1. WHAT IS A 1031 EXCHANGE?
A 1031 exchange is simply a method by which a real property owner disposes of one property and acquires another without having to pay any capital gains tax on the transaction. This method is allowed by Internal Revenue Code Section 1031, whereby owners of certain property may sell such property and not pay any capital gains taxes on such sale if the owner buys certain new property within a specified time period.
2. WHAT ARE THE BASIC REQUIREMENTS OF EXCHANGES?
A. BOTH PROPERTIES MUST BE "LIKE-KIND".
Like-kind simply means real property. Like-kind refers to the nature or character, not its grade or quality. Like-kind is a very broad and liberal category where just about any type of investment or business use property would qualify. Properties can be located anywhere within the United States with Exchanges taking place in one or more states. Examples of like-kind: rental properties (single family homes, duplexes, triplexes, apartment buildings and complexes, etc.), raw land, office buildings, shopping centers, businesses, marinas, golf courses, a lease of at least 30 years including options, parking lots, farms, factories, trailer parks, storage facilities, retail stores, and interest in a co-tenancy. Examples of non like-kind: stocks, bonds, notes, interest in a partnership, and personal property. Investors can "mix and match" their properties. For example, an investor can sell a duplex and acquire raw land or sell a parking garage and acquire a multi-unit apartment building and a warehouse.
B. BOTH PROPERTIES MUST BE HELD FOR INVESTMENT OR BUSINESS USE.
Your use of both the relinquished property and replacement property must be investment or business use; each for a minimum of one to two years. Properties must not be used for personal use more than 14 days per year or 10% of the actual number of days the property has been rented in a given year. Replacement property cannot be purchased with the intent to sell immediately.
C. EXCHANGER MUST USE AN ACCOMMODATOR.
One of the safe harbors of the regulations is the use of an accommodator to facilitate the Exchange. The sale of the relinquished property and the acquisition of the replacement property must "flow" through the accommodator. This is done through direct deeding to avoid duplicate transfer taxes. The accommodator may not be the taxpayer or an agent of the taxpayer (realtor, attorney, tax advisor, banker, accountant, employee, etc.) or lineal descendant of the Exchanger.
D. EXCHANGER MUST USE A QUALIFIED ESCROW AGENT AND HAVE NO ACTUAL OR CONSTRUCTIVE RIGHTS TO THE SALE PROCEEDS OF THE RELINQUISHED PROPERTY.
The qualified Escrow Agent may not be the taxpayer or an agent of the taxpayer (realtor, attorney, tax advisor, banker, accountant, employee, etc.) or lineal descendant of the Exchanger. The Exchanger must not have access to the sale proceeds of the relinquished property. The Exchanger is entitled to all earnings on the escrow funds. These taxable funds must also be restricted in the same manner as the principle. The Exchanger chooses the Escrow Agent. The Exchanger is entitled to obtain security for his funds.
E. THE PROPER DOCUMENTATION MUST BE USED IN ORDER TO COMPLY WITH 1031 REGULATIONS. YOU MUST HAVE A 1031 EXCHANGE AGREEMENT BETWEEN THE EXCHANGER AND THE ACCOMMODATOR.
The 1031 Exchange Agreement is the most important document in the Exchange. It is the document in which the Exchanger gives the accommodator the right to acquire the relinquished property from the Exchanger and convey it to the buyer. It also gives the accommodator the right to acquire the replacement property from the seller and then convey it to the Exchanger.
1031 EXCHANGE AMENDMENT AND ASSIGNMENT FOR THE ROLLOVER OF THE RELINQUISHED PROPERTY. This document assigns the Exchanger's rights in the Agreement of Sale with the buyer to the accommodator. Serves as written notification to the buyer of the relinquished property of the Exchangers intent to effect a 1031 Exchange and also provides a hold harmless clause to assure the buyer that there are no additional liabilities or costs to him. If a 1031 Exchange Clause is inserted into the Agreement of Sale, this document is unnecessary.
1031 EXCHANGE AMENDMENT AND ASSIGNMENT FOR THE ACQUISITION OF THE IDENTIFIED REPLACEMENT PROPERTY This document assigns the Exchanger's rights in the Agreement of Sale with the seller to the accommodator. It serves as written notification to the seller of the replacement property of the Exchangers intent to effect a 1031 Exchange and also provides a hold harmless clause to assure the seller that there are no additional liabilities or cost to him. If a 1031 Exchange Clause is inserted into the Agreement of Sale, this document is unnecessary.
F. EXCHANGER MUST ADHERE TO TIME LIMITATIONS.
The 45-Day Identification Period begins at the closing of the relinquished property and requires the identification of like-kind replacement property. During this 45-Day Identification Period, you may revoke an identification and make a new one. If a like-kind replacement property has not been properly identified to the accommodator by midnight of the 45th day, the Exchange will not work and the taxpayer will be unable to defer the capital gains. The 180-Day Exchange Period runs concurrently with the 45-day Identification Period and requires the acquisition of at least one of the identified replacement properties. If the settlement of the relinquished property occurs between October 16 and December 31 of the current year, the 180-day Exchange Period will be shortened to the income tax deadline of April 15 of the next calendar year unless a timely and proper IRS extension is filed for their return. For a corporation, this filing date is March 15 of the next calendar year unless an IRS extension is filed. Exchange Deadlines Calculator
3. WHO SHOULD CONSIDER A 1031 EXCHANGE?
Anyone who is thinking about selling a business use or investment property should consider effecting a 1031 Exchange. An Exchange offers the astute investor an opportunity to reinvest the federal capital gains that would normally be handed over to the IRS and put that money to work for himself. You work too hard to simply pay the tax without carefully considering this reinvestment option. Essentially, 1031 Exchanges should be thought of as an interest free loan from the IRS; one in which the principal may be increased through subsequent exchanges and may never require repayment, if you plan properly.
