1031 Tax-Deferred Exchange

1031

History of Exchanges

The basic concept of tax-deferred exchanging was introduced into the Internal Revenue Code in 1921 in an attempt to eliminate a problem the Treasury Department was having with taxpayers reporting tax losses on barter-type two-party exchanges. This is the reason that taxpayers no longer have the option of reporting a qualifying exchange as either taxable or non-taxable. However, the barter-type exchange which caused so much administrative concern is significantly different from the kind of multi-party transactions that characterizes the present world of tax-deferred exchanging.

The first major change, which was a departure from the barter-type exchange, occurred in 1935 when the board of tax appeals rendered a decision in the case of Mercantile Trust Company of Baltimore vs. Commissioner. The exchange involved a property owner, the taxpayer, a buyer of the taxpayer’s property, and a seller of like-kind replacement property. It is interesting to note the transaction also involved a little company that acted as fourth party facilitator in the transaction. The taxpayer did not want to sell its property because of the tax consequences. Instead, they transferred their property to the title company, which in turn transferred it to the buyer. The title company took the buyer’s money and purchased the replacement property, and then transferred it to Mercantile. This was all carried out on a simultaneous basis. The key to the transaction was that all the legs of the transaction were carried out pursuant to appropriate contracts entered into between the respective parties.

The Board of Tax Appeals rejected the Internal revenue Service’s argument that the transaction did not give rise to an exchange because the title company acted as the agent of the buyer. The Tax Board held that the exchange did in fact meet the requirement of section 112 of the Internal Revenue Code [Section 112 was the forerunner of section 1031]. The courts reasoned that even if the title company was the agent of the buyer, it would not have mattered, because it still would have resulted in an integrated transaction in which the taxpayer received, and was entitled only to receive, like-kind replacement property, and not the buyer’s purchase price of the relinquished property.

The rule made in this case has not changed over the years and it still the rule today. ALL OF THE LEGS OR SEGMENTS OF AN EXCHANGE MUST CONSTITUTE AN INTEGRATED, MUTUALLY INTERDEPENDENT TRANSACTION. There has not been any significant change in the test enunciated in Mercantile in the entire 60 years since that decision.

What is 1031 Tax-Deferred Exchange?

The §1031 Tax Deferred Exchange is a method to achieving property diversification, and is one of the last tax shelters allowed by the Internal Revenue Service.  It is a transaction in which a taxpayer exchanges investment property for like-kind investment property, which defers the payment of Capital Gain Taxes and the Recapture of Deprecation Tax.  The IRS defines like-kind property as all real property held for investment purposes, or the productive use in a trade or business.  This basically includes any real estate held for investment except your primary residence and second family home.  This creates more buying power for the taxpayer than if the Capital Gains Tax was paid, and possibly creates a new schedule of additional Deprecation to take advantage of.  By deferring the payment of Capital Gains Tax, the taxpayer gets to invest the owed Tax dollars into the replacement property interest free from the IRS and State.  The 1031 Tax Deferred Exchange also avoids the California Withholding Tax.

The example below shows the significant advantage of exchanging. This is an example of a $1,000,000 investment property sale which has been fully depreciated with no debt. This assumes a combination of federal and state capital gains tax, including the recapture of depreciation.

Sales price: $1,000,000
Sale vs. Exchange
$75,000  Closing cost $75,000
$352,000 Taxes $0.00 [Deferred]
$573,000 Funds Left to invest $925,000

If the investor leverages his new property to 70% by putting 30% down, he could purchase properties totaling:

Acquisition Value:

$1,910,000 vs. $3,083,300

Selling and reinvesting via a 1031 Tax Deferred Exchange gave this investor increased portfolio growth of percent [64%]. Now the return on equity [ROE] is respectable and opens up the potential to earn a greater monthly return, greater income and greater return on investment [ROI].

Type of Exchanges

There are important rules which must be followed to effectuate a valid exchange. All in all there are Five [5] major types of tax-deferred exchanges:

Simultaneous, Delayed, Reverse, “Build to suit”, and Personal Property 1031 Tax Deferred Exchanges.

