What is a 1031 Exchange?
It is the swap of like-kind real estate for other like-kind real estate, structured pursuant to Section 1031 of the Internal Revenue Code. In the context of real estate, like-kind means real property for real property. Raw land can be exchanged for an apartment complex; a commercial center can be exchanged for a single-family dwelling, etc.
When should I consider exchanging investment property?
It is wise to reserve the right to Exchange any time you dispose of a property. Current federal income tax law allows an investor to dispose of real property and acquire replacement real property without income tax consequences. One of the only remaining tools available today for sheltering tax dollars, Tax Deferred Exchanges are always worth considering if you plan to maintain an investment in real estate. Before you sell, consult your tax advisor to determine if an Exchange is appropriate for you.
If a property is highly depreciated, not performing as expected, located in a declining area, or no longer fits your financial goals and capacity it is time to consider selling so that you can replace it with property that meets your current financial capabilities and needs.
How did Amherst protect the funds it holds?
All Amherst accounts were governed by Qualified Trust Agreements. Exchange proceeds were held in trust for the benefit of taxpayer. Any instruction to move funds had to be signed by the taxpayer, attorney Trustee, and Amherst as Qualified Intermediary. Wiring into and out of individual Trust Accounts for each exchange ensured that funds remained transparent and could be easily monitored.
Funds were not commingled in a general account and then moved into sub-accounts. We only worked with banks willing to provide the extra service of receiving funds directly into and wiring directly from each segregated exchange trust account, making all Amherst accounts 100% transparent throughout the exchange process.
Amherst did not invest exchange funds to maximize its earnings or yours. Priority 1 was protection of principal.
How do I balance my Exchange to be sure I pay zero taxes?
1) The value of the Replacement Property should be of equal or greater value than the net value of the Relinquished Property (selling price reduced by qualifying closing costs and commissions). For planning purposes, use the gross selling price of the Relinquished Property when closing costs and commissions are not yet known.
You can deposit cash into escrow to offset non-qualifying payments such as insurance coverage after you own the Replacement Property. If exchange funds are used for such payments your CPA can separate them from your exchange and have you pay the tax due when your tax return is filed.
2) Any loan paid off at the close of the sale of the Relinquished Property is called Debt Relief. Any debt you are relieved of must be replaced in the purchase of Replacement Property.
- Adding cash out-of-pocket offsets Debt Relief
- Any combination of added cash and new debt offsets Debt Relief
What happens if I do not replace all Debt Relief?
The difference between Debt Relief and unreplaced debt is taxable.
3) Spend 100% of the net exchange proceeds.
What happens if I do not spend 100% of the net proceeds?
Unspent cash at the close of an exchange is taxable.
4) Ask your tax advisor to verify that all payments made through the close of each escrow qualify for exchange treatment.
What are the basic time and procedural requirements of IRC Section 1031?
1) The transaction must be structured as an Exchange. The sale and purchase must be contractually interrelated.
2) The exchange clock begins ticking with the close of the sale of the first Relinquished Property:
45-day Identification period
45 days after closing the sale of Relinquished Property, The Qualified Intermediary (QI) should receive a dated, signed list of potential Replacement Properties – unless all are purchased within the 45-day Identification Period.
180-day Exchange period
Within 180 days of closing the sale, the exchange must be completed.
3) Relinquished Property and Replacement Property must be qualifying
like-kind real property. This provision excludes personal-use property such as a primary residence or 2nd home foreign property if domestic property was sold dealer property (a dealer develops property or purchases property with the intent to make improvements and resell, rather than hold for long-term investment).
Foreign property can be exchanged for foreign property.
All other real estate is qualifying if it is defined as real property under appropriate state law.
An apartment complex can be exchanged for a single-family dwelling that will be rented to generate income; raw land can be exchanged for an office building…
4) The Exchanger may not have actual or constructive receipt of the funds during the Exchange. Any opportunity to use exchange funds, exercised or not, can be deemed constructive receipt.
How did Amherst structure a Tax Deferred Exchange?
Following the structure established in the famous T.J. Starker case and complying with all applicable amendments to the Tax Code, Amherst caused the sale(s) and purchase(s) in the exchange to be interrelated by becoming the substituted Seller of the old property referred to as the Relinquished Property, and the substituted Buyer of the new property referred to as the Replacement Property.
This isolates taxpayer from the sale(s) and the purchase(s) because the QI, not taxpayer, becomes both Seller and Buyer. The QI conveys the Replacement Property to taxpayer to complete the Exchange.
A step-by-step very basic Tax Deferred Exchange structure:
- Exchange documentation creates the necessary interrelatedness of all properties involved in the exchange. These exchange documents clearly set forth all following steps.
- Exchanger transfers the Relinquished Property to the QI.
- The QI completes the sale of the Relinquished Property to Buyer and receives and controls the funds generated by that sale.
