1031 Exchanges 

What is a 1031 “Like-Kind” Exchange?
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 if such property is exchanged for property of like-kind to be used either for productive use in a trade or business or for investment.

1031 exchanges are not really exchanges in the context of two-party barter. Instead they are typical sale and purchase transactions that involve the same exact ingredients as any other sale or purchase, without the capital gains.  Exchanges date back to 1921.  In 1991, the “final” regulations were issued and since then little has changed.

Deferral of State Capital Gain
A Section 1031 exchange is allowed under the Federal tax code and allows the deferral of FEDERAL gain.  Most states will recognize a 1031 exchange and allow the Taxpayer to defer the state gain as well.  However, there are a few states (including Pennsylvania) that will NOT recognize an exchange and some that have special requirements (such as acquiring replacement property within the same state).  Other states have no income tax so no gain would be recognized.

Benefits of 1031 Exchanges
• Immediate tax avoidance
• Time value of deferred gain
• Greater buying power
• Greater selling power
• Increased income potential
• Less management responsibility
• Diversification
• Consolidation
• Relocation
• Expansion of a business
• Tax forgiven upon death of Taxpayer (heirs receive stepped up basis)
• Defers appreciation gain as well as depreciation recapture

Like-Kind Requirement 
Both the relinquished property and the replacement property must be held for productive use in a trade or business or for investment. 
• Properties may be located anywhere within the United States (50 states or District of Columbia).  U.S. territories are not eligible although Letter Rulings 9038030 and 200040017 allowed Taxpayer to acquire rental property located in the U.S. Virgin Islands.       
• More than one property may be sold or acquired.
• Examples of like-kind property that can be exchanged under Section 1031 include vacant land, office buildings, duplexes, apartment buildings, single family homes used as rentals, warehouses, farms, Bed & Breakfast, 30-year leasehold interest, utility easements, conservation easements, etc.  A tenant-in-common (TIC) interest is also considered like-kind property. 
• Examples of non-like-kind property that cannot be exchanged under Section 1031 include stocks, bonds, notes, mortgages, cash, equipment, goodwill, inventory and interests in a partnership.

Qualified Use Requirement 
Both the relinquished property and the replacement property must be used for productive use in a trade or business or for investment.  The specific length of time the property must be used in this manner is not specified.  Based on case law, one year is used as a rule of thumb but the intent of the Taxpayer is most important.  There must be an intent to hold and maintain the property for business use or investment.  Taxpayer cannot acquire replacement property with the intent to resell immediately.  Therefore, flips and teardowns do not qualify.
• To qualify as an investment property, under Section 280A of the Internal Revenue Code, Taxpayer must not use the property for personal use more than 14 days of the year or 10% the number of days rented, whichever is greater.

Use of a Qualified Intermediary
A qualified intermediary (QI), such as 1031 CORP., is needed to act as the facilitator or middleman in an exchange.  The word “qualified” refers to the intermediary’s relationship to the Taxpayer.  To be a “qualified” intermediary, the party must not be the actual Taxpayer or the Taxpayer's accountant, attorney, real estate professional, financial planner, employees, partners or close relative.  
• The QI handles all required documentation, coordinates every detail with the Taxpayer and Taxpayer’s agents (real estate professional, tax and/or legal advisor(s) and closing agents) and usually holds the exchange proceeds during the exchange period.
• Both the relinquished property and the replacement property “flow” throw the QI although title passes directly from the seller to the buyer, just as in any typical real estate transaction. 

When must the 1031 exchange be initiated?
Ideally, the Taxpayer will notify 1031 CORP. at least two weeks prior to the scheduled closing of the relinquished property.  This allows 1031 CORP. to prepare and forward the exchange documents to the Taxpayer with sufficient time to review and return them.  It also enables 1031 CORP. to give the closing agent ample notice that the transaction is part of a 1031 exchange.   If the exchange was not planned in advance, 1031 CORP. can initiate an exchange at the last minute, even while someone is sitting at the closing table.  However, once the closing is complete and title of the relinquished property is conveyed to the buyer, it is too late to initiate the exchange and the sale will be a taxable event.

