What is a 1031 Tax Free Exchange?
A 1031 tax deferred property exchange is an exchange in which capital gains tax deferral is available to real estate owners who sell their investment, rental, business or vacation real estate, and reinvest the net proceeds in other real estate. Internal Revenue Code Section 1031 provides that no gain or loss will be recognized on the exchange of any type of business use or investment property for any other business use or investment property. 1031 Exchanges are not really exchanges in the context of two-party barter. Instead, they are typical sales and purchases that involve the same exact ingredients as any other sale or purchase, without the typical gains. The only real difference is the investor is increasing his selling and buying power by electing to avoid the drain of taxes under Section 1031 regulations. No other aspects of the transaction are affected.
Return to top
===============================================================
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.
Return to top
===============================================================
What are common misconceptions in a 1031 exchange?
- Many still believe that you must "swap" properties. Although this was required in the original code, this is rarely done in present times. 1031 Exchanges now enable one to sell their property to someone totally unrelated to the person from whom they are purchasing their replacement property. Although there are guidelines to follow, the only difference between a 1031 Exchange and a typical sale and purchase transaction is the deferral of federal capital gains.
- Many believe only investors of large commercial properties can utilize the benefits of Section 1031. The great thing about 1031 Exchanges is that it applies to all investment properties, large and small. It will work the same way for a corporation selling a large shopping center as it would for an individual selling a single-family home used as a rental property in a vacation area.
- Many believe you must acquire a property of "similar use or service". While 1031 Exchanges are also known as like-kind simply applies to real property held for business use or investment. Therefore, an investor may sell raw land and acquire a five-unit apartment building or sell a warehouse and acquire raw land. He can sell one property and acquire three or sell four and acquire one. Virtually any type of real property used for business use or investment will qualify.
- Many believe 1031 Exchanges are very complicated and not worth doing. The fact is that when working with a qualified intermediary who specializes in Section 1031 tax deferred exchanges, the exchange process is very simple. The intermediary will keep you aware of your time deadlines and ensure you do everything in strict compliance with IRS regulations.
Return to top
===============================================================
What are the advantages of a 1031 exchange?
- The Exchanger will have more buying power because the federal income taxes are deferred. This will enable him to leverage himself up greater than he could had he paid the tax liability. The additional equity to reinvest will make him a more solid buyer and help him get easier financing.
- Investors can do exchange after exchange to create a pyramiding effect. This tax liability is forgiven upon death of the investor as the heirs get a stepped up basis on the inherited property.
- The Exchanger will have greater selling power because he does not have to inflate the sales price to try to cover some of the capital gains that would normally be due upon the sale of an investment property. It will enable him to be more flexible with this selling price.
- The Exchanger can acquire a replacement property with greater income potential. He can sell raw land and acquire income-producing property. Perhaps, he wants to acquire a building with additional units or in an easier to rent location.
- The Exchanger has the opportunity to consolidate several hard to mange properties in one easy to mange property or diversify into one large property. It provides an excellent opportunity to relocate or expand a current business or investment.
- An exchange can also help an investor acquire a less management intense property.
Disadvantages
The basis of your replacement property will be lowered by the amount of gain deferred on the sale of your relinquished property. However, when weighing this against the deferred gain, the astute investor can clearly see he is still significantly ahead.
Return to top
===============================================================
What are the investment goals in a 1031 exchange?
Besides tax reduction, 1031 Exchanges can accomplish many investment goals:
1. Estate presentation.
2. Increased buying power because of greater cash flow.
3. Increased selling power because the federal capital gain fax liability is deferred.
4. Exchange for property with an increased income (more rental units, higher rental
income per unit, lower operating expenses, easier to rent location, etc.).
5. The need or desire to relocate a business or investment property.
6. Exchange for property that requires less management.
7. Exchange for property that is easier to finance.
8. Consolidate smaller properties into a larger property.
9. Diversify a large property into several smaller properties.
10. The need or desire to expand a business into a larger space.
All of the above culminates into one significant power - The ability to create pyramiding wealth accumulation in real estate ownership.
Return to top
===============================================================
What are the basic requirements of a 1031 exchange?
1. Both Properties must be "like-kind".
a. Like-kind simply means real property.
b. Line-kind refers to the nature or character, not its grade or quality.
c. Like-kind is a very broad and liberal category where just about any type
of investment of business use property would qualify.
d. Properties can be lcoated anywhere within the United States with exchanges
taking place in one or more states.
e. Examples of line-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, trailor parks, storage facilities, retail stores,
interest in a co-tenancy.
f. Examples of non like-kind: stocks, bonds, notes, interest in a partnership, personal
property, certificates of trust, choses in action.
g. 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.
2. Both Properties must be held for investment or investment use.
a. 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.
b. Properties must not be used for personal use for more than 14 days per year or
10% of the actual number of days the property has been rented in a given year.
c. Replacement property cannot be purchased with the intent to sell immediately.
Return to top
===============================================================
Who are the parties in a 1031 exchange?
1. Exchanger:
a. The Exchanger is the taxpaper who is electing to defer the capital gains by
affecting a 1031 Exchanger.
2. Seller:
a. The Seller is the person who owns the property the Exchanger wishes to
acquire as a replacement property.
3. Buyer:
a. The Buyer is the person who wants to purchase the property the Exchanger is
selling.
