EXCHANGES UNDER IRC SEC. 1031 –
WHAT YOU NEED TO KNOW

I. WHAT IS AN EXCHANGE?

An exchange is a federal and state authorized procedure to sell investment real estate and to acquire replacement investment real estate, without paying capital gains taxes. The guidelines are set forth in Section 1031 of the Internal Revenue Code and in Regulations thereunder. Most of the compliance with Section 1031 is accomplished in the background of each transaction, so that the exchange proceeds very similarly to the sale of one property to one person and the purchase of replacement property from another person.

A straight two-party “swap” of properties is the simplest exchange, but also the rarest because it is difficult to find and arrange. In the vast majority of exchanges, the closings for the sale and the purchase are separate and independent, and can occur several days or several months apart (but not more than 180 days apart).

II. WHAT ARE THE BENEFITS OF AN EXCHANGE?

Section 1031 is a major assist for building wealth in real estate, and has been referred to as the last remaining tax shelter for investment real estate. An exchange under Section 1031 results in the non-recognition (non-taxability), at both the Federal and State level, of capital gains when investment or business real estate is sold and the proceeds reinvested into replacement investment or business real estate. An investment property owner can make a change in his or her investments, without the drain of capital gains taxes. The investment property owner who “sells” using Section 1031 preserves all of his or her capital appreciation, and can put all of his or her equity towards acquiring new investment or business property. The investment property exchanger does not have to set aside funds to pay capital gains taxes; thus a replacement property which otherwise might have been “out of reach” may be attainable. Exchanging allows for the replacement of underperforming rental property, or property that cannot be rented out (such as raw land), with new property that will generate a more favorable cash flow, without the need to pay taxes on the sale of the old property.

Example: Taxpayers A & B are both selling investment real estate for $240,000. Each party has the same adjusted basis ($100,000) in his property. Both A & B will be acquiring replacement property costing $240,000 or more. A doesn’t structure his transactions as an Exchange, but B does:

III. WHAT ARE THE TIME LIMITS FOR AN EXCHANGE?

First, an exchange must be set up with a Qualified Intermediary before the closing on the Relinquished Property. An exchange cannot be started after the closing on the relinquished property, because a qualified intermediary must take part in the relinquished property closing and must receive the sale proceeds, on behalf of the exchangor, directly from the closing agent. Without an Intermediary in place, the transaction becomes taxable. Second, the replacement property must be identified within 45 days after the date of the closing on the relinquished property. Third, the replacement property must be acquired (i.e., the closing must be completed) within 180 days after the relinquished property closing.

IV. WHO CAN BE THE QUALIFIED INTERMEDIARY?

Understanding who can, and who cannot, fulfill the role of a Qualified Intermediary for a “safe harbor” exchange is critical to securing your tax deferral. The 1991 Regulations specifically state who cannot serve as the Qualified Intermediary for an exchanging party: any person who has acted as your employee, attorney, accountant, investment banker, or real estate agent or broker within the 2-year period ending on the date of the transfer of the first of the relinquished properties. Treas. Reg. Sec. 1.1031(k)-1(k)(2)(iii). Also specifically disqualified from acting as Qualified Intermediary is any person related to you by blood or marriage.

There is no other “qualification” that a person must possess in order to serve as a “Qualified Intermediary”. Anyone can call themselves a “Qualified” Intermediary”, so your choice of Intermediary is critical for the ultimate success of your exchange.

V. WHAT QUALIFIES AS “INVESTMENT” REAL ESTATE”?

Real estate becomes investment real estate when the taxpayer holds the property for appreciation (raw land), or for rental (a multi-family or a single family dwelling), or for productive use in a trade or business. As a result, almost any type of property that a taxpayer does not hold as “stock in trade” (as a dealer or developer would), and does not utilize as a primary or secondary residence, is considered investment property. There is no statutory minimum holding period, but owning property as investment property for at least one year is highly recommended.

“Investment property” includes not only commercial and industrial property, but also raw land, leasehold interests of 30 or more years, and all types of rental residential property (single-family properties, multi-family properties, and condominiums) so long as the residential properties are rented out and not utilized by the taxpayer or members of his or her family. Under current law, vacation homes do not qualify as investment property, unless the taxpayer uses the property for no more than 14 days per year (or less than 10% of the number of days the property is rented out) and receives significant rental income from the property during the year.

All types of investment and trade or business property are considered “like-kind” to each other, and can be exchanged. A taxpayer cannot, however, exchange real property for stocks, bonds, notes, interests in a partnership or any tangible or intangible personal property. Additionally, real property located in the United States is considered like-kind only to replacement property which is also located in the United States.

VI. CAN AN EXCHANGE INVOLVE MULTIPLE PROPERTIES?

Yes, an exchange can be structured with multiple properties on either side; that is, the investment property owner can exchange one property for two or more replacement investment properties (thus maximizing the leverage potential of the cash realized from the relinquished property), without paying capital gains taxes; or, the investment property owner can exchange two or more properties for one higher-value investment property, also without paying capital gains taxes.