1031 CORP. maintains a $2Million Errors and Omissions Policy to protect you in the unlikely event we made a mistake that created a taxable event for you.  For a copy of our Evidence of Insurance, just ask 1031 CORP.

Taxpayer Cannot Have Actual or Constructive Receipt of Exchange Proceeds
The exchange funds must be held by a qualified escrow agent (typically the QI).  The Taxpayer cannot have the right to receive, pledge, borrow or otherwise obtain the benefits of the exchange proceeds held by the QI.  Neither the Taxpayer nor a disqualified party, such as Taxpayer’s attorney, should accept deposit monies from the buyer of the relinquished property.  The Taxpayer has the right to earn interest earnings on the funds which are taxed as any other interest earned by the Taxpayer.

Note that 1031 CORP. places your funds in segregated interest bearing escrow accounts and has a $10Million Fidelity Bond in place to protect your funds.  Many internal safeguards are in place for added security.  We work hard to secure the best possible interest rate on your funds.  No exchange funds are ever pooled or co-mingled.  A new escrow account is opened for each exchange.  For a copy of our Evidence of Insurance, just ask 1031 CORP. 

Required Documentation
•  The 1031 Exchange Agreement with Qualified Intermediary.  Through this agreement the QI acquires and conveys both properties and receives, holds and controls the exchange proceeds during the exchange.
•  Assignment of the Agreement of Sale to the Qualified Intermediary can be included in the Agreement of Sale or signed at closing.  This also serves as the required written Notification of the Buyer of the Relinquished Property and Seller of the Replacement Property.  A hold harmless clause is included assuring the buyer of the relinquished property and the seller of the replacement property there is no additional cost or liability and closing will not be delayed as a result of the 1031 exchange.  
•  HUD-1 Settlement Statement or Closing Statement usually indicate an exchange rather than a typical sale or purchase transaction.

Time Restrictions
The 45-Day Identification Period begins at the closing of the relinquished property and requires the identification of like-kind replacement property.
•    The identification must be made in writing and signed by the Taxpayer.  An identification signed by an agent of the Taxpayer, such as an attorney, accountant or real estate professional, and not the Taxpayer will be an invalid identification.
•    At any time during this 45-Day Identification Period, an identification may be revoked and a new one made. 
•    If a like-kind replacement property has not been properly identified by midnight of the 45th day, the exchange will fail and the Taxpayer will be unable to defer the capital gains.  On the 46th day (or the next business day), all funds from the escrow account will be released to the Taxpayer.  This includes interest earnings.

Word of advice:  There is no way to extend the 45-Day Identification Period but you can take advantage of the time you have before the 45-Day Identification Period starts.  Start looking for desirable replacement property before you have your relinquished property sold.  You can sign an Agreement of Sale for the replacement property before conveying title of the relinquished property to a buyer.  You can request to be reimbursed from the exchange proceeds any out-of-pocket earnest money deposits made on the replacement property.  The reimbursement is made at the time of acquisition of the replacement property.  The dates the Agreements of Sale are signed do not matter; the time deadlines are based on the actual conveyance dates. 

The 180-Day Exchange Period* runs concurrently with the 45-Day Identification Period and requires the acquisition of all desired identified replacement properties.  Signing an Agreement of Sale is not sufficient.  The Taxpayer must actually take legal and equitable ownership of the replacement property on or before the 180th day.

*If the settlement of the relinquished property occurs between October 18 and December 31 of the current year, for individual taxpayers, the 180-Day Exchange Period will be shortened to the due date of the federal income tax return of the next calendar year unless a timely and proper IRS extension is filed for their return. 

Rules of Identification
The Three-Property Rule
• The Taxpayer may identify up to three properties regardless of their fair market value. The Taxpayer is not obligated to purchase all three properties but must purchase at least one of the three identified properties. 
o For example, if selling a relinquished property for $100,000, three replacement properties can be identified with a combined fair market value of $1,000,000.

