Answers to Your 1031 Exchange Questions
Provided by OREXCO Old Republic Exchange Company – last updated January 1, 2012
Information deemed reliable but not guaranteed. Consult with a tax advisor regarding all tax matters prior to buying or selling any property to be used in a 1031 tax deferred exchange
What does the term 1031 refer to? 1031 is the number assigned to the Internal Revenue Code Section that provides for the tax-deferred exchange of real and personal property.
What are “Safe Harbors”? This term refers to the rules established by the 1991 Treasury Regulations for ax deferred exchanges which provide that—if followed—the IRS will allow the exchange to qualify.
What is a Qualified Intermediary? An individual or business entity that provides the following functions/services in a 1031 exchange: (1) acquires the relinquished property from the exchanger and causes it to be transferred to the buyer; (2) holds the exchange proceeds to avoid exchangers’ actual or constructive receipt of funds; and (3) acquires he replacement property and causes it to be transferred to the exchanger.
Why use a Qualified Intermediary? Use of a Qualified Intermediary is sanctioned as a safe harbor by the IRS.
What is Like-kind? Real property is like-kind to all other real property, except foreign real property, as long as it is held for investment or the productive use in a trade or business. Personal Property must be either the same General Asset Class or Product Class or same nature and character.
How do I properly identify my replacement property? Property is properly identified only if it is unambiguously described in a written document signed by you and hand-delivered, mailed, faxed, or otherwise sent to the person obligated to transfer the replacement property to you or to any other person “involved in the exchange” (e.g. the Qualified Intermediary) other than you or a person disqualified under Treas. Reg. §1.1031(k)-1(k). Real property generally is unambiguously described if it is described by a legal description, street address, or distinguishable name (e.g. the Mayfair Apartment Building). If at the end of the identification period—45 days—you have identified more properties than permitted by IRC §1031, you are treated as if no replacement property was identified and your exchange will be disallowed.
What are the 45 and 180-day deadlines? Beginning with the close of the relinquished property, you have 45 days thereafter to identify the properties you intend to purchase and 180 days thereafter (or the due date for your tax return— whichever is earlier) to complete the acquisition of those properties. In addition, the 45-day identification period and the 180-day exchange period are calendar days. If the 45th day or 180th day falls on a weekend or holiday, the deadlines still apply. There are no extensions for Saturdays, Sundays, or legal holidays.
Is there any way to get an extension on the 45-day or 180-day deadlines? No extensions are allowed on the 45-day deadline. Your identification must be sent on or before midnight of the 45th day. With respect to the exchange period, it ends on the earlier of the 180th day or the due date (including extensions) of your tax return for the taxable year in which the transfer of the relinquished property occurs. Thus, if the exchange period is cut short by the earlier occurrence of your tax filing date, you may file for an extension in order to get the full 180-day exchange period.
What is Boot? Broadly defined, boot is anything given or received by the taxpayer that is not like kind or does not qualify under section 1031. Boot may be in the form of cash or a promissory note—i.e. cash boot or it may be in the form of debt—i.e. mortgage boot. Any boot received by the taxpayer in connection with the disposition of the relinquished property that is not offset by boot given on the acquisition of the replacement property is gain that must be recognized—i.e. taxed. Alternatively, if the taxpayer receives boot but does not offset that boot with boot given on the replacement property, there will be a taxable consequence to the extent of the boot received and not offset. Thus, it is important to understand the boot netting rules.
Boot netting rules:
1. Cash paid on the acquisition of the Replacement Property offsets cash received on the disposition of Relinquished Property;
2. Cash paid on the acquisition of Replacement Property offsets debt relief on the disposition of Relinquished Property;
3. Debt acquired/assumed on the Replacement Property offsets debt relief on the disposition of Relinquished Property. Caveat: Debt assumed on the acquisition of Replacement Property will NOT offset cash received on the disposition of Relinquished Property.
If I own a property with another investor, can I exchange my interest if he doesn’t want to? Yes. You should clearly allocate each investor’s interest in the property before you sell. The investor who wishes to exchange may do so, and the other investor may receive cash (taxable). It is, however, very important that the investors be clear on their intentions before entering into an exchange agreement with a Qualified Intermediary.
What is a partial tax exchange? If the equity in your investment property is $150,000 and you want to use only $100,000 to purchase your replacement property and take $50,000 out to buy a new car, you will have a partially tax-deferred exchange. The $50,000 cash you took to purchase the car is considered taxable cash boot.