1- Simultaneous – A Simultaneous Exchange occurs when the relinquished (sale) property and the replacement (acquired) property are transferred concurrently. Taxpayers doing such an exchange often think it is acceptable if the two transactions close on the same day, and that this alone will satisfy the requirements of an exchange. Taxpayers who do not employ a Qualified Intermediary may be surprised to discover their transaction does not qualify for tax deferral, as without the Intermediary, the seller may be deemed to have “constructive receipt” of the sale money. The Qualified Intermediary creates the reciprocal trade by receiving the relinquished property and acquiring the replacement property. The Intermediary also provides the paper trail validating the flow and structure of the transaction and ensures the compliance with Treasury Regulations.

2- Delayed – A Delayed Exchange is much like the Simultaneous, but allows the taxpayer to close escrow on the replacement property at a later date than the relinquished property sale. There are some important rules which must be followed to effectuate a valid Delayed Exchange:

  • The exchange must be set up before the close of escrow on the relinquished (sale) property.
  • The taxpayer must identify the replacement (acquired) property within 45 days after the close of the relinquished (sale) property.
  • The taxpayer must acquire the replacement property within 180 days from the close of the relinquished property, or by the tax return filing of the relinquished property, whichever comes first.
  • The taxpayer must reinvest all net proceeds into the replacement property.
  • The taxpayer must obtain a debt of equal or greater amount on the replacement property.

3- Reverse Exchange – Reverse §1031 Tax-Deferred Exchanges are complex and intricate in nature.  Such an exchange permits the investor to acquire their replacement property before the relinquished property is sold, however the investor may not be on title to both properties simultaneously.  In September 2000 the IRS indicated that a reverse exchange would be permitted if the transaction fell within the scope of “safe harbor” protection.

The durational requirements of the “safe harbor” require the identification of the relinquished property within the 45-day identification period and the sale of the relinquished property within the 180 day exchange period.  The trigger date for these periods is the “parking” of either the relinquished or replacement property with an Exchange Accommodation Titleholder (EAT). The intermediary [Exchange Resources Inc. which we recommend using] arranges for one of its subsidiaries to function as an EAT.  Reverse exchanges are effectuated in one of two ways depending on which property is to be “parked”.  Under either scenario, the parked property must be held under a Qualified Exchange Accommodation Agreement, thereby allowing the investor to treat the EAT as the beneficial owner of the property for federal income tax purposes.

PARK REPLACEMENT PROPERTY ~ EXCHANGE LAST

Under this scenario, title to the replacement property is transferred to the EAT, and not the investor, at close of escrow.  The date of this transfer triggers the 45-day period to identify the property to be relinquished as well as the exchange period to sell the identified relinquished property.  Once the escrow on the relinquished property is ready to close, the EAT enters into a simultaneous exchange with the investor which transfers the title of the parked replacement property to the investor upon the transfer of the relinquished property to a third party buyer.

PARK RELINQUISHED PROPERTY ~ EXCHANGE FIRST

This scenario is more common when financing is obtained for acquisition of the replacement property.  Prior to the closing of escrow on the replacement property, the relinquished property must be transferred to the EAT.  This transfer to the EAT triggers the 45-day period to identify the property to be relinquished and the exchange period during which the identified relinquished property will be sold.  Accordingly, this transfer ideally takes place shortly before the closing of the replacement property.  The intermediary acquires the right to purchase the replacement property and causes it to be deeded directly from the seller to the investor in exchange for the investor’s transfer of the relinquished property to the EAT.  The relinquished property is subsequently sold to a third-party buyer within the exchange period with the EAT acting as the titleholder.

Revenue Procedure (REV. Proc.2000-37) provides a safe harbor for reverse exchanges entered into on or after September 15, 2000 provided the taxpayer does the following:

  1. The safe harbor allows a taxpayer to treat the Exchange Accommodation Titleholder (”E.A.T.”) as the beneficial owner of the property for federal income tax purposes. The parked property must be held under a Qualified Exchange Accommodation Agreement.
  2. The E.A.T. must hold legal title or similar ownership to the property being parked.
  3. The taxpayer must have the intent to park with E.A.T. either the relinquished or the replacement property as part of a 1031 tax deferred exchange.
  4. No later than five (5) business days after the transfer of ownership of the property to the E.A.T., the taxpayer and E.A.T. must enter into a written agreement indicating that this is an exchange and that the accommodating party will be treated as the owner of the property for tax purposes.
  5. Within 45 days after the transfer of ownership of the replacement property to the E.A.T., the taxpayer must identify the property to be relinquished.
  6. No later than 180 days after the transfer of ownership of the property (replacement or relinquished) to the E.A.T., the replacement property must be transferred to the taxpayer or the relinquished property to the ultimate to buyer.