The 200% Value Rule
• The Taxpayer may identify more than three properties but their combined fair market value cannot exceed double (200%) the fair market value of the relinquished property. 
o For example, if a relinquished property was sold for $100,000 and four or more replacement properties are identified, their combined fair market value cannot exceed $200,000 (200% or double the sale price of the relinquished property).
o This rule is very beneficial for personal property exchanges.

Many Taxpayers find the 200% Rule very confusing.  Please keep in mind that it only applies if identifying four or more properties.  If identifying one, two or three properties, there is no limit to combined dollar amount of the properties.

Exceptions to the Three Property Rule and the 200% Value Rule:
• Any replacement property acquired within the 45-Day Identification Period will be treated as properly identified, regardless of whether or not it is within the Three Property Rule or 200% Value Rule. 
• If the Three Property Rule and 200% Value Rule are violated, the property will still be treated as properly identified, provided that 95% of the combined fair market value of the identified replacement property has been acquired. 
o For example, assume a $100,000 property was sold and five properties with a combined fair market value of $800,000 are identified.  This will be treated as properly identified provided all five properties are acquired.  It is almost impossible to acquire 95% of the property without acquiring all 100% of the property.
 
When Funds Can Be Released from Escrow
Exchange proceeds held in escrow can be released with written authorization signed by the Taxpayer for expenditures related to the acquisition of identified replacement property.  Typically this includes earnest money deposits.  Exchange proceeds cannot be used to cover mortgage acquisition costs, such as points, application fees and processing fees.  In order to have funds released for earnest monies, the Agreement of Sale for the replacement property MUST be assigned to 1031 Corp., as the qualified intermediary.  If Taxpayer made an out-of-pocket deposit on the replacement property, it can be reimbursed from the escrow account at the time of acquisition. 

If no replacement property is identified within the 45-Day Identification Period, Taxpayer does not have a valid exchange and the sale is a taxable event.  All funds are released from the escrow account on Day 46 (or the next business day).  In no case can escrow funds be released and the exchange cancelled until the expiration of the 45-Day Identification Period.
If replacement property was identified and Taxpayer elects not to acquire one or all of the identified replacement properties, the exchange funds MUST be held in escrow until the expiration of the 180-Day Exchange Period.  The regulations prevent the early release of funds.

Personal Property Exchanges
Personal property held for business use or investment use may qualify for tax deferral under Section 1031 provided like-kind personal replacement property is acquired.  When dealing with personal property, the term like-kind is very specific and is determined by asset classes (NAICS or SIC codes).  Whether completing a real property exchange or a personal property exchange, the same requirements must be satisfied.  Examples of personal property that can be exchanged are livestock, aircraft, equipment, antique automobiles, antiques, paintings, franchises, coins, cable television assets, oil and gas rights, mineral rights, delivery routes, timber rights, etc.

Mixed Use Property Exchanges
Properties involving mixed uses (combining personal and business use) can be exchanged.  The portion of the property used for business use will qualify for tax deferral treatment under Section 1031.  Depending on its use, the portion of the property used for personal use may qualify for the primary residence exemption (IRC § 121).  Additionally, one can acquire a property that would have mixed uses.  Some examples of properties that may have mixed uses are owner occupied duplexes, bed & breakfasts and farms.

General Rule to Defer All Gain
To defer all gain, the Taxpayer must acquire replacement property equal or greater in value than the net selling price of the relinquished property (contract sales price less routine transaction expenses).  The equity in the replacement property must be equal or greater than the net equity in the relinquished property (contract sales price less routine transaction expenses less the mortgage payoff, if applicable).  A trade down in value or equity creates a taxable event for the Taxpayer.  The Taxpayer is taxed on the greater trade down.  A tax consequences worksheet is enclosed to help give you an idea of how an exchange can work in your situation.  You should always discuss your situation with a tax and/or legal professional before proceeding with a 1031 exchange.

Pulling Cash out Tax-Free
After the exchange is complete, a loophole in the regulations allows a Taxpayer to refinance and pull cash/equity out of the replacement property, tax-free.  It is wiser to pull the cash out after the exchange is complete than to pull the cash out on the relinquished property prior immediately preceding the sale.  