May I take out my basis and reinvest only the gain? No. Both basis and gain must be reinvested to defer taxes. The IRS does not allow you to allocate a portion of the money as basis and a portion as gain. Any money received by the Exchanger will be considered boot and taxed at a capital gain rate.
What is the exchange value of the property? Simply stated, the exchange value is your sales price less your closing costs. The Exchanger is responsible for reinvesting the exchange value (i.e. the cash and loan amount) when they purchase the replacement property. (See section on Boot.)
How is a seller carry-back note handled in an exchange? The note and deed of trust must be drawn in the Qualified Intermediary’s name. During the exchange period, the note must be converted to cash, which cash is then added to the exchange proceeds to be applied to the purchase of the replacement property in one of the following three ways:
1. Sell the note to a third party for cash that is then added to the exchange proceeds; or
2. Obtain the agreement of the replacement property seller to accept the note as part of the purchase price of the replacement property; or
3. Accept only a short-term note that will be paid in full prior to acquisition of the replacement property.
I own a piece of property that includes my primary residence and a rental unit. Would it still qualify for an exchange? Yes, so long as you remain consistent with your past tax returns. Consult with your tax advisor to determine the percentage value of the property you have attributed to investment. You may exchange that portion of the value. See Revenue Procedure 2005-14 for guidance.
Can I defer capital gains tax when I sell my primary residence? No. However, you can exclude up to $250,000 of gain from taxation (or $500,000 if you are married) under IRC §121. Caveat: If you originally acquired your residence as investment property, you must have owned it for a total of 5 years and you must have resided in it for at least 2 of the last 5 years in order to take advantage of the $250,000/$500,000 exclusion. And, the normal $250,000 or $500,000 amount will be reduced based upon the prorated amount of time the property was used for investment purposes.
If I sell an investment property that I previously used as a principal residence, can I exclude gain under the §121 primary residence exclusion and defer investment gain under §1031? Yes. Revenue Procedure 2005-14 established the following rules for applying both sections:
1. §121 applied before §1031; and
2. Gain from depreciation may not be excluded under §121, but can be deferred under §1031; and
3. Boot will be taxed, but only to the extent it exceeds the §121 limitation.
Can I exchange with a related party? You can exchange with a related party subject to certain restrictions. If you buy your replacement property from a related party, or swap with a related party, the related party must also do an exchange and both of you must hold your replacement property for two years. If you sell to a related party, the related party must hold the property for two years and you must hold your replacement property for two years. Caveat: If a related party transaction or series of transactions was designed to avoid the application of the related party rules, the exchange will be disallowed. Related parties include brothers and sisters (whole or half blood), spouses, children, parents and any other ancestors, any lineal descendants, and corporations or other business entities in which you own more than 50% either directly—or indirectly through your family members. Related parties also include certain fiduciary relationships described in IRC §267(b).
Do I have access to my money during the exchange? No. The Treasury Regulations governing exchanges prohibits you from having actual or constructive receipt of the exchange funds during the exchange period. Only if you fail to identify replacement property in writing within the 45 day identification period, you may have your funds on the 46th day following your disposition. Otherwise, you must wait until you complete your exchange or until the expiration of the 180 day exchange period before you receive exchange funds. See Reg. 1.1031(k)-1(g) (6) commonly referred to as the “g6” restrictions or limitations.
Exchange Expenses: Exchange expenses are certain costs incurred in connection with selling property that reduce the amount the taxpayer is required to reinvest because paying for these costs reduces the taxpayer’s gain. The use of proceeds to pay some closing costs, however, may result in boot. Revenue Ruling 72-456 provides that brokerage commissions reduce the taxpayer’s gain and increase the basis of the replacement property. Private Letter Ruling 8328011 implies that other transactional expenses should be allowed (i.e. reduce gain) if paid from the proceeds in connection with the exchange. These allowable expenses are referred to as “exchange expenses” on IRS Tax Form 8824, but are not specifically listed anywhere. Most tax practitioners consider the following exchange expenses to be allowable for purposes of reducing realized gain and recognized gain: real estate commissions, exchange fees, legal fees, title and escrow fees and transfer taxes.
Provided by OREXCO Old Republic Exchange Company – last updated January 1, 2012
Information deemed reliable but not guaranteed. Consult with a tax advisor regarding all tax matters prior to buying or selling any property to be used in a 1031 tax deferred exchange
Tom Martin
Golden Gate Sotheby's International Realty
License Number
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Email: tom.martin@ggsir.com
