THE 1031 EXCHANGE EXPLAINED
Why Is The 1031 Tax Deferred Exchange Important To A Real Estate Property Investor?
An investor in real estate understands how important it is to preserve wealth and assets. In the frequently changing world of taxation, the investor is fortunate to have IRC Section 1031. This tax code allows the investor to exchange from one investment property to another and defer taxes on the gain. This means that a 1031 Exchange is a rollover of equity of like properties, rather than an avoidance of tax. Thus, the investor continues to build wealth through real estate investment, and maintains the hard-earned equity.
Any tax liability through inheritance will be limited to the gains from the date of the inheritor’s acquisition, not during the years of ownership. So in essence, the taxes that are saved now are never paid.
How To Go About A 1031 Exchange And Guidelines Regarding The 1031 Exchange:
The Taxpayer finds a buyer and sells the property through a Qualified Intermediary.
The Taxpayer buys a replacement property through the Intermediary.
The parties may not know each other and their properties can be in different states.
The exchange period begins on the day the relinquished property is transferred and ends on the earlier of 180 days thereafter, or the due date (including extensions) of the tax return for the taxable year in which the transfer of the relinquished property occurs.
The taxpayer’s agent, broker, attorney, accountant or family members are excluded as qualified Intermediaries.
Current Market value $400,000
Loan Balance ($200,000)
Less Selling Expenses ($ 28,000)
Cash to Seller $172,000
Less Taxes on Sale (1) ($ 44,600)*
Calculation Of Taxes On Sale:
Purchase Cost of Property $240,000
Improvements Added $15,000
Subtract Depreciation ($ 30,000)
Adjusted Basis $225,000
Current Market Value $400,000
Less Selling Expense ($ 28,000)
Adjusted Sale Price $372,000
Less Adjusted Basis ($225,000)
Gain on Sale $147,000
Estimated Capital Gains
Tax on Sale (1) $ 44,600*
Tax rates vary – Always consult with your CPA, Attorney or Tax Advisor. Other Losses/Expenses may affect the Gain
With A Properly Executed 1031 Exchange:
If the tax-deterred exchange of the property was properly executed, Tax will be deferred and the investor will have $44,600 more to use towards the purchase of another investment property.
The concept of a tax-deferred exchange is easy to understand. However, there are many details involved in an exchange that need careful consideration. Before taking steps towards a 1031 tax-deterred exchange, please consult your CPA, Attorney or Tax Advisor.
1031 Exchange Limitations Involving A Principle Residence:
On October 22, 2004, new tax legislation became effective that places a five-year restriction on 1031 exchanges involving a principle residence. A taxpayer who exchanges into a rental property as a replacement property that is later converted into their primary residence, is not allowed to exclude capital gain under the principal residence exclusion rules, unless the sale occurs at least five years from the date of its acquisition. Any taxpayer, who previously acquired their current residence through a tax-deferred exchange within the past three years, will now have to wait at least another two years before selling their home and excluding any capital gain. This assumes the taxpayer meets the two out of five year occupancy test.
THE EXCHANGE PROCESS
The Exchanger utilizes a Qualified Intermediary to:
a) Act as Seller of Relinquished Property.
b) Hold proceeds from Sale on Exchanger’s behalf.
c) Act as Buyer of Replacement Property and transfer title to the Exchanger.
Sale Escrow (Relinquished Property)
a) Transfers Exchanger’s right title and interest to the Qualified Intermediary at the moment of close.
b) Must be signed before the close of escrow.
c) Exchanger identifies Replacement Property within 45 days after close of sale.
a) Receives cash proceeds from Sale Escrow/Relinquished Property.
b) Holds proceeds from Sale Escrow/Relinquished Property for Exchanger.
c) Transfers funds to Purchase Escrow/Replacement Property.
Purchase Escrow (Replacement Property):
a) Transfers all of the Exchanger’s rights, title and interest to the Qualified Intermediary at moment of close.
b) Must be signed by all parties before funds are transferred to close.
c) Escrow closes before the 180th day.
d) Excess proceeds disbursed directly to Exchanger from escrow at close of Purchase.
IRC 1031 DELAYED EXCHANGE PERIODS
Identification Period: 45 Days
Total Exchange Period: 180 Days
Begins on the date the taxpayer transfers (closes) the sale of the Relinquished Property and ends at midnight on the 45th day thereafter.
Begins on the date the taxpayer transfers (closes) the sale of the Relinquished Property and ends on the earlier of midnight on the 180th day thereafter OR midnight on the due date (including extensions) for the taxpayer’s income tax return for the taxable year in which the transfer (sale) of the Relinquished Property occurs.
