Introduction to 1031 Exchanges
Section 1031 of IRS code is the basis for tax-deferred exchanges, therefore it has been abbreviated as “1031 Exchanges”. Taxpayers who want to reinvest from sale of property never have to pay income taxes if they intend to reinvest the proceeds in similar kind of property. 1031 Exchange means there must be exchange of property, which means sale of property and then subsequent purchase of replacement property after few weeks/ months will not work. 1031 exchange also attracts a disadvantage of reduced basis for depreciation on the replacement property.
Value of Replacement Property for Depreciation = Purchase Price of New Property – Unclaimed Gain due to 1031 exchange
The exchanged property therefore includes an unclaimed gain that will be taxed in the future if the taxpayer cashes out of his investment.
There are several different ways to structure tax-deferred exchange under Section 1031 of IRS Code. However, among all those ways the “1991 – safe harbor” regulations are the most suitable. They cover most of the stated clauses of Section 1031 such as use of an Intermediary, direct deeding, use of qualified escrow accounts for temporary holding of exchange funds and more. Therefore, it is appropriate to structure exchanges with the 1991- Safe Harbor Regulations, which allows exchanges to employ the services of a facilitator known as a Qualified Intermediary. It is not necessarily required to take the services of an Intermediary when both the parties involved in exchange are willing to enter into exchange agreement directly.
Requirement for 1031 Exchange
Qualifying Property: Surrender property (property which buyer will sold) can only become Qualifying property if it has been held for investment or income generating purposes. It can only be exchanged with similar kind of property. Property which does not qualify for 1031 exchange includes:
a) Personal Residence
b) Under Development Land for resale
c) Partnership Interests
d) Corporation Common Stock
Property Title: Exchanged property (property which buyer will get) must be titled in the same name as the surrendered property was titled. If surrendered property is in the name of two person jointly then the xchanged property must be taken in the same name jointly. There is a condition in section 1031 that the seller of exchanged property must not be the buyer of the taxpayer’s surrendered property.
Exchanged Property must be Similar Kind: In 1031 exchanges, the restriction to similar kind of exchanged property means that any developed or undeveloped real estate held for investment, income or business use can be exchanged with property of similar type. For instance, a personal residence cannot be exchanged against income generating property and vice-versa. Some guidelines are as follows:
• Developed business/ investment real estate can be exchanged against developed real estate
• Developed business/ investment real estate can be exchanged against undeveloped real estate
• Single property can be exchanged against 2 or more properties and vice versa
• A business property can be exchanged against an investment property
Boot in addition to Exchange: Boot is the money and debt relief received by the seller in addition to 1031 exchanged property. The boot is generally given to equalize fair market value of property in a 1031 exchange. Any boot received in addition to the exchanged property will be taxable limited to the extent of the gain realized on 1031 exchange. Debt relief is any reduction in mortgage amount which occurs as a result of the exchange taking into account the debt on the Surrendered Property and Exchanged Property. Boot Money includes all cash equivalents, liabilities of the taxpayer borne by the second party, or liabilities levied on the property exchanged by the taxpayer. The most common sources of boot are net cash received, debt relief and sales proceeds being used to pay non-transaction costs during closing. The non-transaction costs include rent prorations, tenant security deposit transferred to buyer, real estate tax prorations and any other charges unrelated to closing.
So, as a seller, always try to exchange property of equivalent or greater value to avoid any boot being received in your hands.
1. If FMV of Surrendered Property is $100,000 and FMV of Exchanged property is $75,000, then seller will receive $25,000 from buyer. The $25,000 is BOOT which seller received in form of money.
2. If at the time of exchange balance mortgage amount on Surrendered Property is $100,000 and Mortgage amount on Exchanged property is $75,000, then seller will get benefit of $25,000 in term of Mortgage Loan. The $25,000 is BOOT which seller received in form of Debt Reduction.
Different Types of 1031 Exchanges
Simultaneous Exchange: It is an exchange in which the closing of the Exchanged Property and the Surrendered Property occur on the same day. There is no interval of time between the exchanges of properties. This type of exchange is covered by the Safe harbor Regulations. It is the simplest way to schedule a 1031 exchange.
Delayed Exchange: It is an exchange in which the Exchanged Property is acquired at a later date than the closing of the Surrendered Property. The exchanges of properties does not happen on the same day. There are strict time frames established by the Internal Revenue Code and Regulations for completion of a delayed exchange, namely the 45-Day Clock and the 180-Day.
A party willing to do a 1031 exchange lists the property for sale in the normal manner without fulfilling any formalities of 1031 Exchange. A contract to sell the property is accomplished after getting the appropriate buyer. Then the contract gets executed between the buyer and seller on the intended 1031 Exchange. An Intermediary’s services are arranged when the contract is scheduled for closing, after all eventualities related to 1031 Exchange have been met. The seller cannot get sales proceeds directly, he/she has to buy the replacement property with similar value from the sales proceeds.
