There are very specific 1031 exchange identification requirements for identifying potential like-kind replacement properties in your 1031 exchange transaction. The prospective like-kind replacement properties that you identify as part of your 1031 exchange do not need to be under contract or in escrow when you identify them. Below are the 1031 Exchange Rules.
1) REAL PROPERTY USE: Both your old and new properties must qualify as investment or business use. If both properties pass this test, you can exchange nearly any type of real estate.
2) 45 DAY IDENTIFICATION PERIOD: A seller must identify another replacement property that he proposes to buy within 45-day period from the date he sold his relinquished property. The 45-day timeline is very rigid and does not allow any variances (even if the 45th day should fall on a weekend or holiday.) Note that during this period, the proceeds from the sale of the relinquished property are in the custody of the qualified intermediary.
3) 180 DAY EXCHANGE PERIOD: An individual has 180 days from the date of selling their property that was the basis for the 1031 to receipt of the newly-acquired property.
The period within which the person who has sold the relinquished property must receive the replacement property is referred to as the “Exchange Period” under 1031 of the IRC. This period ends at 180 days after the date on which the person transfers the property relinquished or the due date for the person's tax return for the taxable year in which the transfer of the relinquished property occurred, whichever is earlier. A word of caution: Many ill-advised or careless investors see the language referring to the due date for their tax return and assume they can wait until the last minute to purchase the new property. Remember – the deadline is the EARLIEST of the two scenarios. If an individual were to sell their 1031 property in May, the deadline for acquiring a new property (180 days) would fall well before their tax return in the spring of the following year.
While the utilization of 1031 exchanges can be an extremely valuable tool for maximizing tax savings, it is a very complex process and often difficult to navigate.
Identification Rules and Exceptions
1031 Exchange ID Rules
You must comply with at least one of the following identification rules or exceptions when completing the identification of your like-kind replacement properties:
It's advised that you get a purchase agreement set up and a replacement property in mind before starting the 1031 process. This is because "The three-property rule" (under 1031 tax exchange regulations) declares that the exchanger of a relinquished or replacement property may identify up to 3 replacement properties, regardless of their value.
THREE (3) PROPERTY IDENTIFICATION RULE
The three (3) property identification rule limits the total (aggregate) number of like-kind replacement properties that you can identify to three (3) potential like-kind replacement properties. The vast majority of Investors today use this three (3) property identification rule.
You could acquire all three of the identified like-kind replacement properties as part of your 1031 exchange, but most Investors only acquire one of the three identified properties. The second and third identified properties are merely identified as back-up like-kind replacement properties in case you can not acquire the first property.
You will skip the three (3) property identification rule and use the 200% of Fair Market Value Rule if you are trying to diversify your investment portfolio and wish to identify more than three (3) like-kind replacement properties.
200% OF FAIR MARKET VALUE IDENTIFICATION RULE
You can identify more than three (3) like-kind replacement properties as long as the total (aggregate) fair market value of all the identified like-kind replacement properties does not exceed 200% of the total (aggregate) net sales value of your relinquished property(ies) sold in your 1031 exchange. The limitation is only on the total (aggregate) identified value. There is no limitation on the total number of like-kind replacement properties.
For example, if you sold relinquished property(ies) in the amount of ,000,000 you would be able to identify as many like-kind replacement properties as you want as long as the total (aggregate) value of the identified like-kind replacement properties does not exceed ,000,000 (200% of ,000,000).
95% IDENTIFICATION EXCEPTION
If more than three properties have been identified, and their total fair market value exceeds 200% of the value of what was sold, the exchange may still be valid if 95 % of the total cost of all properties on the list are purchased. This means if there are properties costing 0,000 on your list, then you must purchase at least ,000 of them.
At Solid Investments we can assist you in locating a like-kind property for a 1031 exchange and ensure a smooth and successful transaction.
1031 Exchange Rules FAQ
Q: What property is like kind to my property?