Basis of Replacement Property
The basis of the replacement property is lowered by the deferred gain.  Essentially, the basis is carried to the new property and increased by any additional property value acquired. 

Depreciation of the Replacement Property
T.D. 9115 (2/27/04) is a clarification of Notice 2000-4. The basis of the replacement property acquired in a 1031 exchange is generally the same as that of the relinquished property less any cash received plus any gain recognized.  Notice 2000-4 clarified how MACRS replacement property in a 1031 exchange should be depreciated.  The MACRS replacement property should be treated in the same manner as the MACRS relinquished property with respect to so much of the Taxpayer’s basis in the replacement property as does not exceed the Taxpayer’s adjusted basis in the relinquished property.  The replacement property is depreciated over the remaining recovery period of, and using the same depreciation method and convention as that of the relinquished property.  Any excess basis in the replacement property is treated as newly acquired MACRS property.  There will generally be at least two different depreciation schedules in place on one asset.  Notice 2000-4 applies to properties placed into service on or after January 3, 2000.  T.D. 9115 now gives Taxpayers the option to elect out of this depreciation treatment.

Same Taxpayer Requirement
Any Taxpayer or tax entity can complete an exchange.  However, title to the replacement property should be taken the same way title of the relinquished property was held.  The only exception to this rule would be the use of a disregarded entity, such as a single-member limited liability company (LLC).   Except in a community property state, a husband and wife wishing to use a single-member LLC to acquire the replacement property would have to create a separate single-member LLC for each spouse and each LLC would acquire a 50% tenant-in-common interest in the replacement property.  If using a single-member LLC, the Taxpayer would have to elect to be treated as a disregarded entity for tax purposes.  Some other disregarded entities, such as an Illinois Land Trust (Rev. Ruling 92-105) and a revocable living trust (Rev. Rul. 92-105, Rev. Rul. 70-376 and Rev. Rul. 88-103) will also qualify.
A common situation includes a husband or wife that acquired the relinquished property before the marriage.  Now title is only vested with one spouse but they would like to take title to the replacement property jointly.  This may be accomplished but the spouse that owned the relinquished property must acquire an interest in the replacement property that is equal or greater than the net selling price of the relinquished property.  This is something that should be discussed with your tax and/or legal professional.

Conversion of Replacement Property to Primary Residence
After using the replacement property for business use or investment, the Taxpayer may convert the property to a personal use property.  Generally, under Section 121 of the Internal Revenue Code, if used as a primary residence for at least 24 months within the last five years, the Taxpayer may exclude $250,000 in gain ($500,000 if married, filing jointly).  Of course, the Taxpayer may not have taken the Section 121 exclusion within the past two years.  However, under HR 4520 (The Jobs Act) signed into law on October 22, 2004, by President George W. Bush properties acquired in a 1031 exchange must be owned for at least five years and used at least 24 months of the last five years before allowed to take the Section 121 exclusion. Under Section 121, regardless of whether or not a 1031 exchange was involved, Taxpayers cannot exclude depreciation recapture from May 6, 1997 forward so some tax may be due on the sale.

Non-Resident Withholding Tax
Many States have enacted mandatory non-resident withholding taxes that must be withheld at the time of sale if the seller is not a resident of that State.  Closing agents in these States must submit a check representing the required withholding tax to the Recorder of Deeds in order to have the Deed recorded.  When completing a 1031 exchange, the Taxpayer may file for an exemption but most States require this be completed prior to closing. 

The following States currently have non-resident withholding requirements:  California, Hawaii, Maine, Maryland, Mississippi, New Jersey, New York, Rhode Island, South Carolina and Vermont.  Keep in mind other States may enact laws requiring a non-resident withholding tax. 

Your 1031 CORP. Exchange Coordinator and your closing agent will be very helpful with this.   

Related Party Exchanges
Section 1031 exchanges between related parties should be carefully considered as these types of transactions have received considerable attention from the IRS recently.  Please contact 1031 CORP. for more information if considering an exchange between related parties.