An E.A.T. that satisfies the requirements of a Qualified Intermediary under the regulations may also enter into an exchange agreement with the taxpayer to serve as the Qualified Intermediary in a simultaneous or deferred exchange.   The taxpayer can guarantee some or all of the obligations of the E.A.T., including secured or unsecured debt incurred to acquire the replacement property. The taxpayer can also loan or advance funds to the E.A.T. The parked property can be leases by the E.A.T. to the taxpayer or enter into a property management agreement with the taxpayer.

4- Build to Suit – The taxpayer can choose to make repairs or build a structure as part of the replacement property. These types of exchanges can be complicated and very time consuming for everyone involved. The taxpayer must first identify the improvements to be made during the identification period, but the Qualified Intermediary must take title to the land in which the improvement will be built, and must contract for the repairs or construction. There are restrictions on how the sale funds can be handled, and the time periods for completion of the work and conveyance of the improved real property must be done prior to the expiration of the 180 day exchange limit.

5- Personal Property – A Personal Property Exchange allows the taxpayer to exchange planes, business, boats, and types of other personal property held for investment purposes or the productive use for trade or business, but the definition of “Like Kind” is more specific than that of real property.

Identification of Replacement Property

The taxpayer has 45 days from the close of the relinquished property in which to identify Replacement Property. When identifying replacement property, you have a choice between two rules.

First Rule: The first rule is known as the three-property rule.
The taxpayer may identify a maximum of three (3) replacement properties without regard to fair market value.

Second Rule: This rule is known as the 200% rule.

When identifying more than three (3) properties, the total aggregate value of all properties identified cannot exceed 200% of the relinquished property value (or twice the amount of sale price).

 

 

   

Example: Relinquished property sold for $200,000.00
2 x $200,000 = $400,000.00
[The taxpayer can identify a maximum of $400,000 in Replacement Properties].
123 Main Street, Anytown, TX Value $75,000
1031 USA Avenue, Anytown, WA Value $135,000
555 State Street, Anytown, NY Value $65,000
1212 Tax Alley, Anytown, CA Value $125,000
Total Value Listed $395,000

Once the taxpayer has located a “like-kind property the facilitator will be assigned into the Contract/Escrow Instructions as the buyer. When this transaction is ready to close, funds held by the facilitator will be deposited into the escrow to fund the closing. Should escrow require additional funds to close, the taxpayer can deposit funds directly into escrow. The replacement property must be acquired on or before the following dates:

  1. 180 from the date of the transfer of the relinquished property, or
  2. The date the tax return is due for the tax year in which the replacement property is transferred. The taxpayer has the right to request extension.

Contract Language

As a practical matter, many people list their property for sale, and at the time an offer is submitted, they inform the broker that they want to do a tax-deferred exchange. This is usually accomplished by the broker inserting a few words in the Purchase and Sale Agreement to the effect the “Seller” wants to do a tax-deferred exchange.

The following language should be inserted in the sales contract:

“Buyer hereby acknowledges it is the intent of the Seller to affect an IRC Section 1031 tax deferred exchange which will not delay the closing or cause additional expense to the Buyer. The Seller’s rights under this agreement may be assigned to Exchange Resources, Inc., a Qualified Intermediary for the purpose of completing such an exchange. Buyer agrees to cooperate with the Seller and Exchange Resources, Inc. in a manner necessary to complete the exchange.”

Final Word

When a tax-deferred exchange is the ultimate aim of the taxpayer, it is necessary that the taxpayer be restricted from any access or use of the proceeds from the disposition of his property. The essence of an exchange is the transfer of property between owners, while that of a sale is the receipt of cash for property – whether that receipt is actual or constructive if the taxpayer has–or could get–control of the cash.

1031 Tax-Deferred Exchanges is a serious matter. Any discourse or slightest aberration may disqualify the entire transaction.

Photo Credit: amagill

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