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Every Section 1031 Exchange transaction is
different. These "Frequently Asked Questions" are
intended to answer general inquiries. The
application of these principles will depend on the
specific facts of each transaction. Always consult a
competent Qualified Intermediary, attorney, or tax
advisor to determine how an exchange may best be
structured to accomplish your investment objectives.
Q - What is a tax-deferred
exchange?
In a typical transaction, the property owner is
taxed on any gain realized from the sale. However,
through a Section 1031 Exchange, the tax on the gain
is deferred until some future date.
Section 1031 of the Internal Revenue Code
provides that no gain or loss shall be recognized on
the exchange of property held for productive use in
a trade or business, or for investment. A
tax-deferred exchange is a method by which a
property owner trades one or more relinquished
properties for one or more replacement properties of
"like-kind", while deferring the payment of federal
income taxes and some state taxes on the
transaction.
The theory behind Section 1031 is that when a
property owner has reinvested the sale proceeds into
another property, the economic gain has not been
realized in a way that generates funds to pay any
tax. In other words, the taxpayer's investment is
still the same, only the form has changed (e.g.
vacant land exchanged for apartment building).
Therefore, it would be unfair to force the taxpayer
to pay tax on a "paper" gain.
The like-kind exchange under Section 1031 is
tax-deferred, not tax-free. When the replacement
property is ultimately sold (not as part of another
exchange), the original deferred gain, plus any
additional gain realized since the purchase of the
replacement property, is subject to tax.
Q - What are the benefits of
exchanging v. selling?
- A Section 1031 exchange is one of the few
techniques available to postpone or potentially
eliminate taxes due on the sale of qualifying
properties.
- By deferring the tax, you have more money
available to invest in another property. In
effect, you receive an interest free loan from
the federal government, in the amount you would
have paid in taxes.
- Any gain from depreciation recapture is
postponed.
- You can acquire and dispose of properties to
reallocate your investment portfolio without
paying tax on any gain.
Q - What are the different
types of exchanges?
- Simultaneous Exchange: The exchange of the
relinquished property for the replacement
property occurs at the same time.
- Delayed Exchange: This is the most common
type of exchange. A Delayed Exchange occurs when
there is a time gap between the transfer of the
Relinquished Property and the acquisition of the
Replacement Property. A Delayed Exchange is
subject to strict time limits, which are set
forth in the Treasury Regulations.
- Build-to-Suit (Improvement or Construction)
Exchange: This technique allows the taxpayer to
build on, or make improvements to, the
replacement property, using the exchange
proceeds.
- Reverse Exchange: A situation where the
replacement property is acquired prior to
transferring the relinquished property. The IRS
has offered a safe harbor for reverse exchanges,
as outlined in Rev. Proc. 2000-37, effective
September 15, 2000. These transactions are
sometimes referred to as "parking arrangements"
and may also be structured in ways which are
outside the safe harbor.
- Personal Property Exchange: Exchanges are
not limited to real property. Personal property
can also be exchanged for other personal
property of like-kind or like-class.
Q - What are the requirements
for a valid exchange?
- Qualifying Property - Certain types of
property are specifically excluded from Section
1031 treatment: property held primarily for
sale; inventories; stocks, bonds or notes; other
securities or evidences of indebtedness;
interests in a partnership; certificates of
trusts or beneficial interest; and choses in
action. In general, if property is not
specifically excluded, it can qualify for
tax-deferred treatment.
- Proper Purpose - Both the relinquished
property and replacement property must be held
for productive use in a trade or business or for
investment. Property acquired for immediate
resale will not qualify. The taxpayer's personal
residence will not qualify.
- Like Kind - Replacement property acquired in
an exchange must be "like-kind" to the property
being relinquished. All qualifying real property
located in the United States is like-kind.
Personal property that is relinquished must be
either like-kind or like-class to the personal
property which is acquired. Property located
outside the United States is not like-kind to
property located in the United States.
- Exchange Requirement - The relinquished
property must be exchanged for other property,
rather than sold for cash and using the proceeds
to buy the replacement property. Most deferred
exchanges are facilitated by Qualified
Intermediaries, who assist the taxpayer in
meeting the requirements of Section 1031.
Q - What are the general
guidelines to follow in order for a taxpayer to
defer all the taxable gain?
- The value of the replacement property must
be equal to or greater than the value of the
relinquished property.
- The equity in the replacement property must
be equal to or greater than the equity in the
relinquished property.
- The debt on the replacement property must be
equal to or greater than the debt on the
relinquished property.
