1031 Exchange – Deferring Taxes

The next step in determining the specific tax consequences in exchange is to establish the “adjusted basis” of the relinquished property. To do so, take the basis (the cost of the property), add the cost of any capital improvements made to the property (during the taxpayer’s ownership), and subtract any depreciation taken on the property during that same time period.

Note: Most folks are referring to the Adjusted Basis when they ask you about “your basis” in a property you are thinking of selling. But now you know there is an actual difference.

The Taxpayer may identify up to three properties, without regard to their fair market value, aka the “The Three-Property Rule”. More than three properties, without regard to their fair market value of all these properties, can be identified if the total fair market value of all these properties at the end of the 45-day identification period does not exceed 200% of the total fair market value of all properties relinquished in the exchange, aka “The 200%Rule”.

Hint: If you violate any of these rules, the penalty is severe.

The starting point for determining the tax consequences in any transaction. In most cases, a taxpayer’s “basis” in the property is the cost of the property.

In an exchange of real property, any consideration received other than real property is “boot.” There are two types of boot: “cash boot” and “mortgage boot.” Cash boot is cash or anything else of value received. Mortgage boot is any liabilities assumed in the exchange.

The buyer is the person with cash who wants to acquire the taxpayer’s property.

A reverse exchange can be combined with a deferred exchange. For example, the taxpayer can exchange into a 50% undivided interest in a replacement property in a deferred exchange. The EAT can then acquire the remaining 50% undivided interest in that replacement property and hold it for up to 180 days while the taxpayer sells a second relinquished the property to exchange for the parked portion. Take your ulcer medication and cross your fingers… these are really tricky.

The party who acquires the taxpayer’s relinquished property is NOT the same party who owns the replacement property. The exchange is NOT a swap whereby two individuals swap properties with one another. This is KEY Because you as the Taxpayer are NOT ALLOWED TO TOUCH the Funds. Not even for one brief second. The instant you do – Poof = Taxes Due.

If the taxpayer actually receives the proceeds from the disposition of the relinquished property, then the transaction will be treated as a sale and not as an exchange. This can be as simple as the money move through your account, or even an account you have control over. The crucial question in every non-simultaneous exchange is whether the taxpayer’s control over the proceeds from the disposition of the relinquished property is “substantially limited or restricted”. As there are a number of complicated rules a taxpayer must follow; give us a call at 818.781.0255 and we will put in touch with one of our trusted accounting partners.

Sometimes when the relinquished property is transferred (escrow closes/records) to the buyer, the taxpayer often does not yet know what property he or she wants to acquire. When that is the case, a deferred exchange is necessary. The structure of the deferred exchange with a QI is essentially the same as the simultaneous exchange. However, because the replacement property is not known at the time of the first transfer the two legs of the exchange take place at different times.

The taxpayer has 45 days, from the close of the first escrow to identify one or more properties he or she wishes to use as their up-leg property. Subsequently, the escrow for the up-leg property must close within 180 days of the transfer of the relinquished property. Remember – 180, not 181 or more or you owe the taxes.

It may seem silly to mention this, but Section 1031 specifically requires that an exchange take place. This means that one property must be exchanged for another property, rather than sold for cash. 

Tip: Another way to look at this is: – The taxpayer must swap one property for one or more properties, and in the process not receive any money during the exchange. This is why the QI touches the money.

How long must I hold property in order for it to qualify for a 1031 exchange? We get this question all the time……

Here is the answer from our Tax Professionals: The holding period is one factor used to determine whether the Purpose Requirement (see above) has been met. If the replacement property is acquired and then immediately sold, say in the example of a “flip”; that might indicate the property was actually acquired for “immediate” resale and is, therefore, dealer property and consequently cannot qualify for tax-deferred treatment. A one year holding period is commonly used as a rule of thumb but has no basis in statutory or case law. Two years is more prudent.

Replacement property acquired in an exchange must be “like-kind” to the property being relinquished. Like-kind means “similar in nature or character, notwithstanding differences in grade or quality.” All real property is like-kind, regardless of whether it is improved of unimproved and regardless of the type of improvement or interest. Therefore, raw land may be exchanged for land with a building. One property may be exchanged for more than one property. 

Hint: Real property is not like-kind to personal property.

Generally, the QI will acquire title to the replacement property, use the exchange funds for the construction, and then transfer title of the now improved property to the taxpayer before the expiration of the 180-day time period. All the funds from the first transaction must be used for the construction, the Taxpayer may not access any of the funds, or even take control of them in any way.

If the taxpayer wants to include new construction as replacement property, then the construction must be done prior to the date that the taxpayer acquires title to the replacement property. Any construction occurring after the taxpayer acquires title does not qualify as like-kind replacement property in the exchange.

