Tax is calculated upon the capital gain. Gain and Equity are two separate and distinct items. Equity is calculated by subtracting the net loan balance from the net sales proceeds. The resulting figure has nothing to do with the amount of potential taxes owed. Capital Gain is calculated by subtracting the adjusted basis of the property (original purchase price minus depreciation taken plus the cost of any improvements) from the net sale proceeds. It is this figure that represents the amount realized from the sale that is potentially taxable. This is also known as the 'realized gain". The amount of the realized gain that is subject to tax is called the "recognized gain". In a taxable sale (no 1031 exchange) the realized gain is all recognized. In a fully deferred 1031 exchange, no gain is recognized; the realized gain is deferred.
Is there a simple rule for structuring an exchange where all the taxable gain will be deferred?
Yes, 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; the gain will be totally deferred.
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.
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 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 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 Exchanger 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?
In March 2008, the IRS issued Revenue Procedure 2008-16. This provided guidance how a second home or vacation home could be made eligible for a 1031 exchange. In the Revenue Procedure, the IRS created safe harbors under which it will not challenge whether a second or vacation home that is either relinquished or replacement property in a 1031 exchange qualifies as property held for use in a trade or business or for investment purposes.
The safe harbor for a second or vacation home to qualify as relinquished property in a 1031 exchange requires the Exchanger to have owned it for at least two years before the exchange. In addition, within each year immediately before the exchange, the Exchanger must have 1) rented it at fair market rental for 14 or more days; and 2) restricted personal use to no more than 14 days or 10% of the number of days it was actually rented (whichever is more) within each of the two years before the exchange.
In addition, the safe harbor also applies to a second or vacation home as a replacement property. To qualify, the Revenue Procedure requires the Exchanger to own the second or vacation home for two years after the exchange. In addition, for each of those two years, the Exchanger must 1) rent the unit at fair market rental for 14 or more days; and 2) restrict personal use to 14 days or 10% of the number of days it was actually rented (whichever is more) during each of the two years after the exchange. After that, the Exchanger could move into the property as his or her primary residence or solely use it for personal purposes as a vacation property.
Accordingly, Revenue Procedure 2008-16 provides another "exit strategy" from investment real estate. An investor can sell any type of investment property (an office building, a farm or ranch, an apartment building, etc.) and exchange into a future personal use property (primary residence or a vacation home). As long as the Exchanger complies with the requirements of Revenue Procedure 2008-16, the IRS will not challenge whether the dwelling is "Qualified Property". If the Exchanger fails to comply with the safe harbor after the purchase, then there is an affirmative obligation to amend the income tax return for the year the exchange was reported.
What 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 twenty-four months from the end of the tax year in which the property was converted. You may also apply for a twelve month reinvestment extension.
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.
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.
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.
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.
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 forty-five 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.
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 two hundred percent 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 total at least ninety-five percent of the properties identified.
Should identifications be made to the intermediary or an attorney, escrow, closer or title company?
Identifications may be made to any party listed above. However, many times the escrow holder or closer is not equipped to receive your identification if they have not yet opened a transaction file. Therefore it is easier and safer to identify through the intermediary or facilitator provided the identification is postmarked or received within the forty-five day identification period.
DISCLAIMER: To ensure compliance with requirements imposed by the IRS, we inform you that the information posted at this website does not contain anything that is intended as legal or tax advice, and that nothing herein can be relied upon as legal or tax advice. Further, the IRS wants us to let you know that nothing herein can be used for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any tax-related matter addressed herein. If acting as your Qualified Intermediary in a Section 1031 tax-deferred exchange, 1031 Library cannot advise the owner concerning specific tax consequences or the advisability of a tax-deferred exchange for tax purposes. We recommend that anyone contemplating an exchange seek the advice of an accountant and/or attorney.