A 1031 exchange, in its simplest form, is a person or business entity selling real estate and purchasing other real estate. As long as the proper procedures are followed, the Internal Revenue Service will recognize the transaction, not as a sale and purchase, but as an exchange of a relinquished property for a replacement property. This recognition as an exchange allows the seller to defer the payment of taxes that would otherwise be due upon the sale. Those taxes include capital gains tax, depreciation recapture tax, net investment income tax and state taxes.
There are many factors that must be considered to determine if an exchange will work for any taxpayer, however, the main factors are 1) Will there be capital gains tax due upon selling property and 2) Do I want to continue to own real estate?
If the answer is yes to both of these questions, then a 1031 exchange is an
excellent tax avoidance tool that should be considered. More on when to do a 1031 Exchange.
Any taxpaying person or business entity may complete an exchange including partnerships, trusts, LLCs and corporations. It is important to be aware that the person or entity who is the seller on the property being sold must be the same person or entity on the new property acquired in the exchange. There are some variations or exceptions to this "same taxpayer" rule depending on the circumstance.
The process of completing an exchange
some time periods that must be adhered to in order for an exchange to be valid.
The first is 45 days to identify your replacement property. Identification
simply means that you must designate in writting the property that you plan
to acquire to complete your exchange. The second is 180 days to close
on the new replacement property. This 180 days can be
shortened if the due date of your tax return falls within the 180 days,
unless an extension is filed.
There are some variations to this process depending on each exchangers situation, particularly if the exchange is a reverse exchange.
Please contact us once you put your property on the market. We will then be able to advise on the beginning steps of an exchange. *Remember it is important that a taxpayer not take receipt of sale proceeds from their property sale. If the taxpayer touches the proceeds, an exchange is no longer possible. We will start with:
The status of your purchase agreement?
Has a closing date been set?
Who is the closer on the sale?
Once we have this information, we will prepare the exchange documents and contact the closer to arrange for the exchange documents to be signed at closing.
The term Qualified Intermediary is a creation of the United States Treasury Code (Section 1031 of course). Since the tax laws restrict exchangers from taking receipt of the proceeds funds from the sale of their relinquished property during the exchange, the qualified intermediary is hired to hold those proceeds, as well as, facilitate the exchange. The intermediary must be an independent third party from the taxpayer. The intermediary cannot be an agent of the taxpayer defined as the taxpayer's attorney, real estate agent, accountant or employee. Someone related to the taxpayer such as their spouse, parent, sibling or a related business also can't be an intermediary. Additionally, someone related to the agent of the taxpayer as defined above also cannot be an intermediary. For instance, a title company partially or wholly owned by an attorney or real estate broker where that attorney or broker has provided services to the taxpayer is not qualified to act as that taxpayer's intermediary.
Section 1031 of the Internal Revenue Code states
that property must be exchanged for property of like kind. This language often
produces some confusion in exchanging. Exchangers tend to think they need to
exchange for a property of similar use.
Actually, all real estate in the United States is considered like kind to other real estate so long as it is held for productive use in a trade or business or for investment purposes. For example, a duplex can be exchanged for a four-plex, rental property can be exchanged for retail property, office property can be exchanged for a warehouse, land can be exchanged for improved property etc. A vacation home used strictly for personal use does not qualify. There are some specific rules that will allow a vacation property to qualify for a 1031 exchange. Please call for details.
To achieve maximum tax deferral upon completing a 1031 exchange,
the exchanger must avoid receipt of proceeds from the relinquished property
sale and purchase a replacement property that is equal or greater in value than
the relinquished property sold. Any proceeds received or decrease in replacement
property value will likely get taxed as capital gain. A Taxpayer can still
complete an exchange with some pro-rata tax deferral, even if these rules are
violated, depending on the relinquished property's basis. Of course, a Taxpayer
should always work with their tax professional to determine if an exchange is
right for them. Here is an
excellent article on calculating gain and tax deferred with an exchange.
Yes, there is no limit to how many relinquished or replacement properties can be part of an exchange. If there are multiple relinquished properties, there are some factors to consider as to whether or not the sales will be considered one of multiple exchanges. The proper identification rules must also be followed if multiple replacement properties are being considered.
IRS form 8824 is used to report a 1031 exchange.
Yes, it is possible to include improvements on the replacement property as part of an exchange if structured correctly. An exchanger will include newly constructed improvement on a replacement property when the exchanger wants to increase that property's value to maximize the amount of tax deferred in the exchange. To achieve complete tax deferral when completing a 1031 exchange, the exchanger needs to acquire a replacement property that has a value that is at or higher than the sale price of the relinquished property.
When completing a 1031 exchange the exchanger must exchange currently owned real estate for newly acquired real estate. Buying building materials and paying contractors to build new improvements on a parcel of property is not considered acquiring new real estate and will not count as part of a replacement property's value in an exchange. The only way to include new improvements on a replacement property's value is to have the improvements constructed before the exchanger buys it (closes on it). That way the improvements are now part of the real estate and can be considered in the exchange calculation on the exchanger's tax return.
Of course, having the improvements built before the exchanger acquires the replacement property is tricky. The seller of the replacement property can build the improvements before conveying to the exchanger at a price which includes the cost of the improvements, but sellers are not typically cooperative with that option, unless the seller is a builder or developer.
The typical solution is to do a built-to suit exchange. In a build-to-suit exchange the exchange company holds title to the replacement property while improvements are constructed. The property is then transferred to the exchanger once improvements are complete, once the replacement property value reaches the desired number or within a maximum of 180 days. The exchanger has then acquired real estate with the increased value of the improvements and can include that value in the exchange. If the improvements are not complete within the 180 days, the value of the improvements that are completed within the 180 days can be included in the value of the property, even if the improvements are not 100% complete.
It is important that the exchanger not take title to the replacement property until improvements are part of the real estate if the exchanger desires to include the value of those improvements in the replacement property's value.
That is a great question. Of course, for a 1031 exchange to be completed, a Taxpayer needs to purchase a replacement property. If they fail to purchase a property then the relinquished property will be taxed as an outright sale as if no exchange was ever anticipated. The most optimal strategy is to have a replacement property in mind before beginning an exchange, but that is not always possible. It is possible to enter into a contract to acquire a replacement property before selling the relinquished proeprty and that is acceptable within the exchange rules. Unless anticipating a reverse exchange, the relinquished property will need to close before the replacement property.
If a replacement property is not identified within the 45 day period then exchange funds will be returned to the Taxpayer. Please be aware that there are limitations on when funds can be returned should an Exchangor desire to cancel an on-going exchange. The earliest date is 46 days after the sale of the relinquished property.
One of the nice benefits to beginning an exchange is that the Exchanger does have the 45 day identification period to decide if an exchange will work. Many Taxpayers see the 45 day period as an "option" period where they can shop for a suitable replacement property. If they don't find one, then they are able to cancel the exchange by not identifying a replacement property. All exchange funds will then be returned on day 46.