1031 Exchanges     TIC's Explained     FAQ     SK Realty Home

 

1031 EXCHANGES EXPLAINED:

The tax deferred exchange, as defined in Section 1031 of the Internal Revenue Code of 1986, as amended, offers investors one of the last great opportunities to build wealth and save taxes. By completing an exchange, the investor (Exchanger) can dispose of their investment property, use all of the equity to acquire replacement investment property, defer the capital gain tax that would ordinarily be paid and leverage all of their equity into a replacement property. Other than the timing requirements for the identification and closing of replacement property, the two major requirements that must be met in order to defer the capital gain tax are: (a) the Exchanger must acquire “like kind” replacement property and (b) the Exchanger cannot receive cash or other benefits (unless the Exchanger pays capital gain taxes on this money).

In any standard 1031 exchange, the Exchanger must enter into the exchange transaction prior to the close of the relinquished property. The Exchanger and the Qualified Intermediary enter into an Exchange Agreement, which essentially requires that (a) the Qualified Intermediary acquires the relinquished property from the Exchanger and transfers it to the buyer by direct deed from the Exchanger and (b) the Qualified Intermediary acquires the replacement property from the seller and transfers it to the Exchanger by direct deed from the seller. The cash or other proceeds from the relinquished property are assigned to the Qualified Intermediary and are held by the Qualified Intermediary in a separate, secure account. The exchange funds are used by the Qualified Intermediary to purchase the replacement property for the Exchanger.

To avoid the payment of capital gain taxes the exchanger should follow three general rules:

  • 1.  Purchase replacement property that is the same or greater value as the relinquished property.
     
  • 2.  Reinvest all of the exchange equity into the replacement property.
     
  • 3.  Obtain the same or greater debt on the replacement property as on the relinquished property.  The Exchanger can offset the amount of debt obtained on the replacement property by putting the equivalent amount of additional cash into the exchange.

A Tenants In Common (TIC) §1031 Exchange allows property owners to exchange their management-intensive property for an institutional grade property with the potential to generate income, tax benefits and appreciation potential.  

REQUIREMENTS FOR A QUALIFIED EXCHANGE

Section 1031 of the Internal Revenue Code specifies that the properties must be held for investment or business purposes and that these properties being exchanged must be “like-kind,” referring to the type of property being exchanged (real estate, personal property, etc.)  Qualifying property is broadly defined, for both the property being transferred and that received, as realty used for investment or business purposes.

In effect, all investment real estate, whether it is an office building, farm, ranch, or a vacant lot, can be exchanged to any other piece of investment property.  Investment real estate can be exchanged for real property used in a trade or business and vice versa.  

IRC Tax Code states the following are not considered "like-kind".  These include:

QUALIFIED INTERMEDIARY:

Section 1031 describes the need of a “safe harbor,” such as a Qualified Intermediary (QI), to facilitate the exchange.  The exchanger must not have “Constructive Receipt” of the sale proceeds – no cash or other benefits can go to the exchanger; 

If an exchanger actually or constructively receives non-like-kind property known as boot (e.g., money or personal property) for the relinquished realty anytime before receiving the like-kind replacement property, the transaction is a sale and not a deferred exchange.  As a result, the structuring of a deferred real property exchange requires documentation to support an interdependent and integrated transaction with the sale proceeds not being paid to the exchanger at the settlement date (or held in escrow).

The Buy/Sell Contract should contain wording similar to the following:

“Buyer hereby acknowledges that it is the intent of the Seller to effect an IRC §1031 tax deferred exchange which will not delay the closing or cause additional expenses to the Buyer. The Seller’s rights under this agreement may be assigned to a Qualified Intermediary, named by Seller, for the purpose of completing such an exchange. Buyer agrees to cooperate with the Seller and the Qualified Investor in a manner necessary to complete the Exchange.” 

Qualified Intermediary Rules Include:

  1.  QI is an entity or individual independent of the exchanger and not deemed to be its agent, either objectively or subjectively.  Under the objective test, the QI cannot be the taxpayer’s closing attorney or anyone else who has had a business relationship with the exchanger during the last two years.
  2. The QI is the recipient of the net proceeds from the closing of the relinquished property, with the money impounded for subsequent reinvestment into other realty.  Any earnings on these monies may not be paid to the exchanger until the end of the exchange.
  3. In a three-party deferred exchange, the QI is the third party, with the other two being the exchanger and the replacement property owner.  
  4. IRS Revenue Ruling 2002-83 prohibits a QI from using the impounded funds to acquire the property of a party related to the exchanger to be used as the replacement realty. Such a disposition by the related party would be deemed a sale under IRC 1031(f), precluding any party from cashing out during the two-year period following the exchange.

IDENTIFICATION OF A REPLACEMENT PROPERTY:

There are three ways to identify properties the exchanger wishes to purchase.  The most common is the “3-property” rule. In this rule, the identification period begins with the sale of the relinquished property and gives the exchanger 45 days to identify up to 3 possible investment properties.  If the exchanger has no possible exchange properties at the end of this 45 day time period, or the properties that were identified are no longer available, then the exchange is busted and the exchanger must pay the capital gains tax.

To Identify Replacement Property it must be:

  1. 1.  identified in a written agreement using a portion of the impounded funds for the earnest money deposit; or
     
  2. 2.  designated as replacement property in a written document signed by the exchanger and hand-delivered, mailed, faxed, or otherwise received by the Qualified Intermediary before the end of the identification period.  
The regulations permit more than one property to be identified as replacement property.  The maximum number of replacement properties which the exchanger may identify under the regulations is as follows:
  1. 1.  Three properties of any fair market value (FMV); or
     
  2. 2.  Any number of properties, as long as the aggregate FMV of all properties identified as of the end of the identification period does not exceed 200% of the aggregate FMV of all relinquished properties as of the date of transfer; or
     
  3. 3.  Under the 95% rule, an exchanger is permitted to identify any number of properties of any total value, provided that 95% of what has been identified is actually acquired within the 180-day replacement period.
Replacement property acquired during the 45-day period reduces the number of properties that can be identified under the above rules.