Free Real Estate Investing Reports

Non Qualifying Properties
- Personal Residences
- Dealer Property
- Partnership Interests
- Inventory

Reason to Exchanges
- Restoring Depreciation that will soon expire - by exchanging one property for another
of greater value.
- To upgrade size and/or quality of investment. An exchange can be utilized to combine the equity of one or more properties into a larger singular investment.
- To change investment location. An exchange can be executed in anticipation of market
trends to maximize appreciation potential.

General Requirements 

           Business or Investment Property.  The property sold (“relinquished property”) and the property received (“replacement property”) must both be held for productive use in a trade or business or for investment purposes.

           Property Excluded.  Neither property can be: stock in trade or other property held primarily for sale; stocks, bonds or notes; interests in partnerships; certificates of trust or beneficial interests; or choses in action.

           Like-Kind Property.   The relinquished property and the replacement property must be of “like kind.”  Generally speaking, any real property exchanged for other real property should qualify as like kind.  For example, an apartment house property can be exchanged for raw land.

            Exchange.  There must be an exchange of property, not a sale and a reinvestment of the proceeds in another property.

Types of Exchanges

           A simultaneous or two party exchange is an exchange in which the relinquished property and the replacement property are exchanged on the same date, with each party swapping its property in exchange for the other party’s property.  This type of exchange is not common in the real estate area.

           A non-simultaneous or two party delayed exchange is an exchange in which the taxpayer closes on the sale of the relinquished property on one date, but does not close on the purchase of the replacement property until a later date. The exchange is not simultaneous or on the same day. This is sometimes referred to as a "Starker Exchange" after a Supreme Court case which ruled in the taxpayer's favor for a delayed exchange.  A Starker Exchange is utilized where the taxpayer must close on the sale of the relinquished property but has not yet located or is not yet able to close on the purchase of the replacement property.  This is the most common type of exchange in the real estate area.

           A reverse exchange is an exchange in which the taxpayer needs or desires to close on the replacement property before he has found a buyer to buy his relinquished property.  Generally an intermediary takes title to the replacement property and holds or “parks” the property until the taxpayer has sold the relinquished property.  These are sometimes called “parking transactions.”

There are many ways to structure an exchange and with proper planning almost any transfer of real estate can be structured as an exchange.  However, like-kind exchanges must be carefully planned with appropriate documentation and adherence to the applicable Code provisions and Regulations.

Special Rules for a Starker or Non-simultaneous Exchange

The most popular form of exchange is a non-simultaneous or Starker exchange in which the taxpayer closes on the sale of the relinquished property and at a later date closes on the purchase of the replacement property. Section 1031 and the applicable regulations permit Starker exchanges with the use of a qualified intermediary and set out the procedures which must be followed.

A taxpayer who wants to do a Starker exchange under Section 1031 will typically market his property just as he would without consideration of the exchange. A sales contract is signed which contains language requiring the buyer to cooperate with the taxpayer in the intended exchange. Prior to closing, the taxpayer enters into an exchange agreement with a qualified intermediary which permits the qualified intermediary to substitute for the taxpayer in accordance with the requirements of the Code and Regulations. Among other things, the exchange agreement contains provisions for:  

           An assignment of the taxpayer's contract to the qualified intermediary.
           Payment of the proceeds of sale at closing to the qualified  intermediary instead of to the taxpayer.
           Deeding of the property directly by the taxpayer to the buyer.

After closing on the sale of the relinquished property, the taxpayer locates replacement property.  There are special rules relating to the manner of identification of the replacement property, time limitations on identification and acquisition of replacement property, and the use of qualified intermediaries.

Identification Period. The taxpayer must either close on replacement property or identify the Replacement property within 45 days from the date of transfer of the relinquished property. This requirement is satisfied if replacement property is received before 45 days has expired. Otherwise, the identification must be made in writing signed by the taxpayer and hand-delivered, mailed, faxed, or otherwise sent to the Qualified Intermediary, or other persons named in the regulations. After 45 days have expired, it is not possible to designate any additional replacement properties.

Identification Notice. The identification notice must contain an unambiguous description of the replacement property. This includes, in the case of real property, the legal description, street address or a distinguishable name.

The taxpayer may identify more than one property as replacement property but the maximum number of replacement properties that the taxpayer can identify is (i) any three properties regardless of their market values (the 3-Property Rule); (ii) any number of properties as long as the aggregate fair market value of the replacement properties as of the end of the identification period does not exceed 200% of the fair market value of the relinquished property (the 200 Percent Rule); or (iii) any number of replacement properties but only if the taxpayer receives identified replacement property constituting at least 95% of the aggregate fair market value of all identified replacement properties (the 95% Rule).

