Although tax deferred exchanging in some form has existed since the 1920s, history alone does not bestow the type of knowledge necessary to determine whether or not your situation would benefit by an exchange.
So for that reason you need to consult with your tax advisor. In this guide we will attempt to provide a practical guide to how exchanges work in their most basic form as well as the logistics you can expect when considering a 1031 exchange. However this is no substitute for professional guidance and advice that your tax advisors can provide.
The first two questions any potential Exchanger should consider are:
1) Is my exchange facilitator or Qualified Intermediary properly experienced and equipped to help me? and
2) How safe will my money (your exchange proceeds) be in their possession?
Our depth of technical expertise and practical experience has been developed over many years. Additionally our professionalism and commitment to our customers is demonstrated every day through regional attorneys and experienced staff to provide information and guidance for you and your advisors; sales executives located throughout the United States who are available for accredited seminars and complimentary exchange consultations; and expert preparation of exchange documents which is essential for a timely closing.
Safety and security of funds is of paramount importance. We pride ourselves as being an industry leader in providing the highest assurances available to safeguard your exchange funds. More details are available on our website at www.ipx1031.com.
In developing this tutorial, our desire is to create a brief synopsis of the fundamentals involved with tax deferred exchanges. In compiling a tutorial of this type, remember that for brevity, it was necessary to deal with those issues arising out of common exchange scenarios. Therefore, we have deliberately left out certain obscure exchange nuances or extenuating circumstances in an effort to focus on exchanging basics.
As you read the tutorial, please keep in mind this caveat:
Exchanging can sometimes involve complicated legal and tax issues. The failure to comply with applicable regulations can jeopardize the potential tax deferral status of your transaction. Therefore, when considering an exchange, seek out the counsel of qualified legal and tax professionals. Advise them of the facts and circumstances of your proposed transaction and secure the services of a recognized and respected exchange facilitator.
WHAT IS A TAX DEFERRED EXCHANGE?
A 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. It is this distinction between exchanging and not simply selling and buying, which ultimately allows the taxpayer to qualify for deferred gain treatment.
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 regulations, issued by the Treasury Department in 1991, that we find generally accepted standards and rules for completing a qualifying transaction.
Any 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 to 30%, depending on the appropriate combined federal and state tax rates. To put it another way, the investor who sells, pays taxes and reinvests the after tax proceeds has 70 to 80% of the money to reinvest than the investor who completes a 1031 exchange.
The table below illustrates the benefits of exchanging versus selling (a combined 28% federal and state tax rate is assumed):
MISCONCEPTIONS ABOUT EXCHANGING
Before we continue discussing the various types of exchange structures and their associated rules, let´s identify four common exchange misconceptions:
All exchanges must involve the swapping or trading with other property owners. (NO)
Before the case of Starker v. U.S. in 1979, and the codification of delayed exchanges in 1984, exchange transactions required the actual swapping of deeds and simultaneous closing among all parties to successfully complete a 1031 exchange. Often these exchanges were comprised of multiple exchanging parties as well as numerous exchange properties. However since 1984 and the issuance of the 1031 regulations in 1991, there is no such requirement to swap your property with someone else in order to complete a valid 1031 exchange. The regulations make the process similar to a standard sale and purchase of property.
All exchanges must close simultaneously. (NO)
As discussed above, there was a time when all exchanges had to be closed on a simultaneous basis, however, exchanges are usually not completed in this format any longer. A majority of exchanges are now closed as delayed or deferred 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 that the property being acquired must be utilized in the same form as was the property being exchanged. In other words, apartments for apartments, hotels for hotels, farms for farms, etc. However, the term like-kind refers to the nature or character of property not its grade or quality. For this reason nearly all real property is like-kind to each other. The like-kind standard has been interpreted more narrowly in the case of exchanges of personal property held for investment or business use. Under the 1031 regulations for personal property, depreciable tangible personal property which is held for productive use in a trade or business is considered like-kind if exchanged for property that is either like-kind or like class. For more information about like-kind property (including examples), please click here.