- The QI places the exchange funds in a fully segregated bank account with a secure financial institution.
- The bank account, in the case of Amherst, was governed by a Qualified Trust Agreement which required 3 signatures to move funds from the bank to purchase Replacement Property. The required signers were Amherst, Exchanger and an attorney trustee.
- Exchanger must identify potential Replacement Property(ies) in writing within 45 days of the close of the sale of the Relinquished Property.
- Exchanger negotiates the purchase of properly identified property and directs the QI to purchase the Replacement Property.
- The QI purchases the Replacement Property and transfers it to Exchanger to complete the exchange within the 180-day IRS time limit.
- Unused exchange funds (Cash Boot) belong to Exchanger and can be paid at the close of the final purchase, or on the first business day following the 180th day, depending on circumstances specific to the exchange.
- If a loan was paid off at the close of the sale of Relinquished Property, exchanger was relieved of that debt and is required to replace it with a loan or the deposit of cash. Cash offsets Debt Relief. Any unreplaced Debt Relief (Debt Relief Boot) is equally as taxable as Cash Boot.
Can I identify more than one Replacement Property?
Within very clearly defined limitations called Safe Harbors, the IRS allows alternative Replacement Property identification. Safe Harbor 1) Up to 3 properties of any value may be designated; or, Safe Harbor 2) Called the 200% Rule, if more than 3 properties are identified, as many properties as desired can be designated provided their combined fair market values do not exceed 200% of the fair market value of the Relinquished Property; or, Safe Harbor 3) As many properties as desired can be identified, of any value(s), so long as 95% of all properties identified are actually purchased. 4) If the ID Letter limits the number of properties to be purchased, once taxpayer has purchased “all of the properties to which taxpayer is entitled”, after the 45th day, the exchange is closed and the QI can disburse any unused proceeds to taxpayer.
Check with your tax advisor to determine how you can comply when identifying multiple Replacement Properties. It is always a good idea to identify back-up properties.
Can the Replacement Property be improved using Exchange proceeds?
When taxpayer finds it advantageous to purchase a property of lesser value and use exchange proceeds, added cash or financing to improve that property, it is called an Improvement Exchange or Build-to-Suit Exchange. Amherst becomes the owner of record by purchasing the property from seller utilizing a portion of the exchange proceeds. Exchanger manages the construction project and submits approved invoices for payment by the QI utilizing exchange proceeds, construction loan funds or added cash. When all proceeds are used OR all intended improvements are completed OR the 180th day approaches, whichever comes first, the QI sells the improved Replacement Property to Exchanger for what it paid to purchase the property plus what it spent to improve and operate the property.
Is it possible to purchase the new property before the old property is sold?
When it is advantageous to acquire the Replacement Property before the Relinquished Property can be sold, an Exchange Accommodation
Titleholder (EAT) can purchase the Replacement Property (Exchange Last Format) OR the
Relinquished Property (Exchange First Format) using funds provided by taxpayer. This is a Reverse Exchange, a warehousing or parking arrangement whereby the property is held by an EAT until a buyer can be found for the Relinquished Property. Please refer to Reverse Exchange Basics for further information.
What properties qualify for exchange treatment?
In order to receive the tax sheltering benefits of an exchange, both the property being sold, and the new property being purchased must be held as an investment, or for productive use in a trade or business. The property must be purchased with the intent of holding for long-term investment.
Examples:
- A dentist’s dental office
- A manufacturer’s offices, production space, parking lot
- Raw land, productive orchard land, farmland
- Single family dwelling held as a rental
- Apartment complex
- Office building
- Shopping center
- Hotel, motel, bed and breakfast…
What properties do not qualify for exchange treatment?
Examples:
- Any personal use property (personal residence, 2nd home…)
- Property held by a developer for resale
- Land under development for resale
- Property purchased to fix-up and sell
- Stocks, bonds
- Notes whether secured or unsecured
- Partnership interests
- Foreign property of domestic property is being sold
- U.S. property if foreign property is being sold
What happens if an Exchange fails? When can funds be distributed?
An Exchange is terminated when an IRS requirement is not met, not because taxpayer has a change of mind and decides not to complete the Exchange. Once you are in an Exchange, an Exchange in not elective.
If the QI does not have a properly executed Letter of Identification in its possession on or before midnight on the 45th day, that QI will be contractually obligated to transfer all proceeds to taxpayer on the first business day following the 45th day, subject to applicable state withholding requirements, and the Exchange will be terminated.
If that QI receives a Letter of Identification, the 45th day passes, and funds remain in the exchange account, that QI is then contractually obligated to hold those funds for the purchase of properly identified Replacement Property for the full 180-day Exchange Period. Any unspent funds must be transferred to taxpayer on the first business day following the 180th day, subject to applicable state withholding requirements.