4. WHY SHOULD I TRANSACT A 1031 EXCHANGE?
A 1031 exchange allows an investor to defer capital gains tax on a sale of property thereby allowing the investor more money to purchase another property.
An investor can diversify by selling one property and acquiring multiple properties or an investor can consolidate by selling multiple hard-to-manage properties and acquire one property.
5. HOW DO I GET STARTED?
Contact your accommodator to discuss your specific needs, answer any questions that you may have, and review the procedures of conducting a successful 1031 exchange. If you do not already have a accommodator, please contact us and we will assist you in finding one.
6. WHAT PROPERTIES QUALIFY FOR A 1031 EXCHANGE?
Any property held for productive use in a trade or business or property held for investment purposes can be exchanged for any like-kind property. Property may be real or tangible personal property such as an apartment building, raw land, single family rental, shopping center, 30 year or more leasehold interest or equipment. Like-kind property refers to the nature of the property (i.e. held for use in a business or for investment) not the use of the property – so a shopping center may be exchanged for an apartment building or an apartment building may be exchanged for raw land. Furthermore, one property can be sold and three properties acquired; or four properties can be sold and one acquired.
Section 1031 does exclude certain property such as stocks, bonds, partnership interests and stock in trade (i.e. inventory).
7. IS IT TOO LATE TO QUALIFY FOR A 1031 EXCHANGE AFTER I HAVE SIGNED THE SALES CONTRACT?
No, as long as you have not closed on the property you are selling and received the sale proceeds, a 1031 exchange can still be completed. However, once the closing occurs, it is too late to take advantage of Section 1031.
8. CAN YOU TAKE CASH OUT OF A 1031 EXCHANGE?
You cannot take cash out of an exchange without creating a taxable event. If an Exchanger elects to take some of the equity out of the sale proceeds in the way of cash or a note, this is called "BOOT" and is taxable. However, to avoid taxable boot, an Exchanger can opt to refinance after the exchange transaction is completed. Capital Gain Tax Calculator.
9. CAN YOU DIRECT DEED WHEN USING AN ACCOMMODATOR?
Yes, IRS regulations allow the method known as direct deeding from the grantor to the grantee, as in a typical sale transaction. This procedure eliminates payment of additional transfer taxes. Therefore, in most typical exchanges, the deed is prepared as normal with the title conveyed directly from the seller to the buyer.
10. HOW DO I REPORT MY 1031 EXCHANGE TO THE IRS?
Initially, your 1031 Exchange is reported on the IRS form 1099S which should indicate that you are effecting a 1031 Exchange and will receive property as consideration for the sale of your relinquished property. IRS Form 8824 must be completed as part of your annual federal return. In addition to determining your realized gain, recognized gain and your new basis, this form will ask the date you sold your relinquished property, identified and acquired your replacement property. Form 8824 is actually a supporting form for IRS Form 4797. The income received on rental properties must be reported on Schedule D of Form 1040.
11. IS IT POSSIBLE TO COMBINE AN IRS 1031 EXCHANGE WITH THE UNIVERSAL EXCLUSION?
It is possible to work with both IRS 1031 (1031) and the Universal Exclusion on the same parcel of property. Examples of this (U.E.) would include:
A. A working farm containing the farmer’s residence...the working land would fall under section 1031 rules while the farmers home would fall under the Universal Exclusion.
B. A duplex or similar multi-unit building with one unit owner occupied (U.E.), the balance tenant occupied (1031).
C. A residence (U.E.) containing a home office (1031).
12. CAN I ACQUIRE MORE THAN ONE PIECE OF PROPERTY?
You can come out of one relinquished property and acquire any number of replacement properties. As long as the value that you sell is at least the value you purchase, there will not be a taxable event.
13. WHAT IS THE TERM "TRADING UP?"
It is adding money to an exchange and acquiring an even more expensive piece of property than you sold. Or, you can increase your debt, but you must use all of the proceeds from the relinquished property as well.
14. CAN I USE PART OF THE CASH FROM THE TRANSACTION FOR OTHER MEANS AND USE THE REMAINING PROCEEDS TO DO A REAL ESTATE EXCHANGE?
Yes, but the cash will be subject to taxation. This is called a partial exchange.
15. WHAT IS A DEFERRED/DELAYED EXCHANGE?
You surrender your relinquished property at one time and acquire the new replacement property, no later than 180 days from the closing of the relinquished property, or the due date for the tax return for the year of the sale, whichever is earlier.
16. WILL I EVER HAVE TO PAY TAXES ON THE PROPERTY?
Only when you finally sell the property you exchanged into, without doing another exchange. You can continue to roll over sold properties into new properties without any tax obligation.
17. HOW WILL THIS AFFECT MY ESTATE PLANNING?
If you hold the exchanged property until death, your heirs receive a stepped up basis to fair market value, and the capital gain is never taxed. Which means the income taxes that were deferred by you now become permanently tax-free to your heirs.
18. CAN I EXCHANGE MY PROPERTY FOR A PROPERTY IN ANOTHER STATE?
Yes, anywhere in the U.S.A.
19. IS A PARTIALLY TAXABLE EXCHANGE POSSIBLE?
Yes, you acquire with part of the funds, and you pay taxes on the balance of the funds.