Exchange Period. The replacement property must be received and the exchange completed no later than the earlier of 180 days after the transfer of the Relinquished property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was transferred. The replacement property received must be substantially the same as the property which was identified under the 45-day rule described above. There is no provision for extension of the 180 day period.

If an exchange commences late in the tax year, the 180-day exchange period can end later than the April 15 filing date of the taxpayer’s tax return. If the exchange is not complete by the time for filing the tax return, the taxpayer must obtain an extension of time to file. If the taxpayer does not obtain an extension, the exchange period will end on the due date of the return.

Qualified Intermediary

During the exchange period, the taxpayer must avoid actual or constructive receipt of money or other property from the sale of the replacement property.  Any receipt of money or other property before the acquisition of the replacement property will disqualify the exchange.  This means that the taxpayer may not receive cash in hand, nor may the taxpayer derive economic benefit from cash or other property held by an intermediary in an exchange escrow account.  The funds in escrow cannot be pledged as security for a loan to the taxpayer.

Accordingly, at the closing on the sale of the relinquished property, a qualified intermediary (instead of the taxpayer) receives the cash proceeds and holds the proceeds in an escrow account for use in acquiring replacement property.

A qualified intermediary may not be the taxpayer or a “disqualified person.” The Regulations define a “disqualified person” as any “agent of the taxpayer”, meaning generally any employee, attorney, accountant, investment banker, real estate agent or broker who had such relationship with the taxpayer during the two year period leading up to the exchange, as well as family members.

The qualified intermediary enters into an exchange agreement with the taxpayer to acquire the relinquished property from the taxpayer, transfer the relinquished property to its buyer, acquire replacement property, and transfer the replacement property to the taxpayer.  The qualified intermediary holds the proceeds from the sale of the relinquished property and applies the proceeds to the acquisition of the replacement property. 

In practice, the taxpayer may enter into a contract to sell the relinquished property and thereafter assign the contract to the intermediary.  The deed may pass directly from the taxpayer to the buyer.  Similarly, the taxpayer may enter into a contract to purchase the replacement property.  The contract is then assigned to the qualified intermediary, the seller is notified of the assignment, and the replacement property is deeded directly to the taxpayer.

The exchange agreement should clearly spell out the intention of the taxpayer to engage in a tax deferred exchange, the duties and obligations of the qualified intermediary, and limit the right of the taxpayer to receive money or other property held by the qualified intermediary.

7 Steps for a Successful 1031 Tax Deferred Exchange

Step 1: Consult with your tax and financial advisors to determine if a tax deferred exchange is appropriate for your circumstances and compatible with your investment goals.

Step 2: Listing the Relinquished Property for sale with a licensed real estate broker. During the first step the Exchanger will list the Relinquished Property with a real estate broker. The broker/agent will disclose the intent to complete an exchange in the listing agreement.

Step 3: Offer, Counter Offer and Acceptance. The Exchanger enters into a contract with the Buyer for the sale/exchange of the Relinquished Property. The broker/agent discloses the Seller/Exchanger's intent to exchange into the Purchase Agreement and Receipt for Deposit.

Step 4: Open escrow for the Relinquished Property and coordinate with the Facilitator. The Facilitator prepares the exchange agreement and coordinates with the escrow holder to close escrow as Phase I of a tax deferred exchange. Important: The exchange agreement must be in place and signed by all parties prior to close of escrow. Additionally, all earnest money deposits should be placed with the title company.

Step 5: Replacement Property Identification. After closing escrow for the sale of the Relinquished Property, the Exchanger must identify all Replacement Property within 45 days from day after close of escrow.

Step 6: Contracting for the Replacement Property. After closing on the Relinquished Property the Exchanger has 180 days to acquire the Replacement Property. With the help of his or her agent the Exchanger enters into contract to purchase the Replacement Property from the Seller. In the contract to purchase the agent discloses the Exchanger's intent to complete the exchange and obtains the Seller's cooperation.

Step 7: Open escrow for the Replacement Property. The Facilitator prepares the Phase II Exchange Agreement and coordinates with the Replacement Property Escrow holder. The funds held in trust by the Facilitator are placed in escrow and the Replacement Property is purchased by the Facilitator from the seller. The Facilitator then transfers the Replacement Property to the Exchanger and the transaction is closed as Phase II of a delayed exchange.

Identification of Replacement Property
Regardless of the number of relinquished properties transferred by the Exchanger as part of the same exchange, the maximum number of replacement properties that the Exchanger can identify is as follows:

3 Property Rule: Three properties without regard to the fair market values of the
replacement properties.

Or

200 Percent Rule: Any number of properties as long as their aggregate fair market value as of
the end of the identification period does not exceed 200 percent of the aggregate fair market value of all the relinquished properties as of the date the relinquished properties were transferred by the Exchanger.