Exchanges must be limited to one relinquished property and one replacement property. (NO)
This is another exchanging myth. There are no restrictions on the number of relinquished properties. However there are restrictions on the number of replacement properties which can be identified. For more information on the identification rules in a 1031 exchange please click here.
PARTIES TO AN EXCHANGE
There are four parties involved in a delayed or deferred 1031 exchange.
In Phase One (the sale of your relinquished property), they are: the Taxpayer (also called the Exchanger), the Buyer or Purchaser, and the Qualified Intermediary (also called the facilitator).
In Phase Two (the purchase of your replacement property), they are: the Taxpayer (also called the Exchanger), the Seller, and the Qualified Intermediary (also called the facilitator). The process is explained in more detail below in the section entitled "Deferred or Delayed Exchanges".
BASIC EXCHANGE RULES - DEFERRING ALL CAPITAL GAIN
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. If you acquire replacement property that has:
1) A purchase price greater or equal to the net sales price of the relinquished property (in other words you buy equal or up in value),
2) Net equity greater or equal to the equity in the relinquished property (in other words you move all the equity from your relinquished property to the replacement property), and you,
3) Replace the value of the debt that was on the relinquished property. This can be achieved by placing a loan on the replacement property equal in value to the loan that existed on the relinquished property, adding cash from outside of the 1031 exchange or a combination of the two.
If you satisfy all three of these items you will have a fully tax deferred exchange. If you do not, your 1031 exchange is still valid, however you will pay taxes on the "boot" (non like-kind property) received. The gain subject to tax is the lesser of the boot received or the realized gain. In other words, realized gain serves as the ceiling on the amount of gain that can be taxed.
TYPES OF EXCHANGES
Although the vast majority of exchanges occurring presently are delayed exchanges, let us briefly explain a few other exchanging alternatives.
Two Party Direct Trade (Swap)
In this structure, the Exchanger transfers the relinquished property to a second party and simultaneously receives the replacement property. The structure is depicted in Diagram 1:
This structure is difficult to achieve because it is rare that two property owners want the other's property. In addition, if the properties are not equal in value, one party will have taxable boot. A more common simultaneous exchange structure utilizes a Qualified Intermediary.
Four Party Exchange Using a Qualified Intermediary
In this structure, the Exchanger sells the relinquished property to any person or entity for cash which is passed through the Qualified Intermediary (QI) to a separate individual or entity that transfers the replacement property to the Exchanger. The structure is depicted in Diagram 2:
Utilizing a Qualified Intermediary allows the Exchanger to sell the relinquished property to anybody and buy the replacement property from almost anybody. No longer is it necessary to find two individuals who have equal value property and want to trade. In addition, in the event the transfers do not occur simultaneously, the exchange can still be structured to qualify for tax deferral under section 1031 as a delayed exchange since the same 1031 exchange documentation is used.
There is a common misconception that if the sale to Buyer and purchase from Seller occurs on the same day that a QI is not needed. That is not true and there are multiple court cases that hold it is not a valid exchange without a QI since there is no "exchange" without using a QI.
IMPROVEMENT AND CONSTRUCTION EXCHANGES
The Build-To-Suit Exchange, also referred to as a construction or improvement exchange, gives the Exchanger the opportunity to use all or part of the exchange funds for construction (or improvement) of the replacement property and still accomplish a tax deferred exchange. In the most common type of Build-To-Suit Exchange (Delayed Improvement Exchange) the Exchanger sells the relinquished property in a delayed exchange and then acquires the replacement property after it has been improved with the exchange funds from the relinquished property. It is important to note that any improvements made to the replacement property after the Exchanger takes title are considered to be "goods and services" (are not like-kind to the relinquished property) and will result in taxable boot. For this reason, escrow hold back accounts, prepaying for construction services or for building materials, etc. do not work for Build-To-Suit Exchanges. Instead, the transaction is structured using the "safe harbor" guidelines provided by Revenue Procedure 2000-37 wherein the Build-To-Suit Exchange is accomplished using an Exchange Accommodation Titleholder (EAT) to hold title to the replacement property while the improvements are made.