A: When it comes to real estate generally, all property is like kind to all other real estate. For example, farmland can be exchanged for an office building or a condominium can be exchanged for a trailer park. The state law of the jurisdiction in which the property is located will define the definition of what is an interest in real estate, such as mineral interests, water rights, etc. Our business focuses on exchanges of real estate and exchanges of certain other tangible personal property, like airplanes, equipment, and livestock can be exchanged. Whether personal property is like kind is determined by reference to certain depreciation classifications. We can handle exchanges of real estate or personal property.
Q: What must I do to have a fully deferred exchange?
A: The general rule is that, in order to have a fully tax deferred exchange, the exchanger must trade equal or up in equity and debt. The effect of this rule is that the exchanger must use the entire net proceeds from the relinquished property as down payment on the replacement property. Also, the exchanger must replace any mortgage paid off at the sale of the relinquished property with an equal or greater mortgage on the replacement property. Any cash received by the exchanger whether at the sale of the relinquished property or at the purchase of the replacement property will be deemed "cash boot" and tax will be recognized to the extent of gain. This rule applies regardless of the exchanger’s cash position in the relinquished property. Regardless of the size of the exchanger’s down payment, principal pay-down, or capital improvements on the relinquished property, the exchanger will be treated as having received "cash boot" if cash is received as part of the exchange. The fair market value of the relinquished property can be calculated by subtracting from the selling price the ordinary and customary transaction costs of the sale. These transaction costs are limited to those costs directly related to the sale of the relinquished property. The most common transaction costs are brokerage fees, title insurance fees, exchange service fees, and recording fees.
Q: May I have a partially tax deferred exchange?
A: If the rule described in the answer above is violated, a partially tax deferred exchange is the likely outcome. If the exchanger trades down in either debt or equity then some gain is likely to be recognized. If the exchange portion of the transaction is otherwise valid, a partially deferred tax exchange is the result.
Q: What is boot?
A: "Boot" is anything of value received by the exchanger, which is not "like-kind" to the relinquished property.
Cash Boot - If the exchanger receives cash upon sale of the relinquished property this will be treated as "cash boot" and tax will be recognized to the extent of gain in the transaction. For example, if the QI receives ,000 upon sale of the relinquished property and the exchanger elects to receive ,000 in cash at closing, the exchanger will pay tax on ,000 while the exchange is completed with the remainder of the funds held by the QI.
Mortgage and other Boot - If the exchanger fails to purchase a replacement property of equal or greater value than the relinquished property there is a strong possibility that he will be deemed to have received "mortgage boot." For example, if the exchanger relinquishes a property valued at 0,000 and deposits ,000 with their QI and a ,000 mortgage is paid off, then replaces with a property valued at ,000 with ,000 cash down and a replacement mortgage of ,000 the exchanger will pay tax on ,000. This is an example of the receipt of "mortgage boot." An exchanger can also receive other property, which will be deemed boot. For example, if the exchanger receives an automobile, artwork, or any other thing of value as part of an exchange, that other non-like kind property will be deemed boot and taxed on the fair market value allocated to it.
Q: Can I refinance a property immediately prior to the exchange?
A: Recent tax authority suggests that a refinancing of the relinquished property prior to sale with receipt of cash by the exchanger may not be deemed "cash boot" under certain limited circumstances. This course of action is not generally recommended. In the event the exchanger needs cash for a bonifide independent business purpose, it is strongly recommended that the exchanger refinance the replacement property after acquisition and when the independent need for cash arises. 1031 Exchange Rules.
Q: How long do I have to identify, how do I identify, what constitutes sufficient identification, is there any leeway?
A: The replacement properties must be identified within 45 days after the closing on the sale of the relinquished property. This requirement is strictly enforced, even if the 45th day falls on a holiday. Identification must be in writing, signed and dated by the exchanger and received by the QI no later than 45 days after the sale of the relinquished property. Replacement property must be identified unambiguously. Usually either a legal description or a mailing address is sufficient. Beware of an exchange where an exchanger identifies a property in whole and then closes on only a part of the whole. If challenged, this may be an insufficient identification for a successful exchange.