Under Internal Revenue Code Sections 267(b) and 707(b), a related party is anyone who bears a relationship to the Taxpayer.  Any one of the following is considered a related party:

• Family members such as siblings, spouse, ancestors and lineal descendants.
• Individual and corporation where more than 50% in value of the stock is owned directly or indirectly by or for such individual.
• Two corporations part of the same control group.
• A grantor and a fiduciary of the same trust.
• A fiduciary and a beneficiary of the same trust.
• A fiduciary of a trust and the fiduciary or beneficiary of another trust where the same person is the grantor of both trusts.
• A fiduciary of a trust and a corporation more than 50% in value of the outstanding stock in which is owned, directly or indirectly, by or for the grantor of the trust.
• A corporation and partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of capital interest or profits interest in the partnership.
• An S corporation and another S corporation or a C corporation if the same persons own more than 50% of the value of the outstanding stock of each corporation.
• Two partnerships in which the same persons own, directly or indirectly, more than 50% capital interests or profit interests.
• A partnership and a person owning, directly or indirectly, more than 50% capital interests, or profits interest, in such corporation.

Construction Exchanges
Construction/Improvement exchanges occur when the Taxpayer wishes to make improvements to the replacement property utilizing the sale proceeds of the relinquished property.  This usually transpires when the fair market value of the replacement property is less than that of the relinquished property.  If the Taxpayer were to acquire the replacement property and construct the improvements, the improvements would not qualify as like-kind property.  Therefore, the Taxpayer cannot take title to the replacement property until the improvements are completed. Typically, an intermediary will take title, sign the contract with the builder and have the improvements completed.  Once the improvements are completed, the intermediary conveys title to the Taxpayer.  The improvements must be identified within the 45-day exchange period and title of the improved property must be passed to the Taxpayer within the 180-day exchange period. 

 There are several ways a construction exchange may be structured.  Please contact 1031 CORP. for additional information. 

There are more costs associated with a construction exchange than a typical 1031 exchange.

Reverse Exchanges
A reverse 1031 exchange occurs when a Taxpayer must acquire the replacement property prior to the disposition of the relinquished property.  This can occur for a variety of reasons.  Most reverse exchanges are structured as simultaneous exchanges between an Exchange Accommodation Titleholder (EAT) or parking intermediary and the Taxpayer, with the EAT acquiring and "parking" title of the replacement property until the relinquished property is conveyed to a buyer.  It can also be structured where the intermediary parks the relinquished property, if necessary.  The financing method and the anticipated length of time the intermediary is expected to "park" title are usually the determining factors when deciding whether the intermediary takes title to the replacement or the relinquished property.  Revenue Procedure 2000-37 provides a safe harbor for parking arrangements for transactions initiated after September 15, 2000.  

A reverse exchange is more complicated and takes longer to structure, especially when a lender is involved.  Please contact 1031 CORP. at least 30 days prior to the scheduled closing of a replacement property if the relinquished property will not be sold prior to that date.  There are greater costs associated with a reverse exchange than a typical 1031 exchange.

Tenant-in-Common (TIC) Interests
Syndicated Tenant-in-Common (TIC) interests allow Taxpayers to acquire an undivided fractional interest in large institutional quality properties. Basically, many unrelated co-owners each have fee interest in the property.  Taxpayers looking at TIC interests as replacement property in a 1031 exchange must keep in mind that there is no guarantee the particular TIC interest they are considering will qualify as like-kind property.  All TIC interests differ and so does the product of one Sponsor to the next.  The Revenue Procedure provides guidelines not a safe harbor.  Taxpayers should have their tax and/or legal advisor review the investment opportunity as well as look at the structure of the TIC product and compare it to the guidelines provided in Revenue Procedure 2002-22. 

For assistance with all of your Real Estate Investments, please contact John Luca at 302-999-6966 or John@TriStateTeam.com

Every 1031 exchange is unique.  You should always discuss your situation with a tax and/or legal professional.  1031 CORP. cannot and does not provide tax and/or legal advice.

Copyright: 1031 CORP with permission John Luca, The Luca’s Tri-State Team.