Every Section 1031 Exchange transaction is different. These
"Frequently Asked Questions"are intended to answer general
inquiries. The application of these principles will depend on the specific
facts of each transaction. Always consult a competent Qualified Intermediary,
attorney, or tax advisor to determine how an exchange may best be structured
to accomplish your investment objectives.
What is a tax-deferred exchange?
What are the benefits of exchanging vs.
selling?
What is Tenant in Common (also known as
Undivided Fractional Interest)?
How Can I Use Tenant in Common to Make an
Investment?
What are the requirements for a valid
exchange?
What are the general guidelines to follow
in order for a taxpayer to defer all the taxable gain?
When can I take money out of the exchange
account?
Can the replacement property eventually be
converted to the taxpayer's primary residence or a vacation home?
What is a Qualified Intermediary (QI)?
Why is a Qualified Intermediary needed?
Can the taxpayer just sell the
relinquished property and put the money in a separate bank account, only to be
used for the purchase of the replacement property?
If the taxpayer has already signed a
contract to sell the relinquished property, is it too late to start a
tax-deferred exchange?
Does the Qualified Intermediary actually
take title to the properties?
What are the time restrictions on
completing a Section 1031 exchange?
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?
Is there any limit to the number of
properties that can be identified?
What are the requirements to properly
identify replacement property?
What happens if the exchange cannot be
completed within 180 days?
Can the proceeds from the relinquished
property be used to make improvements to the replacement property?
What is the difference between
"realized" gain and "recognized" gain?
What is Boot?
What is Mortgage Boot?
What is Cash Boot?
What are the boot "netting" rules?
Can you sell rental property and
reinvest it into rental property without paying capital gains tax?
I have heard that I can sell my
rental property and use the proceeds to purchase rental property of greater
value and the transaction is viewed just like an exchange in that the tax is
deferred until the new property is sold. Is this true?
We sold a rental property last year and
used the §1031 Tax Deferred Exchange law to defer the gains into another
like-kind property. How do I handle this transaction on my tax return?
What is a tax-deferred exchange?
In a typical transaction, the property owner
is taxed on any gain realized from the sale. However, through a Section 1031
Exchange, the tax on the gain is deferred until some future date.
Section 1031 of the Internal Revenue Code provides that no gain or loss shall
be recognized on the exchange of property held for productive use in a trade
or business, or for investment. A tax-deferred exchange is a method by which a
property owner trades one or more relinquished properties for one or more
replacement properties of "like-kind", while deferring the payment
of federal income taxes and some state taxes on the transaction.
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.
vacant land exchanged for apartment building). Therefore, it would be unfair
to force the taxpayer to pay tax on a "paper" gain.
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.
What are the benefits of exchanging vs. selling?
Section 1031 exchange is one of
the few techniques available to postpone or potentially eliminate taxes due on
the sale of qualifying properties.
• By deferring the tax, you have more money available to invest in another
property. In effect, you receive an interest free loan from the federal
government, in the amount you would have paid in taxes.
• Any gain from depreciation recapture is postponed.
• You can acquire and dispose of properties to reallocate your investment
portfolio without paying tax on any gain.
What
is Tenant in Common (also known as Undivided Fractional Interest)?
The purchase of a tenant in
common (or undivided fractional interest) structure allows investors to
purchase an interest in a significant real estate asset, perhaps larger than
they could obtain individually. The investor acquires a percentage ownership
(title and deed) and receives passive rental income while receiving the tax
benefits of traditional real estate. The investors own and control the
properties, not a third party. TIC ownership provides investors with the first
ever means for ownership diversity, both in location and type, of their real
estate portfolio.
Unlike partnership real estate, TIC ownership entitles each owner to the same
ownership rights regardless of the equity invested. This element of the
investment structure puts no individual owner (or group of owners) in direct
control of the property over any other investor(s). You can truly have all of
the ownership benefits and security of a large commercial asset with
significantly fewer obstacles. As with any type of investment real estate, the
value of a fractional interest typically increases annually due to escalations
inherent in most tenant leases.
How
Can I Use Tenant in Common to Make an Investment?
Best known for the use of tenant
in common structured real estate investments approved for use in §1031
exchanges. Many investors also use these acquisitions for cash and IRA
investments. Structuring all offerings with "non-recourse"
amortizing debt and passive income makes them ideal for any type of
investment. Used as an IRA investment, UFI ownership properties have the same
tax treatment (deferred taxation) as any other IRA approved investment.
What are the requirements for a valid exchange?
Qualifying Property - Certain
types of property are specifically excluded from Section 1031 treatment:
property held primarily for sale; inventories; stocks, bonds or notes; other
securities or evidences of indebtedness; interests in a partnership, and
certificates of trusts or beneficial interest. In general, if property is not
specifically excluded, it can qualify for tax-deferred treatment.
• Proper Purpose - Both the relinquished property and replacement property
must be held for productive use in a trade or business or for investment.
