Like much of tax law, any specific application is dependent on circumstances that can vary from one case to another. The following FAQs address many of the most common issues regarding 1031 Exchanges. We strongly advise you to discuss your individual circumstances with your CPA or attorney before you initiate any tax transaction.
Q: What is a Section 1031 Like Kind Exchange?
A: In most transactions, gains from the sale are subject to taxation. However, if you exchange business or investment property solely for business or investment property of a like-kind, no taxable gain or loss is recognized under Internal Revenue Code Section 1031 but is deferred until a later date. 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. timber land exchanged for rental home, etc.) Therefore, it is considered good economic policy to not require payment of tax under these circumstances. Top
Q: How is like-kind property defined as it relates to real estate?
A: Real properties generally are of like-kind, regardless of whether the properties are improved or unimproved. However, real property in the United States and real property outside the United States are not like-kind properties. Top
Q: Does the 1031 Exchange apply to all types of investments?
A: Section 1031 does not apply to exchanges of inventory, stocks, bonds, notes, other securities or evidence of indebtedness, property held primarily for sale, property acquired for immediate resale, personal residences, interests in a partnership, certificates of trusts or beneficial interest, choses in action or certain other assets. While (business) personal property exchanges are permitted, the definition of like-kind is significantly different from real estate. Top
Q: Is all gain from the transaction tax free?
A: 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. If, as part of the exchange, you also receive other (not like-kind) property or money, gain is recognized to the extent of the other property and money received, but a loss is not recognized. Top
Q: What are the benefits of a 1031 Exchange?
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Q: What are the different types of exchanges?
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Q: What are the requirements for a valid exchange?
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Q: What are the general guidelines to follow in order for a taxpayer to defer all the taxable gain?
A: Four criteria must be met, all essentially addressing ways in which taxpayers may attempt to realize a gain from the transaction.
Q: When can I take money out of the exchange account?
A: 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. Any cash withdrawn from the transaction must be done before the funds are deposited with the Qualified Intermediary. Top
Q: Can the replacement property eventually be converted to the taxpayer's primary residence or a vacation home?
A: Yes, subject to holding requirements sufficient to demonstrate investment intent. The IRS has no specific regulations on holding periods although they have said that the transaction will be assumed to qualify if the Replacement Property is held for two years as an investment. However, many experts feel that the taxpayer is in compliance if the property is held as an investment for a period of at least one year. Since 2004, there is now a five year holding period requirement if the owner wants to take advantage of the home owner's exemption (up to $250,000 or $500,000 for a couple). Top
Q: What is a Qualified Intermediary (QI)?
A: 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. Top
Q: Why is a Qualified Intermediary needed?
A: 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. Top
Q: What are the responsibilities of a QI?
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Q: If the taxpayer has already signed a contract to sell the relinquished property, is it too late to start a tax-deferred exchange?
A: No, as long as the taxpayer has not transferred title, or the benefits and burdens of the relinquished property, they can still set up a tax-deferred Exchange. In other words, five minutes before the closing there is still time; five minutes after the closing it is too late. Top
Q: Does the Qualified Intermediary actually take title to the properties?
A: 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. It is the taxpayer's interests in the property purchase and sale contracts that 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). Top
Q: What are the time restrictions on completing a Section 1031 exchange?
A: 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 unless they obtain an extension of the due date for filing their tax return. With an extension of time to file, the full 180 days would remain available. Top
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?
A: The time requirements for a 1031 Exchange are very specific. Like many other requirements for a 1031 Exchange, there are no exceptions 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, with only limited exceptions having to do with Presidential Orders regarding, for instance, disaster area(s). Top
Q: What are the rules regarding property identification? Is there any limit to the number of properties that can be identified?
A: 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. Top
Q: What are the requirements to properly identify replacement property?
A: Potential replacement property must be identified in 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. Top
Q: What is a "multi-asset" exchange?
A: Many exchanges are "multi-asset" exchanges, involving both real property 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. Top
Q: What is a reverse exchange?
A: A reverse exchange, sometimes called a "parking arrangement," occurs when a taxpayer acquires a Replacement Property before disposing of their Relinquished Property. The taxpayer is not permitted to own both the Relinquished and Replacement properties at the same time. The actual acquisition of the "parked" property is done by an Exchange Accommodation Titleholder (EAT) or parking entity. Top
Q: Is a reverse exchange permissible?
A: 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. Top
Q: How does a reverse exchange work?
A: 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. Top
Q: What happens if the exchange cannot be completed within 180 days?
A: 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. Top
Q: Can the proceeds from the relinquished property be used to make improvements to the replacement property?
A: 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. Top
Q: What is the difference between "realized" gain and "recognized" gain?
A: 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. In a properly constructed 1031 Exchange with no boot, there is therefore no taxable gain. Top
A: 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. Top
A: 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. Top
A: 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. Top
Q: What are the boot "netting" rules?
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Q: I bought a property as a single person and I would like to acquire the replacement property together with my spouse? How can this be done?
A: The most conservative way is to stay consistent and complete the exchange the same way it was started and to add the spouse after the completion of the exchange. An exception can be made if there is a lender requirement that the spouse has to be added in order to qualify for a loan. If an exchange is planned well ahead of time, another solution would be to add the spouse to the title of the currently held property. Timing should be discussed with your CPA or tax attorney. Top
Q: I closed escrow on my first replacement property within the 45 day identification period. Can I now identify three more properties within my 45 day identification period?
A: If you are using the three property rule, the completed acquisition counts as one and you may identify only up to two additional properties. Top