Questions relating to a standard 1031 exchange come first. Questions on more complex exchanges follow.
Please consult with us to ensure that these answers will apply to your specific transaction. Each 1031 exchange is different and should be handled on a case by case basis.
Specific 1031 Questions
I have just sold investment real estate for $400,000 and ADE is holding net proceeds of $200,000 which should cover the cost of my chosen replacement property. If I have reinvested all of my cash proceeds, will there still be any tax consequences?
Yes. Based on your description, there would be a tax consequence. In order to defer all taxes in an exchange, you must meet several requirements:
- All the proceeds from the relinquished property sale must be used in the replacement property acquisition; and
- Any new debt on the replacement property acquisition must equal or exceed the debt that was paid off or assumed on the relinquished sale.
An easier rule of thumb is the replacement property costs must equal or exceed the price of the relinquished property and you must use all of the proceeds to get total gain deferral. In this instance, it appears there must have been approximately $200,000 worth of mortgage that was paid off on the sale (sold for $400,000 but net proceeds of $200,000). Because you only acquired a $200,000 replacement property, you used all of your cash but you failed to replace the debt that was paid off. Because your new property cost $200,000 less than your old property, you have created what is referred to as “mortgage boot” which is taxable to the extent of the gain.
Exchange Time Period
I am getting ready to begin my first exchange. Are there any situations in which the exchange period can be something other than 180 days?
Although the vast majority of exchange periods are 180 days long (as per IRS guidelines), shorter variations can occur when the sale of your relinquished property occurs between October 15thand December 31st and also depending on when you file your tax return. The IRS stipulates that the exchange period ends on the 180th day or the filing date of your tax reporting period----whichever comes first.
Holding Period for Relinquished Property
How long must I own a property before it qualifies for a 1031 tax-deferred exchange?
There is no minimum time that a taxpayer must own a property in order to properly complete a 1031 exchange. Many tax professionals feel that if a relinquished property would qualify for long-term capital gains treatment (i.e. it has been owned for at least one year), an investor is safe in seeking 1031 exchange treatment. As background, the IRS has twice requested, in 1989 and again in 1997, that Congress implement a minimum one-year holding period for property to qualify for a 1031 exchange. Neither of these requests were approved by Congress, so there is no statutory minimum ownership period that applies.
Please be aware, however, that certain types of real estate do not qualify for 1031 exchanges. These include “flip property” which is property held primarily for sale or any property that would be considered “inventory”. How long a property is owned by a taxpayer is one just one of the factors that is analyzed when determining whether or not a property qualifies. Other criteria that come into play relate to the original intent of the taxpayer, actual marketing activities, and how the property is reported for federal income tax purposes. It is important that these additional elements be considered along with the length of time the property is held to determine the viability in executing of 1031 tax- deferred exchange.
Like- Kind Definition
I've heard tax deferred exchanges referred to as "like-kind" exchanges. I am selling a piece of undeveloped land and want to buy a small apartment building. Would these two properties be considered like-kind?
Yes. The "like-kind" definition for real estate is very broad. The IRS Code defines "like-kind" as any property “held … investment.” So by definition, any investment real estate falls under the definition of property held for investment. Because of this flexibility, a rental condo can be exchanged for an apartment building or a distribution warehouse can be exchanged for several tracts of undeveloped land. The type of investment real estate and even the number of properties sold or acquired need not be the same.
I am selling a triplex I primarily hold for investment, but I live in one of the three units. The contract price is $750,000. Am I eligible to do a 1031 exchange on this transaction?
Yes, you can. The unit that you are living in would be considered your primary residence. As long as you have owned and lived in the property for at least 2 of the past 5 years, you would be able to use the primary gain exemption on the sale of that portion of the triplex. (Under Section 121 of the IRC, the exemption is $250,000 if you are single and $500,000 if you are married). As the other two units are rental units, they would be treated as qualified property for a 1031 exchange.
Partial Use of Proceeds
Although I intend to use the majority of my exchange proceeds to acquire another investment property, I would like to keep some of the cash. Can I do this without invalidating my entire exchange?
Yes. If you would like to keep a portion of the proceeds, you can opt to complete a "partial" exchange. Tax would be due on the portion of cash that you keep. (For other items that can trigger a taxable consequence in an exchange, see a related question below.) In order to derive the maximum exchange benefits, however, you would need to reinvest 100% of the cash.
Property Identification- Methods
I have just started my exchange and am looking for replacement property. I understand that I have 45 days to identify these properties. How are the properties properly identified?
Replacement property must be identified in writing and delivered to a party who is (i) not considered "disqualified" and (ii) directly related to the transaction by midnight on the 45th day following the sale of the relinquished property. A "disqualified" party is any person who is or has been the taxpayer's agent by acting as his employee, attorney, accountant, investment banker or broker, or real estate agent within two years prior to the closing of the relinquished property. Blood relations are also considered "disqualified". Typically, an exchanger sends his or her identification to a qualified intermediary.
Property Identification- Number Allowed
Is there any limit to the number of properties that I can identify?
Basically, there are three ways to identify property:
- Identify three properties of any value; you may acquire any or all as replacement properties.
- Identify four or more properties with an aggregate value no greater than two times the value of the property(s) that you sold (200% Rule), you may acquire any or all as replacement properties.
- Identify four or more properties of any value, but you must acquire at least 95% value of these identified properties (95% Rule).
Qualified Intermediary- Definition
What is a Qualified Intermediary (QI)?
A Qualified Intermediary (QI) is an independent party who facilitates tax-deferred exchanges pursuant to Section 1031 of the Internal Revenue Code. The QI cannot be the taxpayer or a disqualified person.
- Acting under a written agreement with the taxpayer, the QI acquires the relinquished property and transfers it to the buyer.