The Exchange Agreement usually provides for:
a) Intermediary is responsible for the seller’s contract to buy and sell surrendered property
b) The Intermediary receives all the sales proceeds at the time of closing. Direct Deeding is then used to realize funds from Intermediary. So, seller has no rights on sales proceedings to the funds being held by Intermediary until exchange is completed or revoked.
c) There are time limits in which seller has to find replacement property and enter into the contract to purchase the property. The time limit is subject to 2 rules: 45 days rule and 180 day Rule.
d) It is Intermediary’s responsibility that the seller has to adhere contract to purchase replacement property
e) In the end, Intermediary has to transfer exchange funds in its possession to the seller of replacement property.
The 45 Day Identification Rule: The first restriction for a delayed 1031 exchange is that the seller has to identify the replacement property within 45 days from the date of transfer of the Surrendered Property. This rule is complied by either seller purchasing the replacement property or identifying the property and notifying in writing to the Intermediary. The Identification notice must contain complete description and details of replacement property.
The 45-Day Rule for Identification imposes restrictions on the number of prospective Replacement Properties, which can be identified and received as Replacement Properties. More than one prospective Replacement Property can be identified by one of the following three rules:
a) 200% Rule: There can be multiple properties as long as aggregate Fair Market Value (FMV) of the replacement properties does not exceed 200% of the combined FMV as of initial transfer date of all of exchanged properties.
b) 95% Rule: There can be multiple properties as long as aggregate FMV of the replacement properties actually received by the end of contract must be at least 95% of the combined FMV of all prospective replacement properties identified.
The 180 Day Receipt of Exchange Property Rule: The Exchanged property must be received and 1031 exchange completed on or before
a) Transfer of exchanged property must be within 180 Days.
b) Due Date of income tax return, including extension, for the tax year in which Surrendered Property was transferred.
Reverse Exchange: It is an exchange in which the Exchanged Property is purchased and closed before the Surrendered Property is sold. Usually buyer take title to the Exchanged Property and holds title of Surrendered Property until other party can find a buyer and close on the sale under 1031 exchange agreement with buyer.
Safe Harbor Exchange: If a party who owned a property within prior 180 days and wants to enter into 1031 exchange through reverse exchange, that property will be declared ineligible under safe harbor procedures. The safe-harbor clauses governing reverse exchanges are concisely stated below:
a) 5 Day Rule: A “1031 Exchange – Reverse” agreement must be entered into between seller and Intermediary within 5 days after the title to exchanged property is taken by seller
b) 45 Day Rule: Seller has to identify replacement property within 45 days from the date of transfer of Surrendered Property. He/She can identify more than one property similar to the rules of delayed exchange.
c) 180 Day Rule: The Reverse Exchange must be accomplished within 180 days of the taking title of Exchanged Property by the seller. This rule become a problem in case of improvement of the properties before exchange. It usually become very difficult to complete large construction/ improvements within 180 days to complete requirement of reverse exchange.
An Improvement Exchange: It is an exchange in which buyer wish to acquire a property (exchanged property) and make arrangement for construction of improvements on the property before taking title of exchanged property. The enhancements in exchanged property is generally the construction of building on an unimproved lot or development in an already improved building. These enhancements are done in order to create increase value of exchanged property and make it of equivalent value to surrender property. This helps in ensuring that no boot occurs at the time of 1031 exchange. The IRS doesn’t consider any improvement in exchanged property after 1031 exchange. Therefore it is necessary to make all enhancements before the transfer of titles.
Role of Qualified Intermediary
A Qualified Intermediary is a person who is not the seller or buyer and who enters into the “exchange agreement” with the seller. The Qualified Intermediary acquires the Surrendered Property from the seller, transfers the Surrendered Property to the buyer, acquires the Exchanged Property and transfers the Exchanged Property to the seller. The Qualified Intermediary does not actually have to be in the chain of title. The services of Qualified Intermediary is necessary requirement to successfully complete delayed exchanges and reverse exchange.
The seller and Intermediary must have entered into written agreement in order to take services of qualified Intermediary with respect to restricting seller’s rights to fulfill limitations of 1031 exchange. IRS do not provide any licensing requirements to become Intermediaries. IRS restricts related parties, attorneys, accountant and realtors who have provided services to the seller within past 2 years to become qualified intermediary for seller in a 1031 Exchange. A Qualified Intermediary has full rights over the exchanged cash during the course of 1031 Exchange. An Intermediary can invest money in variety of ways and legally it is hard to recover money if an intermediary becomes bankrupt or insolvent. Therefore seller has to wisely select Intermediary who can be trusted with the handling of funds from 1031 Exchange.
1031 Exchange Procedure Chart
Investors usually enter into 1031 Exchange to avoid tax payments on Capital Gain from sale of properties. Parties interested in 1031 Exchange must fulfill key requirements before entering into exchange. Parties can choose from multiple types of exchange as per there situation and needs. The accounting and tax implications vary based on the type of exchanges. 1031 exchanges can be fairly complicated, so its best to engage an accounting and taxation expert to structure the exchange.