Q: How long do I have to purchase my replacement?
A: The replacement property must be purchased and closing complete within 180 days after the transfer of the relinquished property.
Q: May I do a multiple leg exchange?
A: Yes, several relinquished properties may be exchanged for a single replacement property. One relinquished property may be exchanged for several replacement properties. The important thing is that the exchange be part of a unified exchange agreement from the beginning. The 45-day identification rule and 180-day replacement rule will start running from the date of the sale of the first relinquished property. Sometimes because of this timing issue it is better to structure the exchange as a series of exchanges rather than a multiple leg exchange.
Q: May I exchange less than 100% of my interest?
A: Yes, a fractional part of the relinquished property may be exchanged and/or a fractional part of the replacement property may be acquired.
Q: How should I take title to replacement property?
A: Title to the replacement property must be taken in the same name in which the relinquished property was held. Caution dictates that this rule is followed even when husbands and wives are involved.
Q: What is a related party and can I do an exchange with them?
A: This is an evolving area in 1031 exchanges. Generally speaking, if an exchange occurs involving related persons or entities then all exchanged properties must be held by the exchanger and the related party for a period of two years after the date of the last transfer or the exchange will not qualify for tax deferral. Related parties are defined as: lineal ancestors and descendants, brothers and sisters and business entities in which the exchanger owns at least a 10% interest. In a deferred exchange, the exchanger may acquire property from a related party as long as tax avoidance is not an issue.
Q: Do I receive a tax basis in my replacement property?
A: No, tax basis from the relinquished property is carried forward into the replacement property. Any additional cash investment or increase in a mortgage by the exchanger increases tax basis in the replacement property. Once a depreciation allowance is taken on the relinquished property it may not be used a second time on the replacement property. This rule is generally regarded as a negative consequence of a 1031 exchange. Both investors and brokers frequently misunderstand it.
Q: Can an entity do an exchange? Corporation, partnership, LLC, trust
A: Yes, title to the replacement property must track with the relinquished property. A partnership interest in one partnership may not be exchanged for a partnership interest in another partnership. A share of stock in one company may not be exchanged for a share of stock in another company. However, legal entities may perform exchanges under 1031.
Q: Can I receive title to replacement property before giving up title to relinquished property?
A: Reverse 1031 exchanges are permitted. However, the exchanger may not hold title to both properties at the same time. Instead an Exchange Accommodation Titleholder must hold title to one of the properties. Contact us for more detail.
Q: Can I use exchange funds to pay down mortgage on property I already own?
A: No. The IRS does not consider this a like kind exchange. 1031 exchange rules
Q: Can I use exchange funds to do fix up on replacement property?
A: It is generally best to have the owner of the replacement property perform the fix up prior to acquisition of the replacement property. As a second alternative, it is better to use funds other than exchange funds to perform the fix up on the replacement property. Finally, exchange funds can be used to perform fix up on the replacement property if the fix up is accomplished prior to the exchanger actually acquiring title.
Q: Can I use exchange funds to build improvements on replacement property?
A: Generally speaking the best way to accomplish this goal is to have a "Special Purpose Entity" acquire title to the replacement property, have the Special Purpose Entity build the improvements, and have the exchanger acquire the replacement property from the Special Purpose Entity under the regulations for exchanges. Please contact your QI if you are asked to perform a construction exchange.
Q: As an closing agent, what do I do when I am notified that a party to a transaction I will be closing, intends to do a 1031 Tax Deferred Exchange?