Property acquired for immediate resale will not qualify. The taxpayer's
personal residence will not qualify.
• Like Kind - Replacement property acquired in an exchange must be
"like-kind" to the property being relinquished. All qualifying real
property located in the United States is like-kind. Personal property that is
relinquished must be either like-kind or like-class to the personal property
which is acquired. Property located outside the United States is not like-kind
to property located in the United States.
• Exchange Requirement - The relinquished property must be exchanged for
other property, rather than sold for cash and using the proceeds to buy the
replacement property. Most deferred exchanges are facilitated by Qualified
Intermediaries, who assist the taxpayer in meeting the requirements of Section
1031.
What are the general guidelines to follow in order for a taxpayer to defer all
the taxable gain?
The value of the replacement
property must be equal to or greater than the value of the relinquished
property.
• The equity in the replacement property must be equal to or greater than
the equity in the relinquished property.
• The debt on the replacement property must be equal to or greater than the
debt on the relinquished property.
• All of the net proceeds from the sale of the relinquished property must be
used to acquire the replacement property.
When can I take money out of the exchange account?
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. If you want to receive a portion of the proceeds in cash, this must
be done before the funds are deposited with the Qualified Intermediary.
Can
the replacement property eventually be converted to the taxpayer's primary
residence or a vacation home?
Yes, but the holding requirements
of Section 1031 must be met prior to changing the primary use of the property.
The IRS has no specific regulations on holding periods. However, many experts
feel that to be on the safe side, the taxpayer should hold the replacement
property for a proper use for a period of at least one year.
What is a
Qualified Intermediary (QI)?
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.
• Acting under a written agreement with the taxpayer, the QI acquires the
relinquished property and transfers it to the buyer.
• The QI holds the sales proceeds, to prevent the taxpayer from having
actual or constructive receipt of the funds.
• Finally, the QI acquires the replacement property and transfers it to the
taxpayer to complete the exchange within the appropriate time limits.
Why
is a Qualified Intermediary needed?
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.
Can the taxpayer just sell the relinquished property and put the money in a
separate bank account, only to be used for the purchase of the replacement
property?
The IRS regulations are very
clear. The taxpayer may not receive the proceeds or take constructive receipt
of the funds in any way, without disqualifying the exchange.
If
the taxpayer has already signed a contract to sell the relinquished property,
is it too late to start a tax-deferred exchange?
No, as long as the taxpayer has
not transferred title, or the benefits and burdens of the relinquished
property, she can still set up a tax-deferred Exchange. Once the closing
occurs, it is too late to take advantage of a Section 1031 tax-deferred
exchange (even if the taxpayer has not cashed the proceeds check).
Does the Qualified Intermediary actually take title to the properties?
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. The taxpayer's interests in the
property purchase and sale contracts 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).
What are the time restrictions on completing a Section 1031 exchange?
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. However, the taxpayer can get the full 180
days, by obtaining an extension of the due date for filing the tax return.
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?
Unfortunately, there are no
extensions 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.
Is there any limit to the number of properties that can be identified?
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.
What are the requirements to properly identify replacement property?
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.
What
happens if the exchange cannot be completed within 180 days?
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.
Can
the proceeds from the relinquished property be used to make improvements to
the replacement property?
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.
What is the difference between "realized" gain and
"recognized" gain?
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.
What is
Boot?
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.
What is Mortgage Boot?
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.
What is Cash Boot?
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.
What
are the boot "netting" rules?
• Cash boot paid offsets cash
boot received
• Cash boot paid offsets mortgage boot received (debt relief)
• Mortgage boot paid (debt assumed) offsets mortgage boot received
• Mortgage boot paid does not offset cash boot received
Can you sell rental property and reinvest it into rental property without
paying capital gains tax?
Unless you exchange properties in
a qualifying like-kind exchange, you may not defer the gain on the sale of
your rental property by purchasing replacement property. For additional
information on like-kind exchanges, refer to Publication 544, Sales and Other
Dispositions of Assets.
I have heard that I can sell my rental property and use the proceeds to
purchase rental property of greater value and the transaction is viewed just
like an exchange in that the tax is deferred until the new property is sold.
Is this true?
What you have heard about is a
like-kind exchange. Like-kind exchanges are subject to several rules and
restrictions listed in Publication 544, Sales and Other Dispositions of
Assets.
We
sold a rental property last year and used the §1031 Tax Deferred Exchange law
to defer the gains into another like-kind property. How do I handle this
transaction on my tax return?
Report the exchange of like-kind
property on Form 8824, Like-Kind Exchanges. The instructions for the form
explain how to report the details of the exchange. Report the exchange even
though no gain or loss is recognized.
If you have any taxable gain because you received money or unlike property,
report it on Form 4797, Sales of Business Property, and Form 1040, SCHEDULE D,
Capital Gains and Losses. Refer to Publication 544, Sales and Other
Dispositions of Assets, which has a detailed section on like-kind exchanges.