4. Intermediary:
a. The use of a qualified Intermediary is required by the regulations of Section 1031.
The role of the Intermediary is to act as a middleman in both the sale and purchase
transactions.
Return to top
===============================================================
How long to hold the replacement property and can I use it?
Both properties must be held for investment or business use.
a. Your use of both relinquished property and replacement property must
be investment or business use; each for a minimum of one to two years.
b. Properties must not be used for personal use for more than 14 days per year
or 10% of the actual number of days the property has been rented in a given year.
c. Replacement property cannot be purchased with the intent to sell immediately.
Return to top
===============================================================
What is an Intermediary or Facilitator?
Exchanger must use a qualified Intermediary or Facilitator.
a. One of the safe harbors of the regulations is the use of a qualified Intermediary
to facilitate the Exchange.
b. The sale of the relinquished property and the acquistion of the replacement
property must "flow" through the Intermediary. This is done through direct
deeding to avoid duplicate transfer taxes.
c. The qualified Intermediary may not be the taxpaper or an agent of the taxpayer
(realtor, attorney, tax advisor, banker, accountant, employee, etc.) or lineal
descendant of the Exchanger.
Return to top
===============================================================
What documentation is necessary in a 1031 exchange?
The proper documentation must be used in order to comply with 1031 regulations.
a. 1031 Exchange Agreement between the Exchanger and the Intermediary.
-This is the most important document in the Exchange. It is the document in
which the Exchanger gives the Intermediary the right to acquire the relinquished
property from the Exchanger and convey it to the buyer. It also gives the Intermediary
right to acquire the replacement property from the seller and then convey it to the
Exchanger.
b. 1031 Exchange Escrow Agreement between the Intermediary and Escrow Agent.
-If the Exchanger is acting as both your Intermediary and Escrow Agent, the Escrow
Agreement will be incorporated into the 1031 Exchange Agreement between the
Exchanger and the Intermediary.
c. 1031 Exchange Amendment and Assignment for the rollover of the relinquished
property.
-Assigns the Exchanger's rights in the Agreement of Sale with the buyer to the
Intermediary.
-Serves as written notification to the buyer of the relinquished property of
Exchanger's intent to create a 1031 Exchange and also provides a hold harmless
clause to assure the buyer that there are not additional liabilities or costs to him.
-If a 1031 Exchange Clause is inserted into the Agreement of Sale, this document is
unnecessary.
d. 1031 Exchange Amendment and Assignment for the acquistion of the identified
replacement property.
-Assigns the Exchanger's rights in the Agreement of Sales with the seller to the
Intermediary.
-Serves as written notification to the seller of the replacement property of the
Exchanger's 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.
Return to top
===============================================================
What is the identification period and the exchange period?
Exchanger must adhere to time limitations.
a. The 45-Day identification Period* begins at the closing of the relinquished
property and requires the identification of like-kind replacement property.
b. During this 45-Day identification Period, you may revoke an identification
and make a new one.
c. If a like-kind replacement property has not been properly identified to the
Intermediary by midnight of the 45th day, the exchange will not work and the
taxpaper will be unable to defer capital gains.
d. The 180-Day Exchange Period* runs concurrently with the 45-Day Identification
Period and required the acquisition of at least one of the identified replacement
properties.
e. If the settlement of the relinquished property occurs between October 16 and
December 31 of the current year, the 180-Day Exchange Period for an individual
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.
Return to top
===============================================================
What are the rules on replacement properties?
Limitations on the number of replacement properties that can be identified:
a. Three Property Rule:
-Exchanger may identify up to three properties regardless of their
fair market value. The Exchanger is not obligated to purchase all
three properties but must purchase at least one of the three identified
properties. For example, if selling a relinquished property for $100,000, three
replacement properties can be identified with a combined fair market of $750,000.
b. 200% Value Rule:
-Exchanger may identify more than three properties but their combined or
fair market value cannot exceed double (200%) the fair market value of the
relinquished property. For example, if a relinquished property was sold for
$100,000 and four or more replacements are identified, their combined fair
market value cannot exceed $200,000 with 200% or double the sale price
of the relinquished property.
c. Exceptions to the Three Property Rule and 200% Value Rule:
-Any replacement property acquired within the 45-day Identification Period
will be treated as properly identified, regardless of whether or not it is within
the Three Property Rule or 200% Value Rule.
-If the Three Property Rule and 200% Value Rule are violated, the property
will still be treated as properly identified, provided that 95% of the combined
fair market of the identified replacement property has been acquired. For
example, assume a $100,000 property was sold and five properties with a
combined fair market value of $800,000 are identified. This will be treated as
properly identified provided all five properties are acquired. It is almost impossible
to acquire 95% of the property without acquiring all 100% of the property.
Return to top
===============================================================
What can a 1031 exchange do for my investment goals?
Besides tax reduction, 1031 Exchanges can accomplish many investment goals:
1. Estate preservation
2. Increased buying power because of greater cash flow
3. Increased selling power because the federal capital gain tax liability is deferred
4. Exchange property with an increased income (more rental units, higher rental
income per unit, lower operating expenses, easier to rent location, etc.)
5. The need or desire to relocate a business or investment property
6. Exchange for property that requires less management
7. Exchange for property that is easier to finance
8. Consolidate smaller properties into larger property
9. Diversify a large property into several smaller properties
10. The need or desire to expand a business into a larger space
Return to top
===============================================================
