Completing a 1031 tax deferred exchange can sometimes be overwhelming if it is your first time. Being prepared, and understanding the mechanics and rules associated with your exchange is instrumental in not only minimizing your exposure, but also in strategizing for the best results. Below are  questions and answers to hopefully provide you with the necessary information in successfully navigating through your exchange.

What are the benefits of exchanging vs. selling?

  1. A Section 1031 exchange is a technique available to delay or potentially eliminate taxes due on the sale of property that is held for use in productive trade or business or held for investment.
  2. By deferring the tax, you have more money available to invest in a replacement property. In effect, you receive an interest free loan from the federal government, and some states the state government, in the amount you would have paid in taxes.
  3. Any gain from depreciation recapture is postponed.
  4. You can buy and sell properties to recalibrate your investment portfolio without paying tax on any gain.

What are the most common types of exchanges

Delayed Exchange : The Delayed, or Starker exchange is the most common type of exchange today. The IRS formally recognized the delayed exchange for the first time in 1984. In this exchange, the relinquished property is sold at Phase 1 (Down Leg), and after a delay the replacement property is acquired at Phase 2 (Up Leg). There are time constraints and rules that must be followed for the exchange to qualify for deference. 
Reverse Exchange : A situation where the replacement property is acquired prior to transferring the relinquished property. The IRS has offered a safe harbor for reverse exchanges, as outlined in Rev. Proc. 2000-37, effective September 15, 2000. These transactions are sometimes referred to as “parking arrangements” and may also be structured in ways which are outside the safe harbor. 

What are the requirements for a lawful exchange?

  1. Qualifying Property – Certain types of real estate are specifically excluded from Section 1031 treatment: property held primarily for sale (traders or packagers who buy for quick resale); and interests in a partnerships
  2. Proper Purpose – Both the relinquished property and replacement property must be held for productive use in a trade or business or for investment. Property acquired for immediate resale will not qualify. The taxpayer’s personal residence will not qualify.
  3. Like Kind – Replacement property acquired in an exchange must be “like-kind” to the property being relinquished. All qualifying real property located in the United States is like-kind. Personal property that is relinquished must be either like-kind or like-class to the personal property which is acquired. Property located outside the United States is not like-kind to property located in the United States.
  4. Exchange Requirement – The relinquished property must be exchanged for other property, rather than sold for cash and using the proceeds to buy the replacement property. Most deferred exchanges are facilitated by Qualified Intermediaries, who assist the taxpayer in meeting the requirements of Section 1031.

What are the general guidelines to follow in order for a taxpayer to completely defer all the taxable gain?

  • The value of the replacement property must be equal to or greater than the  value of the relinquished property.
  • The equity in the replacement property must be equal to or greater than the equity in the relinquished property.
  • All of the net proceeds from the sale of the relinquished property must be used to acquire the replacement property.

What are the time restrictions on completing a Section 1031 exchange

  • A taxpayer has 45 days after the date that the relinquished property is transferred to properly identify potential replacement properties.
  • The exchange must be completed by the date that is 180 days after the transfer of the relinquished property, or the due date of the taxpayer’s federal tax return for the year in which the relinquished property was transferred, whichever is earlier. Thus, for a calendar year taxpayer, the exchange period may be cut short for any exchange that begins after October 17th. However, the taxpayer can get the full 180 days, by obtaining an extension of the due date for filing the tax return.

What if the taxpayer cannot identify any replacement property within 45 days, or close on a replacement property before the end of the exchange period?

Unfortunately, there are no extensions available. If the taxpayer does not meet the time limits, the exchange will fail and the taxpayer will have to pay any taxes arising from the sale of the relinquished property.

Is there any limit to the number of properties that can be identified?

There are three rules that limit the number of properties that can be identified. The taxpayer must meet the requirements of at least one of these rules:

  • 3-Property Rule: The taxpayer may identify up to 3 potential replacement properties, without regard to their value; or
  • 200% Rule: Any number of properties may be identified, but their total value cannot exceed twice the value of the relinquished property, or
  • 95% Rule: The taxpayer may identify as many properties as he wants, but before the end of the exchange period the taxpayer must acquire replacement properties with an aggregate fair market value equal to at least 95% of the aggregate fair market value of all the identified properties.