- All of the net proceeds from the sale of the
relinquished property must be used to acquire
the replacement property.
Q - When can I take money out
of the exchange account?
Once the money is deposited into an exchange
account, funds can only be withdrawn in accordance
with the Regulations. The taxpayer cannot receive
any money until the exchange is complete. If you
want to receive a portion of the proceeds in cash,
this must be done before the funds are deposited
with the Qualified Intermediary.
Q - Can the replacement
property eventually be converted to the taxpayer's
primary residence or a vacation home?
Yes, but the holding requirements of Section 1031
must be met prior to changing the primary use of the
property. The IRS has no specific regulations on
holding periods. However, many experts feel that to
be on the safe side, the taxpayer should hold the
replacement property for a proper use for a period
of at least one year.
Q - What is a Qualified
Intermediary (QI)?
A Qualified Intermediary is an independent party
who facilitates tax-deferred exchanges pursuant to
Section 1031 of the Internal Revenue Code. The QI
cannot be the taxpayer or a disqualified person.
- Acting under a written agreement with the
taxpayer, the QI acquires the relinquished
property and transfers it to the buyer.
- The QI holds the sales proceeds, to prevent
the taxpayer from having actual or constructive
receipt of the funds.
- Finally, the QI acquires the replacement
property and transfers it to the taxpayer to
complete the exchange within the appropriate
time limits.
Q - Why is a Qualified
Intermediary needed?
The exchange ends the moment the taxpayer has
actual or constructive receipt (i.e. direct or
indirect use or control) of the proceeds from the
sale of the relinquished property. The use of a QI
is a safe harbor established by the Treasury
Regulations. If the taxpayer meets the requirements
of this safe harbor, the IRS will not consider the
taxpayer to be in receipt of the funds. The sale
proceeds go directly to the QI, who holds them until
they are needed to acquire the replacement property.
The QI then delivers the funds directly to the
closing agent.
Q - Can the taxpayer just sell
the relinquished property and put the money in a
separate bank account, only to be used for the
purchase of the replacement property?
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 exchange.
Q - If the taxpayer has
already signed a contract to sell the relinquished
property, is it too late to start a tax-deferred
exchange?
No, as long as the taxpayer has not transferred
title, or the benefits and burdens of the
relinquished property, she can still set up a
tax-deferred Exchange. Once the closing occurs, it
is too late to take advantage of a Section 1031
tax-deferred exchange (even if the taxpayer has not
cashed the proceeds check).
Q - Does the Qualified
Intermediary actually take title to the properties?
No, not in most situations. The IRS regulations
allow the properties to be deeded directly between
the parties, just as in a normal sale transaction.
The taxpayer's interests in the property purchase
and sale contracts are assigned to the QI. The QI
then instructs the property owner to deed the
property directly to the appropriate party (for the
relinquished property, its buyer; for the
replacement property, taxpayer).
Q - What are the time
restrictions on completing a Section 1031 exchange?
A taxpayer has 45 days after the date that the
relinquished property is transferred to properly
identify potential replacement properties. The
exchange must be completed by the date that is 180
days after the transfer of the relinquished
property, or the due date of the taxpayer's federal
tax return for the year in which the relinquished
property was transferred, whichever is earlier.
Thus, for a calendar year taxpayer, the exchange
period may be cut short for any exchange that begins
after October 17th. However, the taxpayer can get
the full 180 days, by obtaining an extension of the
due date for filing the tax return.
Q - What if the taxpayer
cannot identify any replacement property within 45
days, or close on a replacement property before the
end of the exchange period?
Unfortunately, there are no extensions available.
If the taxpayer does not meet the time limits, the
exchange will fail and the taxpayer will have to pay
any taxes arising from the sale of the relinquished
property.
Q - Is there any limit to the
number of properties that can be identified?
There are three rules that limit the number of
properties that can be identified. The taxpayer must
meet the requirements of at least one of these
rules:
- 3-Property Rule: The taxpayer may identify
up to 3 potential replacement properties,
without regard to their value; or
- 200% Rule: Any number of properties may be
identified, but their total value cannot exceed
twice the value of the relinquished property, or
- 95% Rule: The taxpayer may identify as many
properties as he wants, but before the end of
the exchange period the taxpayer must acquire
replacement properties with an aggregate fair
market value equal to at least 95% of the
aggregate fair market value of all the
identified properties.
Q - What are the requirements
to properly identify replacement property?