A: If you are notified, either verbally or in the Buy-Sell Agreement, that a party to the Agreement wants to do an exchange, you must include the "language" in your closing escrow instructions to the effect that Buyer agrees to cooperate with Seller, or Seller agrees to cooperate with Buyer, or Buyer and Seller agree to cooperate with each other. American Equity Exchange is pleased to provide you with sample language if your company needs it. Remember, if you have placed "exchange intent language" in your closing escrow instructions and are subsequently notified that the party will not be doing an exchange, you must prepare an amendment deleting that clause so it does not appear as if you closed and forgot to do the exchange.
Q: When do I need to notify the Exchange Intermediary Company of my involvement in a transaction?
A: Typically you will contact American Equity Exchange after sale or purchase contingencies (i.e. physical inspection, environmental assessments, title review, etc.) have been removed. If you have a very quick closing escrow, do not wait for the contingency period to be removed, notify our office immediately. Otherwise, after contingencies are removed, you need to immediately furnish our office with a copy of the Buy-Sell Agreement, Title Commitment, and info on who will be the closing agent on the transaction.
Q: What does a The Qualified Intermediary do after they receive the Buy-Sell Agreement & Title Commitment from the Closing Agent?
A: Upon their receipt of the Purchase and Sales Agreement and Title Commitment, they will then prepare our Exchange Agreement and Substitution of either Buyer or Seller for your use in the escrow. Our exchange file is then set up to coincide with how your escrow is structured (see notes below as to the percentage interests; Purchase Money Mortgages etc.). They then forward the documents to the Closing Agent. Please return the documents to the QI as soon as the signatures are obtained.
From the point in which the Substitution of Buyer or Seller has been prepared, the Qualified Intermediary is then your Buyer or Seller. This means that any subsequent amendments, etc. that require the party’s signature must show American Equity Exchange in addition to the original parties. If the Qualified Intermediary is not specified in the documents, you are jeopardizing the exchange transaction.
So remember, place the Qualified Intermediary name in place of the Exchangor’s, as the principal, and have the Exchangor merely "acknowledge receipt" of all subsequent instructions. This rule applies if you are canceling or superseding your escrow instructions.
Q: As the Closing Agent, how do I handle the estimated closing statements?
A: The Qualified Intermediary will show as either the Buyer or Seller. You will send us the Estimate for our approval with a copy of the Exchangor's acknowledgement of same on the bottom. We cannot sign until this acknowledgement is received. Additionally we must receive the final closing statement immediately upon escrow closing showing our name as principal together with any other documentation requested in our instruction letter. We cannot complete our exchange file without these items. 1031 exchange rules.
Q: As the closing agent, how do I handle the money received and/or disbursed from the closing escrow transaction?
A: In the event your Buyer is the one doing an exchange that means that American Equity Exchange is already in receipt of exchange funds. You must contact our office to see if the initial deposit is coming from us as Intermediary or if the Exchangor/Buyer will be depositing it directly. Often the Buyer will need to come up with money in addition to the exchange proceeds to complete the purchase. If American Equity Exchange gives you the initial deposit, you should show us on the receipt and your original Closing Escrow Instructions. However, most of the time, you will be receiving an initial deposit directly from the Exchangor/Buyer and they will be shown as the Buyer until American Equity Exchange has been substituted in as Buyer at a later date. CAUTION: In this event, your closing statement will need to show a line item as "return of initial deposit to Exchangor" in order to clarify to IRS that the Exchangor did not have any constructive receipt of funds. Furthermore, any and all proceeds and/or refunds that you prepare in your escrow must be made payable to American Equity Exchange, even if they are after the close of escrow or you will jeopardize the exchange. Remember that once American Equity Exchange is substituted in as either buyer or seller, American Equity Exchange is the principal. This is very important to remember so that you always keep our office informed.
Q: How do we handle the situation where the Seller is doing an Exchange and they will be carrying back a note and deed of trust or mortgage?