What are the requirements to properly identify replacement property?

Potential replacement property must be identified in writing, signed by the taxpayer, and delivered to a party to the exchange who is not considered a “disqualified person”. A “disqualified” person is any one who has a relationship with the taxpayer that is so close that the person is presumed to be under the control of the taxpayer. Examples include blood relatives, and any person who is or has been the taxpayer’s attorney, accountant, investment banker or real estate agent within the two years prior to the closing of the relinquished property. The identification cannot be made orally. Although the definition of like-kind is much narrower for personal property and business equipment, careful planning will allow the taxpayer to enjoy the benefits of an exchange for the entire relinquished property, not just for the real estate portion. 

What is a reverse exchange?

A reverse exchange, sometimes called a “parking arrangement,” occurs when a taxpayer acquires a Replacement Property before disposing of their Relinquished Property. A “pure” reverse exchange, where the taxpayer owns both the Relinquished and Replacement properties at the same time, is not allowed. The actual acquisition of the “parked” property is done by an Exchange Accommodation Titleholder (EAT) or parking entity. 

Is a reverse exchange permissible

Yes. Although the Treasury Regulations still do not apply to reverse exchanges, the IRS issued “safe harbor” guidelines for reverse exchanges on September 15th, 2000, in Revenue Procedure 2000-37. Compliance with the safe harbor creates certain presumptions that will enable the transaction to qualify for Section 1031 tax-deferred exchange treatment.  

How does a reverse exchange work

In a typical reverse (or “parking”) exchange, the “Exchange Accommodation Titleholder” (EAT) takes title to (“parks”) the replacement property and holds it until the taxpayer is able to sell the relinquished property. The taxpayer then exchanges with the EAT, who now owns the replacement property. An exchange structured within the safe harbor of Rev. Proc. 2000-37 cannot have a parking period that goes beyond 180 days. 

What happens if the exchange cannot be completed within 180 days?

If the reverse exchange period exceeds 180 days, then the exchange is outside the safe harbor of Rev. Proc. 2000-37. With careful planning, it is possible to structure a reverse exchange that will go beyond 180 days, but the taxpayer will lose the presumptions that accompany compliance with the safe harbor. 

What is the difference between “realized” gain and “recognized” gain

Realized gain is the increase in the taxpayer’s economic position as a result of the exchange. In a sale, tax is paid on the realized gain. Recognized gain is the taxable gain. Recognized gain is the lesser of realized gain or the net boot received. 

What is Boot

Boot is any property received by the taxpayer in the exchange which is not like-kind to the relinquished property. Boot is characterized as either “cash” boot or “mortgage” boot. Realized Gain is recognized to the extent of net boot received.

What is Mortgage Boot 

Mortgage Boot consists of liabilities assumed or given up by the taxpayer. The taxpayer pays mortgage boot when he assumes or places debt on the replacement property. The taxpayer receives mortgage boot when he is relieved of debt on the replacement property. If the taxpayer does not acquire debt that is equal to or greater than the debt that was paid off, they are considered to be relieved of debt. The debt relief portion is taxable, unless offset when netted against other boot in the transaction. 

What is Cash Boot?

Cash Boot is any boot received by the taxpayer, other than mortgage boot. Cash boot may be in the form of money or other property.

What are the boot “netting” rules?

  • Cash boot paid offsets cash boot received
  • Cash boot paid offsets mortgage boot received (debt relief)
  • Mortgage boot paid (debt assumed) offsets mortgage boot received
  • Mortgage boot paid does not offset cash boot received

What is the necessary holding period for your property to qualify for Section 1031? 

A currently unresolved issue is: How long must a taxpayer hold property in order for it to qualify for tax deferred treatment? The question applies both to the relinquished property and to the replacement property. A proposed amendment to Section 1031 would have required that both the original property and the replacement property be held for at least one year in order to qualify for tax-deferred treatment. Although that proposal failed, the one-year period which has been a rough rule-of-thumb used by those dealing with exchanges will continue to be used until a specific holding period is established by law or regulation.

The holding period is a fact or circumstance to be considered in determining whether the Purpose Requirement has been met. For example, if a replacement property is acquired and then immediately sold, that might indicate that the property was in fact acquired for resale and is therefore dealer property and consequently cannot qualify for tax-deferred treatment.

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