Potential replacement property must be identified
in a writing, signed by the taxpayer, and delivered
to a party to the exchange who is not considered a
"disqualified person". A "disqualified" person is
any one who has a relationship with the taxpayer
that is so close that the person is presumed to be
under the control of the taxpayer. Examples include
blood relatives, and any person who is or has been
the taxpayer’s attorney, accountant, investment
banker or real estate agent within the two years
prior to the closing of the relinquished property.
The identification cannot be made orally.
Q - Are Section 1031 Exchanges
limited only to real estate?
No. Any property that is held for productive use
in a trade or business, or for investment, may
qualify for tax-deferred treatment under Section
1031. In fact, many exchanges are "multi-asset"
exchanges, involving both real property and personal
property.
Q - What is a "multi-asset"
exchange?
A multi-asset exchange involves both real and
personal property. For example, the sale of a hotel
will typically include the underlying land and
buildings, as well as the furnishings and equipment.
If the taxpayer wants to exchange the hotel for a
similar property, he would exchange the land and
buildings as one part of the exchange. The
furnishings and equipment would be separated into
groups of like-kind or like-class property, with the
groups of relinquished property being exchanged for
groups of replacement property.
Although the definition of like-kind is much
narrower for personal property and business
equipment, careful planning will allow the taxpayer
to enjoy the benefits of an exchange for the entire
relinquished property, not just for the real estate
portion.
Q - What is a reverse
exchange?
A reverse exchange, sometimes called a "parking
arrangement," occurs when a taxpayer acquires a
Replacement Property before disposing of their
Relinquished Property. A "pure" reverse exchange,
where the taxpayer owns both the Relinquished and
Replacement properties at the same time, is not
allowed. The actual acquisition of the "parked"
property is done by an Exchange Accommodation
Titleholder (EAT) or parking entity.
Q - Is a reverse exchange
permissible?
Yes. Although the Treasury Regulations still do
not apply to reverse exchanges, the IRS issued "safe
harbor" guidelines for reverse exchanges on
September 15th, 2000, in Revenue Procedure 2000-37.
Compliance with the safe harbor creates certain
presumptions that will enable the transaction to
qualify for Section 1031 tax-deferred exchange
treatment.
Q - How does a reverse
exchange work?
In a typical reverse (or "parking") exchange, the
"Exchange Accommodation Titleholder" (EAT) takes
title to ("parks") the replacement property and
holds it until the taxpayer is able to sell the
relinquished property. The taxpayer then exchanges
with the EAT, who now owns the replacement property.
An exchange structured within the safe harbor of
Rev. Proc. 2000-37 cannot have a parking period that
goes beyond 180 days.
Q - What happens if the
exchange cannot be completed within 180 days?
If the reverse exchange period exceeds 180 days,
then the exchange is outside the safe harbor of Rev.
Proc. 2000-37. With careful planning, it is possible
to structure a reverse exchange that will go beyond
180 days, but the taxpayer will lose the
presumptions that accompany compliance with the safe
harbor.
Q - Can the proceeds from the
relinquished property be used to make improvements
to the replacement property?
Yes. This is known as a Build-to-Suit or
Construction or Improvement Exchange. It is similar
in concept to a reverse exchange. The taxpayer is
not permitted to build on property she already owns.
Therefore, an unrelated party or parking entity must
take title to the replacement property, make the
improvements, and convey title to the taxpayer
before the end of the exchange period.
Q- 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.
Q - What is Boot?
Boot is any property received by the taxpayer in
the exchange which is not like-kind to the
relinquished property. Boot is characterized as
either "cash" boot or "mortgage" boot. Realized Gain
is recognized to the extent of net boot received.
Q - What is Mortgage Boot?
Mortgage Boot consists of liabilities assumed or
given up by the taxpayer. The taxpayer pays mortgage
boot when he assumes or places debt on the
replacement property. The taxpayer receives mortgage
boot when he is relieved of debt on the replacement
property. If the taxpayer does not acquire debt that
is equal to or greater than the debt that was paid
off, they are considered to be relieved of debt. The
debt relief portion is taxable, unless offset when
netted against other boot in the transaction.
Q - What is Cash Boot?
Cash Boot is any boot received by the taxpayer,
other than mortgage boot. Cash boot may be in the
form of money or other property.
Q - What are the boot
"netting" rules?
- Cash boot paid offsets cash boot received
- Cash boot paid offsets mortgage boot
received (debt relief)
- Mortgage boot paid (debt assumed) offsets
mortgage boot received
- Mortgage boot paid does not offset cash boot
received
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