Additional Rules In Calculating Exchange Periods:
a) If several Relinquished Properties are to go “into one Exchange”, the Identification Period and the Exchange Period are determined by the closing date of the FIRST Relinquished Property.
b) The Identification Period and Exchange Period are NOT extended to the next succeeding date if the last day fall on a Saturday, Sunday, or legal holiday.
c) Property is treated as close when “legal title” is transferred. “Closing” in some States is not necessarily “Recording of the Deed”.
RULES TO IDENTIFY REPLACEMENT PROPERTY
The General Rule For Replacement Property:
Sale price is equal to or greater than relinquished property.
What Are The IRS Identification Rules?
Three Property Rule – The Exchanger may identify three (3) properties of any value; or
200% Rule – The Exchanger may identify any number of properties if the total fair market value of what is identified does not exceed 200% of the sale price of the relinquished property; or
95% Rule – If the Exchanger identifies more properties than are permitted under the two rules above, the Exchanger must acquire 95% of what was identified.
How Is The Identification Made?
a) The identification must be made to a party to the exchange (i.e., the Qualified Intermediary).
b) The identification must be in writing and signed by the Exchanger. (The Intermediary furnishes a form to the taxpayer on close of the relinquished property).
c) The identification must include the street address or the legal description.
d) It must be delivered, within 45 days of the close of the relinquished property.
QUESTIONS & ANSWERS
What Real Property Qualifies For A 1031 Exchange?
Relinquished and replacement properties must he property held for investment purposes.
How Long Do You Have To Find A Replacement Property?
Identification must be made within 45 days of the closing date of the relinquished property.
When Must The Replacement Property Close?*
The replacement property must close within 180 days from the closing of the first relinquished property, or the date the Exchanger must file their tax return (including extensions), whichever occurs first. *There are no extensions for Saturdays, Sundays, or Holidays.
Who Controls The Proceeds?
The proceeds must be held and controlled by a Qualified Intermediary, NOT by an agent, escrow company, or related party, including relatives. The Taxpayer/Exchanger should not receive any cash or cash equivalent at any time during the exchange.
May The Taxpayer/Exchanger Receive “Growth Factor”/Interest On The Net Proceeds (From The Relinquished Property)?
Yes, however, any “growth factor”/interest earned will be subject to taxation according to the Taxpayer’s/Exchanger’s method of accounting.
What Is “Boot”?
“Boot” is any excess money or unmatched property coming from the relinquished property.
What Is “Adjusted Basis”?
This is generally determined by taking the sales price from when the property was acquired, plus the cost of capital improvements, less depreciation.
What Is “Fair Market Value” For The Purpose Of A 1031 Tax Deferred Exchange?
“Fair Market Value” is the sales price of the relinquished property and the purchase price of the replacement property, without regard to any debts on either property.
What Is “Like For Like” Property?
Prior to the new rules, if you sold an apartment building, you had to buy an apartment building. However, according to the new rules, “like for like” simply means selling an investment property and purchasing an investment property. In other words, a single-family rental may be exchanged for a multi-family property, which may be exchanged for a commercial property, which may be exchanged for an office building, etc. Please note that foreign real property is not considered like kind to U.S. real property.
From Whom Does The Buyer Of The Relinquished Property Receive Their Deed?
The Buyer may receive the Deed directly from the Exchanger on the relinquished property and the Exchanger may receive the Deed directly from the Seller on the replacement property.
How Does The Taxpayer Defer All Taxes?
The Taxpayer (i.e. Exchanger) must re-invest all cash into the replacement property and the debt on the replacement property must be greater than the debt on the relinquished property.
What Is The Best Way To Establish The Taxpayer’s Intent To Affect A 1031 Exchange?
The intent language should be in the Real Estate Contract and Escrow Instructions/ Purchase Contract. However, a sale can be converted into an Exchange by the creation of an amendment to the Escrow Instructions/Purchase Contract.
Who Makes The Deposit On The Exchanger’s Replacement Property?
The Taxpayer (i.e. Exchanger) may make the deposit directly to the closing agent/escrow company and be reimbursed at the closing, or the Qualified Intermediary may make the deposit from the proceeds of the relinquished property.
The Taxpayer/Exchanger is advised to seek counsel from his or her own independent tax advisors, tax attorneys, and/or certified public accountants as to the tax consequences and tax implications of Reg. Section 1.1031(k)-1.