VII. HOW CAN AN INVESTMENT PROPERTY OWNER USE AN EXCHANGE IN PRE-RETIREMENT PLANNING?

The knowledgeable investment property owner anticipating retirement can utilize Section 1031 to acquire a retirement or vacation home in a tax-free exchange, relying upon the change in use concept which is approved by the IRS. The basic rule is of course that the real estate acquired in an Exchange must be acquired with the intent to own the property as an investment, but the real estate does not have to be held as an investment forever. Section 1031 of the IRC does not mandate a specific holding period for replacement property, because it is an intent-based statute, not a time-based statute. The investment property owner, therefore, can “sell” his investment real estate and exchange into a property that he or she would like to retire to, so long as he or she has the intent to hold the replacement property for investment, and actually rents out the new property for a period of at least two years. The IRS has conceded that an Exchangor can, after two years, change the use of (i.e., move into) the replacement property acquired in an Exchange without in any way jeopardizing the non-recognition of gain in the underlying transaction, so long as the original intent was to hold the property for investment. The Exchangor can decide, after two years, to live in the replacement property and effectively convert investment property into primary residence property, tax-free. And when the Exchangor does retire and move into the replacement property, he or she can then sell the former principal residence, and can typically take advantage of I.R.C. Section 121, which allows for tax-free sale of a principal residence (up to $250,000 of tax-free gain for an individual and up to $500,000 of tax-free gain for a married couple), as long as the taxpayer resided in the property for at least 2 out the past 5 years, with no requirement to reinvest the proceeds.

VIII. HOW SHOULD I PROCEED IF I WANT TO DO AN EXCHANGE?

A “sale” cannot be converted into an “exchange” after a closing. If you want to take advantage of the benefits of Section 1031, you must contact us before you attend a closing or convey your deed.

a. First, once you have found a buyer for your sale property, you may negotiate and sign a normal Purchase and Sale Agreement. The IRS no longer requires that you declare your intention to do an exchange at the time you sign a P&S agreement. The IRS allows you to convert your sale into an exchange by documents you will sign with our company, and by documents we will present at the closing. Thus it is optional to you whether or not you insert special “exchange language” in your purchase and sale agreement.

b. After you sign your sales agreement, you must contact us so that we will have enough time to prepare your exchange documents and to coordinate the exchange aspect of your sale with the closing agent. We will ask you to forward to us a copy of the agreement. We will review with you the details of your particular exchange as well as typical exchange procedures.

c. Your next step in the exchange is to begin searching for a replacement property if you have not already decided on one. You can sign an agreement to buy a property, and pay an earnest money deposit, before you close on your relinquished property, but you must arrange the closings to allow you to sell first and buy later. If you have not found a replacement property as of the date of your relinquished property closing, IRS Regulations specify that the replacement property must be identified in writing to the Intermediary on or before the 45th day after the relinquished property closing. You can sign a purchase agreement for your replacement property before or after your identification date, but you must actually close on your new property on or before the 180th day after your relinquished property closing.

d. The net proceeds from your relinquished property closing will be wired to us, which will protect you from actual or constructive receipt of funds, which makes your transaction an exchange and not a sale. We will provide you with confirmation of our receipt of your funds, and with further instructions on identification and/or acquisition of your replacement property. We will calculate and inform you of the precise date for the end of your identification period, and the ending date for your exchange, and we provide you with an identification letter for you to fill out to comply with the identification process.

e. You will negotiate a purchase and sale agreement with the Seller of the replacement property you wish to acquire, and provide us with a copy when executed. In most cases we will pay the earnest money deposit from your exchange account. We will document and coordinate the exchange aspect of your replacement property closing with the closing agent, including wiring the balance of your exchange account to the closing, and your 1031 exchange will be complete.

IX. CAN I RECEIVE SOME CASH FROM MY SALE AND REINVEST THE REST OF MY PROCEEDS TAX-FREE?

Yes, in what is called a “partially-taxable” exchange. If the Exchangor needs to receive some cash from the sale proceeds, he or she can do so, and still shelter the rest of the proceeds in a valid exchange transaction. This is called a “carve-out” from the sale proceeds and must be discussed with the Intermediary several days before the relinquished property closing so that the Intermediary can properly document and coordinate the carve-out with the closing agent. The direct payment to the Exchangor from the closing agent will be considered “boot” and thus will be taxable, from the first dollar received, at federal and state capital gains rates.

X. WHAT IS A “REVERSE” EXCHANGE?

A reverse exchange is needed when the investment property owner wants to defer capital gains taxes on the sale of his real estate, but circumstances force him to close on his replacement property before his relinquished property is sold. The IRS does not recognize a “pure” reverse exchange, that is, an attempted exchange where the taxpayer takes title to the replacement property in his own name or in the name of a relative or some other person as his agent. The IRS will, however, recognize a reverse exchange if title to either the replacement property or the relinquished property is held by an Exchange Accommodation Titleholder (“EAT”) pursuant to a Qualified Exchange Accommodation Agreement in compliance with RevProc 2000-37. In most reverse exchange situations, it is advisable for the EAT to take title to the replacement property. Within 180 days, the Exchangor sells the relinquished property and then title to the replacement property is transferred from the EAT to the Exchangor, completing the safe-harbor reverse exchange.

A reverse exchange is very effective and safe, but more complicated and expensive than a straight-ahead (sell first and buy later) exchange. What is attractive about the reverse exchange is that the exchanging party does not have to undergo the uncertainties of the 45 day identification period to find his or her ideal replacement property.