The structure of a delayed improvement exchange is the same as a delayed exchange except: the Qualified Intermediary (through the EAT) uses the exchange funds and/or loan funds to purchase the replacement property to be improved; and the EAT enters into a construction contact with a general contractor and a construction management agreement and disbursement agreement with the Exchanger. As the construction is completed, the QI pays the invoices with exchange funds and on or before the 180th day (or tax filing deadline) the EAT transfers the improved property to the Exchanger. Another difference relates to the identification statement. During the 45-day Identification Period, the Exchanger must submit to the QI an unambiguous description of the land (or existing property) and the improvements to be constructed. The 1031 regulations require that the improvements be described "in as much detail as is practicable at the time of the identification." For more information and diagrams relating to Build-To-Suit exchanges, click here.
A reverse exchange is useful when an Exchanger wants to acquire the replacement property first and dispose of the relinquished property later on a tax deferred basis. A reverse exchange may be appropriate if the relinquished property falls out of escrow or the replacement property must close before the relinquished property is sold or ready to close. To have a valid exchange, one of the properties must be "parked" to prevent the Exchanger from being in title to the relinquished property at the same time they are in title to the replacement property.Replacement Property Parked Reverse Exchange
In this type of reverse exchange, the replacement property is "parked" with an entity called an Exchange Accommodation Titleholder (EAT). This is the most common type of reverse exchange and is sometimes known as the "Exchange Last Method". In Phase 1 of a Replacement Property Parked Exchange, the money needed to buy the replacement property is loaned to the EAT by the Exchanger or a 3rd party lender. After receiving the money, the EAT acquires the replacement property from the Seller and holds title to the property for a maximum of 180 calendar days. In Phase 2, a buyer is found and the relinquished property is transferred to that Buyer; the net sale proceeds are transferred to the EAT (through the Qualified Intermediary); the EAT pays off (or pays down) the loan on the replacement property; and transfers that property to the Exchanger in completion of the exchange. The process is summarized in Diagram 3:
If the relinquished property does not close within the 180 days, then there would be no gain to recognize because there would not have been a sale. The EAT would transfer ownership of the replacement property and the Exchanger would simply own both properties.Relinquished Property Parked Reverse Exchange
In this type of reverse exchange, the relinquished property is "parked" with the EAT. It is sometimes called the "Exchange First Method". In Phase 1, money (should be equal to the Exchanger's equity in the relinquished property) is loaned to the EAT by the Exchanger. After receiving the money, the EAT acquires title to the relinquished property (to be held for a maximum of 180 calendar days). The funds loaned to the EAT are put into the exchange through a Qualified Intermediary and used to acquire the replacement property from the Seller. When a suitable buyer for the relinquished property is found, it is sold and the proceeds are used to pay off any third party debt and repay the Exchanger the money loaned to the EAT. If the price paid by the EAT differs from the actual price paid by the ultimate buyer, the Exchanger and EAT enter into a purchase price adjustment agreement to increase or decrease the original purchase price and loan amount that may be necessary to reflect the final purchase price. If the ultimate buyer pays more than was originally estimated, then the Exchanger will have taxable boot equal to that difference. The process is summarized in Diagram 4:
Exchange Timelines in Effect
The 45-day and 180-day timelines still apply to reverse exchanges, albeit differently. The timelines begin from when the EAT acquires the parked property (not from the transfer of the relinquished property). Within 45 calendar days, the Exchanger must identify the relinquished (not replacement) property; and within 180 calendar days the EAT must transfer the parked property.
For more information on Reverse exchanges, click here.
DEFERRED OR DELAYED EXCHANGES
Exchanges that do not occur concurrently and exchanges in which the relinquished property is transferred before the replacement property is received are known as delayed exchanges. They are also referred to as "deferred exchanges" or "Starker exchanges." A reciprocal exchange must take place but it does not need to be simultaneous. The structure is depicted in Diagram 5:
The structure is the same as four party exchanges using a Qualified Intermediary depicted in Diagram 2 above with the addition of the statutory timelines added by the 1984 amendment to Section 1031. The statutory timelines are discussed further in the subsection entitled "Time Requirements" below.