A: In this situation, you must communicate clearly with the Exchangor/Seller, their tax advisor, and our office as to the proper structure of the transaction. If the trust deed or mortgage is to be part of the Exchange, you will show American Equity Exchange as your Beneficiary. Then, through our exchange file, we will handle the assignment of same to the Exchangor/Seller or to whomever it will eventually be assigned. Sometimes the trust deed or mortgage will roll into the Exchangor's "replacement property." If the trust deed or mortgage is not to be a part of the Exchange (typically because the Exchangor/Seller elects installment sale treatment for the trust deed or mortgage) then it is very important that your closing statement reflect the percentage interests and that you prepare an amendment in your closing escrow regarding same.
Q: What is the Qualified Holding Period for a property that was purchased through a 1031 exchange?
A: There is no hard & fast role on this subject. Many people believe two years is necessary. The taxpayer has to intend to hold the property for investment or income producing purposes when the property is acquired. If there is a bona fide intent to meet the holding requirement, the qualified use period may be less. The taxpayer should consult with their tax advisors on their issue.
Q: How much do I need to spend of the exchange value to receive full non-recognition of capital gain?
A: To receive full non-recognition of capital gain you need to spend equal or greater the amount of the exchange value.
Q: When selling a piece of property can it be vested differently than when buying a piece of property?
A: No, when doing a 1031 exchange the vesting in the replacement property must be the same as the vesting in the relinquished property.
Handling Tax Basis in a 1031 Exchange
One area in which we get a lot of questions, is about the handling of basis in a 1031 exchange. The questions go: “When I sell my Old Property, what happens to that basis?” “What about the depreciation I already took?” “If I fully depreciated my Old Property, will doing a 1031 exchange let me ‘freshen up’ my depreciation schedule?” “If I buy the New Property for 0,000, can I depreciate the whole 0,000?” Questions like these all relate back to what happens to the basis of the property when you do a 1031 exchange. 1031 exchange rules.
The first step in determining the basis on your New Property is the basis of your Old Property. Let’s take a simple example: Fred and Sue are selling their purple duplex. They bought it in 1995 for ,000, and they’ve taken ,000 of depreciation on the duplex since they bought it. Their tax basis in the duplex is ,000 (,000 minus ,000). They are selling it for 0,000 and have found a red condo to buy as their replacement property for their 1031 exchange. What is the basis in their red condo? And how is depreciation handled on the red condo?
Notice that they bought the red condo for the same price that they sold the purple duplex. This is an important fact because the purchase price of the New Property is one of the primary facts that affect the answer. The answer is because they “bought equal,” the basis in the new red condo is ,000 – the same as it was on the old purple duplex. In a 1031 exchange, the basis rolls forward from the Old Property (the purple duplex) to the New (the red condo). What’s more, on their future depreciation schedules, the purchase date for the red condo is 1995 (the date of the original purchase of the purple duplex), and the depreciation schedule carries over as if they were still depreciating the purple duplex.
The reason for this is because in the eyes of the IRS, what happens in a 1031 exchange is that you, in effect, still own the original property, except that the address and legal description for the property is now that of the red condo. In a 1031 exchange, the purchase date, holding period and depreciation schedule continue unaffected by the exchange; your basis in the red condo is the same as it was for the purple duplex.
Now, let’s change the assumptions and see what happens: instead of buying the red condo for the same price they sold the purple duplex, they buy a green office building for 0,000. In other words they bought up by ,000. Their basis in the office building is now ,000 which is the combination of the “rollover basis” of ,000 from the purple duplex and the ,000 buy up from the office building. Their depreciation schedule shows the continued depreciation of the purple duplex (as if they still owned it) and the acquisition of the office building portion as of the date they closed on the office building purchase.
What happens if they buy down? Instead of the office building, let’s say Fred and Sue buy a yellow, single-family rental house, for ,000. They sold the duplex for 0,000 and now they are buying down to ,000. Since the basis always rolls over, their basis in the rental house is ,000 – the same as the duplex. Because they bought down, the amount of the buy down (,000) is taxable. This is why I always say that “the gain comes first in a 1031 exchange. 1031 exchange rules."
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