Not every type of property is eligible for tax-deferred treatment. Both the relinquished property and the replacement property must be held for productive use in a trade or business or for investment. 

Hint: You cannot exchange into or out of your own personal residence, or property held for resale as a dealer. Vacation homes may qualify if they are rented out by the taxpayer to unrelated persons, or held primarily for investment rather than personal use. 

Tip: If you don’t have really good and clear documentation that your vacation home was rented out to others (not family), we recommend that you don’t try at 1031.

The intermediary plays a role in almost all exchanges today. It is usually a corporation or limited liability company – or even your attorney. It neither begins nor ends the transaction with any property. It buys and then resells the properties in return for a fee. The Intermediary can not be related to the taxpayer (Don’t make this mistake – it can be quite costly).

In general, most property, both real and personal, can qualify for tax-deferred treatment, but some are specifically disqualified. The brush the surface: stocks, bonds, or notes; securities of indebtedness, interests in a partnership or multi-member limited liability company, or certificates of trust are just some of those items disqualified.

Realized Gain is the difference between the total consideration (cash and anything else of value) received for a property and the adjusted basis. Transaction costs such as commissions and recording costs are deducted from realized gain.

Recognized Gain is that portion of the “realized gain” which is taxable. Realized gain is not taxable until it is recognized. Gain is usually, but not always, recognized in the year in which it is realized.

The property originally owned by the taxpayer and which the taxpayer would like to dispose of in the exchange.

In the first structure, the exchange occurs with the taxpayer acquiring the replacement property and conveying the relinquished property to the Exchange Accommodation Titleholder (“EAT”), using an exchange intermediary.

In the second structure, the EAT acquires the replacement property. The EAT may construct improvements on the property if needed. When the taxpayer’s relinquished property is ready to close, then the taxpayer will exchange the relinquished property for the replacement property through an exchange intermediary.

The new property, that is, the property that the taxpayer would like to acquire in the exchange. In order for an exchange to be completely tax deferred, the replacement property must have a fair market value greater than the relinquished property and all of the taxpayer’s equity or more must be used in acquiring replacement property.

If you acquire an up-leg property that is of lesser value, all of the remaining money will be taxed at the Taxpayers current tax rate.

If the Taxpayer has found his or her replacement property and must close on it prior to the time that the relinquished property is ready to close, then the transaction becomes a “reverse exchange”. The current IRS Code does not allow or prohibit reverse exchanges and the IRS has created a safe harbor for reverse exchanges that use one of the two “parking” procedures below.

The seller is the person who owns the up-leg property that the taxpayer wants to acquire in the exchange.

Most exchanges today employ the services of a QI whose sole purpose in the transaction is to facilitate the exchange. In a simultaneous exchange with an intermediary, title to the relinquished property is transferred directly to the buyer. The buyer pays cash to the intermediary. The intermediary pays cash to the seller who transfers title to the replacement property directly to the taxpayer. As noted above: The taxpayer thus avoids receiving any cash during the transaction, which would be immediately taxable.

The taxpayer has a property and would like to exchange it for a new property. Sometimes easily confused with the “Seller”. Since you are both a Seller and a Buyer – we call you the Taxpayer or “Exchangor.”

There are two critical time limits are established by Section 1031. The taxpayer is required to identify the replacement property within 45 days after the transfer of the relinquished property, AND the taxpayer must close escrow on the replacement property before the earlier of(a) 180 days after the transfer of the relinquished property, or (b) the due date of the taxpayer’s federal income tax return (including extensions) for the year in which the relinquished property is transferred. There are NO exceptions to these time limits.

Two-party exchanges are rare since, in the typical Section 1031 transaction, the seller of the replacement’s property is not the buyer of the taxpayer’s property. The two-party exchange, or swap, is the purest form of exchange. As the name implies, only two parties are involved, and they exchange their properties.

In reverse exchanges, the EAT can not be the taxpayer of a disqualified person (basically a person related to the taxpayer, including an entity in which the taxpayer owns 10% or more, or the taxpayer’s attorney, CPA, real estate or employee) and must be subject to federal income tax. The EAT must hold title to the property at all times from the date of acquisition by the EAT until the property is transferred. The taxpayer and the EAT must enter into a written agreement and the EAT must be treated as the beneficial owner of the property for all federal income tax purposes. The EAT may lease the parked property to the taxpayer or the taxpayer may manage it.

There are several more Mechanics: Please call us so we can put you in touch with our Accounting or CPA partners, so you can be made fully away of all these unique and intricate mechanics.