The following two subsections describe the traditional rules and time constraints for completing a qualifying delayed exchange.
LIKE KIND PROPERTY DEFINED
The relinquished property and replacement property must be like-kind to qualify for exchange treatment under section 1031. The term like-kind refers to the nature or character of the property not its grade or quality. For this reason nearly all real property is like-kind to each other. The following items are all considered like-kind and can be exchanged for each other: vacant land, commercial buildings (office, industrial or warehouse), ranches, farms, rental homes, apartment buildings, tenant-in-common interests as well as leases of 30 years or more (including options).
The Identification Period in a 1031 exchange begins on the date the Exchanger transfers the "benefits and burdens of ownership" of the first relinquished property and ends at midnight on the 45th day thereafter. The Exchange Period begins on the same day as the Identification Period (the date the Exchanger transfers the benefits and burdens of ownership of the relinquished property) and ends at midnight on the earlier of, the 180th day thereafter or the due date (determined with regard to extension), for the Exchanger's tax return for the taxable year in which the transfer of the relinquished property occurred.
It should be noted that the counting of the 45 and 180 periods begins on the day after the first relinquished property is transferred not on the day of transfer itself. Accordingly, the Identification and Exchange Periods are a full 45 and 180 days, respectively. As such, the total Exchange Period is 180 days and the 45 day Identification Period is included in that period; it is not 45 days plus 180 days as many individuals believe. It should also be noted that the time periods are calendar days, not business days. Accordingly, the Identification and Exchange Periods will count weekends and holidays. If the 45th day or the 180th day falls on a weekend or holiday it will NOT be extended until the next business day; for that reason, Exchangers need to be aware of the expiration of the Identification and Exchange Periods and plan accordingly. The Exchanger must receive the "benefits and burdens of ownership" of the replacement property by midnight of the end of the Exchange Period.
Tax Season Issues
When the relinquished property is transferred after October 17th (October 18th when the tax return is due in a leap year), less than 180 days will be available to close on the replacement property for a taxpayer whose tax return is due April 15th of the following year. The Exchanger can have the full 180 days for the Exchange Period by filing an extension of the tax return. Similarly, a corporation with a due date of March 15th will have less than 180 days if the closing of its relinquished property is on or after similar dates in September unless a filing extension is requested.
The easiest way to remember these tax season issues is that the transfer of the relinquished property and the transfer of the replacement property must be reported in one tax return. This is why the IRS allows the Exchanger to file for an extension to provide a full 180 day Exchange Period regardless of what time of year they transfer the relinquished property.
SELECTING A QUALIFIED INTERMEDIARY
Security of the funds that are being held by the Qualified Intermediary (QI) for up to 180 days, is essential to making sure they are available to acquire the replacement property and complete the exchange. When selecting QI, it is very important to consider a number of factors including: how the exchange funds are being held (are they in segregated accounts or are they comingled); the financial strength of the QI well as the soundness of its business practices (are they likely to remain in business for the exchange period and could they withstand a financial loss that could occur as a result of a cybercrime); whether it complies with the statute and IRS regulations (to be within the "safe harbor" given by the IRS); and whether its employees are knowledgeable and competent (to assist you and your client).
With regard to security, the Exchanger should consider the following factors:
- whether there exists a performance guarantee (for the QI) from a financially stable third party;
- whether it has a significant Fidelity Bond (crime insurance);
- whether it has a significant amount of Errors & Omission Insurance; and
- how the exchange funds will be held and/or invested.
With regard to financial strength and the possession of sound business practices, the Exchanger should determine:
- if the QI undergoes 3rd party audits;
- whether the QI requires dual signatures on disbursements of exchange funds; and
- whether the QI has a procedure that requires a written authorization by the Exchanger before exchange funds can be disbursed.