- The QI holds the sales proceeds, to prevent the taxpayer from having actual or constructive receipt of the funds.
- Finally, the QI acquires the replacement property and transfers it to the taxpayer to complete the exchange within the appropriate time limits.
Qualified Intermediary- Who Can Serve
I am considering a 1031 exchange, but have gotten conflicting information about who can serve as my Qualified Intermediary (QI). Are there regulations regarding this role?
There are rules governing who can serve in this role. The identity of the QI is an important element of a 1031 exchange. If you have had a relationship with any of the following persons within the last two years, they are considered disqualified: your attorney, CPA, real estate broker, investment banker or employee of the taxpayer. Also, anyone that is directly related to you by blood or who is related for tax purposes as more clearly defined under Section 707(b) or 267(b) of the Internal Revenue Code would be considered disqualified and cannot serve as the QI.
Tax Reporting on a 1031 Exchange
How do I report a 1031 exchange on my tax return?
You or your tax professional should use IRS form 8824, "Like-Kind Exchanges". Usually, you would report the transaction in the year the relinquished property was sold. Some of the information required includes a description of the properties sold and acquired and the date of your ID letter. Additionally, the form will ask if a related party was involved in either the sale of the relinquished property or the acquisition of the replacement property. Reporting requirements are further outlined in IRS publication 544.
Qualified Intermediaries are not required to report 1031 transactions. The only related exception is if the QI is directly paying you interest on funds held. If so, the QI will report interest earned by sending you a 1099 and filing a report with the IRS on the interest earned.
I sold my property in September, 2011 and planned to do a 1031 exchange. However, I did not acquire any property and eventually received my sale proceeds back from the qualified intermediary in March, 2012. Do I report my gain on the sale of my relinquished property in the year I sold it (2011) or in the year I received the cash (2012)?
It depends on the unique details of your situation. Under the installment sale tax reporting rules outlined in IRC Section 453, you may be able to report the gain in the year you received the cash (2012). But, if you had any recapture of depreciation or a mortgage that was paid off on the relinquished property, you may still have to report certain tax consequences in the year it was sold (2011). Please seek the advice of your tax professional on how to report the transaction if the relinquished sale and receipt of exchange proceeds straddles tax years.
I purchased some rare gold coins in a collection about 10 years ago. Since that time, they have risen in value dramatically. Can I do an exchange on this type of asset to defer the tax that would be due if I sell the coins outright?
Yes, and given the higher 28% tax rate on gold and silver, it’s a great idea to consider.Gold- if held for investment or business purposes and not purchased for dealing or trading- can constitute qualified property. However, in order to meet the like-kind standard, the new gold must be purchased in the same form as the gold investment you relinquish. To comply with the exchange rules, you must exchange within the same narrow category.
I would like to have my replacement property built. Is that allowed?
Yes- but since the value of the property at the time you acquire it as your replacement property is the value that is considered when calculating tax consequences, you would employ a "construction exchange" in order to include the value of improvements being built on the property. To maximize your tax deferral benefit, the value of the replacement property must equal or exceed the relinquished property value. By utilizing a construction exchange, in which an accommodation titleholder purchases the property and holds it while improvements are being constructed, you can increase the value of the replacement property to include improvements that can be built during the 180-day exchange period. The amount of funds used for the initial acquisition and for improvements built during the exchange period will comprise the replacement property value when you acquire it from the accommodation titleholder at the end of the exchange.
I currently own a diner. I have recently entered into a contract to sell my restaurant, the underlying land, and most of my equipment. I'd like to buy another restaurant nearer to my home. Would an exchange be beneficial to me?
A multi-asset exchange might prove very beneficial. Your transaction includes two components: real estate and personal property. If the personal property portion is significant, you may want to consider this exchange technique. Although the definition of like-kind is much narrower for business equipment, many times the tax savings is equal to or greater than the deferral of taxes on the real estate portion of the transaction. With careful planning, this type of transaction allows an investor to reap the benefits of an exchange even when both types of property are included in one transaction.
Personal Property Exchange
I play for a national symphony. The violin that I currently own has greatly appreciated since I bought it ten years ago. I want to upgrade my instrument, but am fearful of the tax consequences. Is this violin the type of personal property that can be exchanged?
Surprisingly, a large number of personal property items can qualify to be exchanged. In your case, a musical instrument would be considered property used in a trade or business and is therefore eligible. In a properly structured exchange, you could sell your current instrument and upgrade to a new violin without incurring any tax.
Although I'd like to exchange, my timing appears all wrong. Because of circumstances beyond my control, I have to buy my new property on July 1st, but can't close the sale of my existing property until September 30th. The seller won't extend my closing date to allow a standard delayed exchange. What can I do?
You should consider a reverse or "parking" exchange. The IRS regulations allow the use of an Accommodation Titleholder (AT) that will acquire and basically “park” the property that you wish to as your replacement property to complete your exchange. When you sell your existing property, the "warehoused" property is sold to you, completing the exchange. When the timing turns upside down, a parking exchange may be an excellent strategy to save the benefits that could be gained from an exchange.
Reverse Construction Exchange
I am considering an improvement or construction exchange, but I am afraid that the time needed to get the building permits and necessary improvements in place will exceed the 180 days allowed. Is there a solution?
A reverse construction exchange is essentially a combination of the two techniques mentioned above. It may be appropriate when (1) the replacement lot must be closed before the relinquished property can be sold or (2) when it will take more than 180 days to construct the desired improvements to the replacement property. With this type of technique, a third party, typically established by a qualified intermediary, will acquire the lot well in advance of the sale of the property that you currently own. This would give you a head start on the approval and building process and help you meet the 180 day requirement.