Exception
95 Percent Rule: Any number of replacement properties identified before the end of the identification period and received before the end of the exchange period, but only if the Exchanger receives before the end of the exchange period identified replacement property the fair market value of which is at least 95 percent of the aggregate fair market value of all identified replacement properties.

In Summary.

When an owner of real estate wants to dispose of one business or investment property and acquire another property, consideration should be given to structuring the transaction as a like-kind exchange under Section 1031.  With careful planning and appropriate documentation, most transactions can be structured as exchanges.  The savings realized by deferring taxes can be substantial.  However, an exchange should not be undertaken without a thorough consideration of all alternatives and discussion with the taxpayer’s accountants, attorneys and tax advisers.

Glossary of Terms

Accommodator: A principal involved in the exchange transaction who agrees to assist the exchanger to effect a tax-deferred exchange. Same as Facilitator or intermediary.
Accommodating Party: In an exchange of properties there is always a person or entity that steps in to accommodate or facilitate the exchange transaction. Depending on how the transaction is structured, the accommodating party may incur additional liability in their efforts to assist in the exchange.

Acquisition Property: Replacement property

Actual Receipt: When the Exchanger actually receives the funds from the sale of the Relinquished Property. Receipt of cash by the Exchanger before he receives the Replacement Property may be enough to destroy the tax deferred treatment of the transaction.

Adjusted Basis: Generally speaking the adjusted basis is equal to the purchase price plus capital improvements less depreciation. Transactions involving exchanges, gifts, probates and receiving property from a trust can have an impact on calculating the property's adjusted basis. The taxpayer's C.P.A. or tax advisor is the party to look to for these types of questions.

Boot: Boot is any type of property received or given up in an exchange that does not meet the like kind requirement. Generally speaking, receiving boot will trigger the recognition of gain and taxes. If the Exchanger receives boot, they will be taxed. Boot added or given up by the Exchanger does not necessarily trigger a taxable event. In a real property exchange, boot received is any type of property received by the exchange which is not real property held for investment or productive use in a trade or business.

Cash Boot: Cash Boot consists of cash and nonqualifying property. A car, a boat or receipt of the beneficial interest in a promissory note are all examples of Cash Boot.

Mortgage Boot: Mortgage Boot consists of the secured debt given up and received as part of the same exchange. If the exchanger increases the amount of debt on the Replacement Property verses the Relinquished Property, they have given mortgage boot. If the exchanger decreases the amount of debt on the Replacement Property verses the Relinquished Property, they have received mortgage boot. Generally speaking, mortgage boot received triggers the recognition of gain and it is taxable, unless offset by Cash Boot added or given up in the exchange.

Constructive Receipt: Even if the Exchanger does not actually receive the proceeds from the disposition of the Relinquished Property, the exchange will be disallowed if the Exchanger is treated as having constructively received the funds.

Delayed Exchange: Also called non-simultaneous, deferred and Starker. A delayed exchange is a tax deferred exchange where the Replacement Property is Received after the transfer of the Relinquished Property. In a delayed exchange the Exchanger must identify all potential Replacement Properties within 45 days from the transfer of the Relinquished Property and the Exchanger must Receive all Replacement Properties within 180 days or the due date of the Exchanger's tax return whichever occurs first.

Like-Kind Property: Refers to the nature of the property the Exchanger gives up or receives as part of the same tax deferred exchange transaction. In order to qualify as like kind the property given up or received must be held for productive use in a trade or business or held for investment to qualify as like-kind.

Realized Gain: Refers to a gain that is not necessarily taxed. In a successful exchange the gain is realized but not recognized and therefore not taxed.

Recognized Gain: Refers to gain which is subject to tax. When someone disposes of property at a gain or profit in a taxable transfer such as a sale, the gain is not only realized, but recognized and subject to tax.

Relinquished Property: The property given up by the exchange to start the 1031 exchange transaction. This property usually passes through an accommodator before transferring to the ultimate Buyer.

Reverse Exchange: An exchange where the Exchange acquires or gains control of the Replacement Property before disposing of the Relinquished Property.

Simultaneous Exchange: Also referred to as a concurrent exchange. A simultaneous exchange is an exchange transaction where the Exchanger transfers out of the Relinquished Property and Receives the Replacement Property at the same time.

Transfer Tax: A tax usually assessed by a city or county on the transfer of property. It may be based on equity or value. When structuring a multi-party exchange an exchange agreement will usually call for direct deeding to eliminate additional transfer tax.

April 15th
A taxpayer must identify replacement property within 45 days after the transfer of the relinquished property, and acquire the replacement property within the earlier of 180 days of the relinquished property closing, or the due date of the taxpayer's tax return.
This means that 1031 escrows that close after Oct. 18 will not have the full 180 days to acquire the replacement property unless the taxpayer files an extension.

Contact your CPA or tax attorney for advise.