Finally, it is important to know whether the Qualified Intermediary has attorneys, accountants and/or Certified Exchange Specialists (CES®) on its staff knowledgeable with the regulations and legal requirements for a 1031 exchange.Qualified Intermediary is an Independent Third Party
A requirement to having a valid 1031 exchange is that the Exchanger must avoid having actual or constructive receipt of the exchange funds. One way to accomplish this is to retain a QI to satisfy the "safe harbor" requirements under Treasury Regulation 1.1031(k)-1(g)(4). The QI must not be a "disqualified person" as defined in the 1031 regulations. Examples of parties disqualified to serve as a QI include parties related to the exchanger which are defined in sections 267(b) and 707(b)(1) of the Internal Revenue Code (e.g. ancestors, lineal descendants, siblings, spouses and related entities) as well as agents of the Exchanger.
For purposes of the regulations, a person who has acted as the Exchanger's employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the two year period prior to the beginning of the exchange is disqualified to serve as the QI. There is an exception for the performance of routine financial, title insurance, escrow or trust services by a financial institution, title insurance company or escrow company or for services solely related to facilitating a 1031 exchange. Accordingly, an Exchanger can use the same QI repeatedly.
As a result when selecting a QI, consideration should not only be given to the service and security they offer but also whether they are considered to be a "disqualified party, especially if the Exchanger would like to have their exchange facilitated by their attorney or accountant.
A FEW COMMON EXCHANGE QUESTIONS AND ANSWERS
Equity and Capital Gain
Is my tax based on my equity or my capital gain?
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.
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. The 1033 exchange involves the "involuntary" conversion of property, a situation frequently caused by the government's power of eminent domain. Eminent domain is defined as "the power of a government to take private property for public use, usually with compensation paid to the owner". Property owners have limited rights when facing the threat of their property being taken via "eminent domain".
The treatment of capital gains tax associated with a property that is appropriated by the government via eminent domain is a subject investment property owners need to be aware of. Section 1033 of the Internal Revenue Code addresses how an investor/business owner can defer payment of capital gains taxes when participating in an involuntary conversion of their investment or business property. This process is alternatively called a 1033 Exchange or a 1033 Rollover. The most common qualifier for a 1033 Exchange is seizure due to eminent domain. Other circumstances that make a property eligible for a 1033 Exchange are:
- Destruction of the property that is beyond the control of the taxpayer (fires, severe storms, floods, etc.);
- Theft - the criminal appropriation of property by another (swindling, false pretenses, etc.); and
- Taking of the property through seizure (contraband and the fruits and instrumentalities of crime).
Taxpayers must replace their 1033 property within the period beginning with the involuntary conversion and ending two (2) years (three (3) years if condemned real property) after the close of the first taxable year in which any part of the gain is realized. Notification of replacement must be included in the owner's tax return for the taxable year or years in which replacement occurs in order to avoid keeping the period for assessment open. The notification must set forth all the details in connection with the investment.
The Replacement Property
Rules for choosing a replacement property set forth in a 1033 Exchange are very specific. The kind of replacement property is narrower than under a 1031 Exchange. The general requirement is that the replacement property must be similar or related in service or use (similar-use requirement). This has been defined to mean property which is functionally similar and has the same uses as the converted property.
Section 1033 allows 2 to 3 years to choose the replacement property. Condemned real estate held for business or investment can be replaced by property held either for productive use in a trade or business or for investment (like-kind standard), which is less restrictive than the similar-use requirement for other involuntary conversions. Other condemned real estate (such as primary residences or second homes) would be subject to the more rigid similar-use requirement. The taxpayer must intend and document that the acquired real estate serve as the replacement for the condemned real estate. The replacement requirement can also be satisfied through construction of a replacement property on land already owned by the taxpayer. Funds from any source (including the condemnation) can be used to construct the replacement property.
Is there a difference between Qualified Intermediaries?
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.
Qualified Intermediaries and Fees
Should fees be a factor in selecting a Qualified Intermediary?
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. Please refer to the section entitled "Selecting a Qualified Intermediary" above for what to look for.
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. See section on improvement exchanges above.
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, if you own and report taxes as tenants in common. However, if your interest is not in the property but actually an interest in the partnership which owns the property, your exchange will not qualify. This is because partnership interests are excepted from deferral treatment by Section 1031(a)(2)(D). But don't be confused! If the entire partnership desires to stay together and exchange their property for a replacement, that would qualify.