement properties.

Does the 1031 Exchange Investor have Access to the Sale Proceeds During the Exchange?

Part of doing a 1031 Exchange is that the investor does not take constructive receipt of the sales proceeds. If no 1031 Exchange property is identified during the 45 day identification period the investor can receive their money on the expiration of the identification period. If the investors identifies properties during the 45 day identification period then does not close on an identified 1031 replacement property the investor will have to wait the full 180 day waiting period to receive their money. There are a few limited exceptions to this1031 Exchange rule.

Is a Delayed 1031 Exchange the Only Way to do a 1031 Exchange?

There are five ways to accomplish a 1031 Exchange. They are a Delayed Exchange, Reverse Exchange, Simultaneous Exchange, Improvement Exchange and a Personal Property Exchange.

How Should the 1031 Replacement property Be Vested?

The investor needs to hold title in the 1031 replacement property exactly as they held title to the property they sold. What this means is that the person or entity beginning the 1031 Exchange needs to be the same person or entity ending the 1031 Exchange. An exception would be a husband and wife (or individual) holding a revocable living trust. Providing the trust is a true pass through the 1031 Exchange property can be sold then and title to the new 1031 replacement property can be held by an individual(s). Other exceptions would be if a single member LLC sells and the sole member buys as an individual or if an individual dies after selling and his or her estate purchases the 1031 replacement property.

Can an Investor Use a Personal Bank Account to Hold 1031 Exchange Sales Proceeds?

No. 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 1031 Exchange.

Is it too late to start a tax-deferred exchange after signing the sales contract before closing?

No, as long as title has not been transferred. Once the sale is closed it is too late to do a 1031 Exchange even if the proceeds check has not yet been cashed.

What is a "multi-asset" 1031 Exchange?

A multi-asset 1031 Exchange involves both real and personal property. For example the sale of a hotel frequently involves both real estate and furnishings and equipment. In this example a 1031 Exchange would be done for the land and building and another 1031 Exchange for the furnishing and equipment in a separate 1031 Exchange. The definition of like-kind for personal property and equipment is much narrower than for real estate.

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.