Exchange Guidelines
What is a 1031 Exchange?
Eligible Property
Ineligible Property
Like-Kind Requirement
Deadlines
Constructive Receipt
Identification Rule
Calculating Tax Benefits
Partially Taxable Exchanges
Closing Costs
Documentation
Tax Filing Requirements
1031 exchanges are defined by section 1031 of the Internal Revenue Code. The code provides that no gain or loss will be recognized on the exchange of property held for productive use in a trade or business or for investment purposes. Exchanges allow investors to dispose of investment property without paying the capital gain tax that would normally be due. By deferring this tax, exchangers retain 100% of their equity to reinvest, providing more buying power and opportunities.
For property to be eligible as either relinquished property or replacement property in a 1031 exchange, it must be held by the exchanger for productive use in a trade or business or for investment purposes. Examples of eligible real property include:
a) rental homes or apartments
b) raw land
c) farms
d) office buildings or condominiums
e) motels or hotels
f) industrial property
g) a thirty-year leasehold interest in real property.
Some property is ineligible as exchange property under Section 1031. Examples of ineligible exchange property include:
a) stock in trade, inventory or other property held primarily for sale
b) stocks, bonds or notes
c) an interest in a partnership
d) a personal residence
e) a vacation or second home that is used by the taxpayer or his family for more than two weeks out of the year, or 10% of the actual number of days the property has been rented in a given year.
The relinquished property and the replacement property must be "like-kind" to each other. For real property, the like-kind requirement is quite broad. One type of real property is like-kind to another as long as both are held by the exchanger for either investment purposes or productive use in a business or trade. For exchange purposes therefore , a farm may be like-kind to an office building. In a personal property exchange, properties are like-kind to each other only if they both fall within the same General Asset Class or the same Product Class as defined in the tax code.
Identification period: Exchangers have until midnight of the 45th day after the transfer of the relinquished property to identify replacement property.
Exchange period: The deadline for acquiring replacement property is the earlier of 180 days after the relinquished property transfer, or the due date for the exchanger's tax return (including extensions) for the year in which the relinquished property was sold.
For individual exchangers, if the transfer of the relinquished property occurs after October 17th, April 15th of the following year will occur before 180 calendar days. An extension of the exchanger's tax return would be necessary to extend the exchange period beyond April 15.
For corporate exchangers, an extension would be necessary to extend the exchange period beyond March 15 th for exchanges occurring on or after September 17 th.
An exchange will fail immediately upon the exchanger being in either actual or constructive receipt of the proceeds from the sale of the relinquished property. Constructive receipt of the exchange funds occurs when the exchanger has the unrestricted ability to ask for the funds at any time during the exchange.
Exchangers avoid constructive receipt by entering into a correctly worded exchange agreement with the qualified intermediary. The agreement must limit the exchanger's right to receive any of the exchange funds until:
a) after the expiration of the 45-day identification period if no replacement property has been identified
b) after the expiration of the 180-day acquisition period if the exchanger has identified replacement property but has not acquired it
c) after the exchanger has acquired all the property which was timely identified.
Exchangers therefore need to be aware that, the intermediary will be required to hold exchange funds 45 days, even if the exchanger decides not to complete the exchange within that time period.
3 Property Rule: In general, the exchanger may identify up to three replacement properties without regard to fair market value of either the relinquished or replacement properties. Exchangers may acquire one, two, or all three of those properties identified in the exchange.
200% Rule: If the exchanger identifies more than three replacement properties, the fair market value of all the identified properties cannot exceed 200% of the fair market value of the relinquished property.
200% Rule Exception:If more than 3 properties are identified, and the fair market value of the identified properties exceeds 200%, the exchanger may successfully complete the exchange by acquiring 95% of the properties identified.
The identification of the replacement property must be in writing, signed by the exchanger, and sent to the intermediary by midnight of the 45th day after transfer of the relinquished property.
Calculating Tax Benefits
Calculating exact tax liability requires knowledge of the specific tax rules, but the following rules of thumb can be utilized in planing an exchange to avoid or minimize tax liability:
a) The fair market value of the replacement property should be equal to or greater than the fair market value of the relinquished property
b) The equity the exchanger has in the replacement property should be equal to or greater than the equity in the relinquished property
c) Any mortgages on the relinquished property that were paid off from the sales proceeds should be offset by new mortgages on the replacement property, or cash paid by the exchanger.
d) The exchanger should not take cash or other non like-kind property as consideration for the relinquished property
An exchanger may complete an exchange that only defers a portion of the tax liability. Generally, exchangers will be taxed on the trade-down in fair market value, the trade-down in equity, or any cash or other property ("boot") received before, during or after the exchange.
The payment of closing costs incurred for the transfer of the relinquished or replacement property are considered deductible exchange expenses, and may be paid with exchange funds. Common examples may include attorney's fees, deed transfer fees, and real estate commissions. However, certain expenses such as fees related to obtaining a mortgage, and other items which are commonly allocated between buyer and seller but which reduce the exchanger's equity, are not considered deductible exchange expenses. Examples include mortgage origination points, security deposits, prepaid rents, and property taxes. Settlement statements for each closing should be reviewed for tax considerations.
Exchanges should be well documented from inception to indicate the exchanger's intent, and to alert other parties to the exchange and obtain their necessary cooperation. The following language is suggested for inclusion in the contracts for the sale of relinquished property and the purchase of replacement property in an exchange.
- Relinquished Property Contract Language:
- The Seller expressly reserves the right to assign its rights under this agreement to Investors Title Exchange Corporation as Qualified Intermediary, for the purpose of effecting an IRC Section 1031 tax-deferred exchange. The Buyer hereby acknowledges Seller's right to assign this contract, and agrees to cooperate with the Seller in a manner necessary to complete the exchange which will not delay the closing or cause additional expense to the Buyer.
- Replacement Property Contract Language:
- The Buyer expressly reserves the right to assign its rights under this agreement to Investors Title Exchange Corporation as Qualified Intermediary, for the purpose of effecting an IRC Section 1031 tax-deferred exchange. The Seller hereby acknowledges Buyer's right to assign this contract, and agrees to cooperate with the Buyer in a manner necessary to complete the exchange which will not delay the closing or cause additional expense to the Seller.
The qualified intermediary will draft other documents prior to the sale of the relinquished property and before the purchase of the replacement property. Typical documents include an Exchange Agreement, a Relinquished Property Assignment and a Replacement Property Assignment.
Upon completion of an exchange, exchangers will be required to report the transaction to the IRS with their tax return for the year in which the relinquished property was transferred. IRS reporting forms include Form 8824 and either Schedule D or Form 4797. Exchangers should also check with state taxing authorities for state-specific reporting requirements.