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Frequently Asked Questions
Every Section 1031 Exchange transaction is different. These "Frequently Asked
Questions" are intended to answer general inquiries. The application of these
principles will depend on the specific facts of each transaction. Always consult
a competent Qualified Intermediary, attorney, or tax advisor to determine how an
exchange may be structured to accomplish your investment objectives.
Q - What is a tax-deferred exchange?
In a typical transaction, the property owner is taxed on any gain realized from
the sale. However, through a Section 1031 Exchange, the tax on the gain is deferred
until some future date.
Section 1031 of the Internal Revenue Code provides that no gain or loss shall be
recognized on the exchange of property held for productive use in a trade or business,
or for investment. A tax-deferred exchange is a method by which a property owner
trades one or more relinquished properties for one or more replacement properties
of "like-kind," while deferring the payment of federal income taxes and
some state taxes on the transaction.
The theory behind Section 1031 is that when a property owner has reinvested the
sale proceeds into another property, the economic gain has not been realized in
a way that generates funds to pay any tax. In other words, the taxpayer's investment
is still the same, only the form has changed (e.g. vacant land exchanged for apartment
building). Therefore, it would be unfair to force the taxpayer to pay tax on a "paper"
gain.
The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the
replacement property is ultimately sold (not as part of another exchange), the original
deferred gain, plus any additional gain realized since the purchase of the replacement
property, is subject to tax.
Q - What are the benefits of exchanging v. selling?
• A Section 1031 exchange is one of the few techniques that allow you to defer taxes
due on the sale of qualifying properties.
• By deferring the tax, you have more money available to invest in another property.
In effect, you receive an interest free loan from the federal government, in the
amount you would have paid in taxes.
• Any gain from depreciation recapture is postponed.
• You can acquire and dispose of properties to reallocate your investment portfolio
without currently paying tax on any gain.*
*Generally, TIC investments are illiquid and there is no secondary market for the
sale of such investments.
Q - What is Tenant in Common (also known as Undivided Fractional Interest)?
Participation in a tenant in common (or undivided fractional interest) structure
allows investors to purchase an interest in a significant real estate asset, perhaps
larger than they could obtain individually. The investor acquires a percentage ownership
(title and deed) and receives passive rental income while receiving the tax benefits
of traditional real estate. The investors own and control the properties, rather
than a
third party. TIC ownership provides investors with the means for ownership diversity,
both in location and type, of their real estate portfolio.
Unlike partnership real estate, TIC ownership entitles each owner to the same ownership
rights regardless of the equity invested. This element of the investment structure
puts no individual owner (or group of owners) in direct control of the property
over any other investor(s). You can truly have all of the potential ownership benefits
of a large commercial asset with significantly fewer obstacles. As with any type
of investment real estate, the income from a fractional interest has the potential
to increase annually due to escalations inherent in most tenant leases. Of course,
should tenancy decline, income may fall as well.
Q - What are the requirements for a valid exchange?
• Qualifying Property - Certain types of property are specifically excluded from
Section 1031 treatment: property held primarily for sale; inventories; stocks, bonds,
or notes; other securities or evidences of indebtedness; interests in a partnership;
certificates of trusts or beneficial interest. In general, if property is not specifically
excluded, it can qualify for tax-deferred treatment.
• 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.
• 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
.
• 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.
Q - What are the general guidelines to follow in order for a taxpayer to 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.
• The debt on the replacement property must be equal to or greater than the debt
on the relinquished property.
• All of the net proceeds from the sale of the relinquished property must be used
to acquire the replacement property.
Q - When can I take money out of the exchange account?
Once the money is deposited into an exchange account, funds can only be withdrawn
in accordance with the regulations. The taxpayer cannot receive any money until
the exchange is complete. If you want to receive a portion of the proceeds in cash,
this must be done before the funds are deposited with the Qualified Intermediary.
Q - Can the replacement property eventually be converted to the taxpayer's primary
residence or a vacation home?
Yes, but the holding requirements of Section 1031 must be met prior to changing
the primary use of the property. The IRS has no specific regulations on holding
periods. However, many experts feel that to be on the safe side, the taxpayer should
hold the replacement property for a proper use for a period of at least one year.
Consult your tax or legal advisor for advice about your specific circumstances.
Q - What is a Qualified Intermediary (QI)?
A Qualified Intermediary 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.
Q - Why is a Qualified Intermediary needed?
The exchange ends the moment the taxpayer has actual or constructive receipt (i.e.
direct or indirect use or control) of the proceeds from the sale of the relinquished
property. The use of a QI is a safe harbor established by the Treasury Regulations.
If the taxpayer meets the requirements of this safe harbor, the IRS will not consider
the taxpayer to be in receipt of the funds. The sale proceeds go directly to the
QI, who holds them until they are needed to acquire the replacement property. The
QI then delivers the funds directly to the closing agent.
Q - Can the taxpayer just sell the relinquished property and put the money in
a separate bank account, only to be used for the purchase of the replacement property?
The IRS regulations are very clear. The taxpayer may not receive the proceeds or
take constructive receipt of the funds in any way, without disqualifying the exchange.
Q - If the taxpayer has already signed a contract to sell the relinquished property,
is it too late to start a tax-deferred exchange?
No, as long as the taxpayer has not transferred title, or the benefits and burdens
of the relinquished property, they can still set up a tax-deferred Exchange. Once
the closing occurs, it is too late to take advantage of a Section 1031 tax-deferred
exchange (even if the taxpayer has not cashed the proceeds check).
Q - Does the Qualified Intermediary actually take title to the properties?
No, not in most situations. The IRS regulations allow the properties to be deeded
directly between the parties, just as in a normal sale transaction. The taxpayer's
interests in the property purchase and sale contracts are assigned to the QI. The
QI then instructs the property owner to deed the property directly to the appropriate
party (for the relinquished property, its buyer; for the replacement property, the
taxpayer).
Q - 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.
Q - 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.
Q - 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.
Q - 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, or real estate agent within the two years
prior to the closing of the relinquished property. The identification cannot be
made orally.
Q - Can the proceeds from the relinquished property be used to make improvements
to the replacement property?
Yes. This is known as a Build-to-Suit or Construction or Improvement Exchange. It
is similar in concept to a reverse exchange. The taxpayer is not permitted to build
on property he already owns. Therefore, an unrelated party or parking entity must
take title to the replacement property, make the improvements, and convey title
to the taxpayer before the end of the exchange period.
Q- 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.
Q - 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.
Q - 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.
Q - 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.
Q - 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
Q - Can you sell rental property and reinvest it into rental property without
paying capital gains tax?
Unless you exchange properties in a qualifying like-kind exchange, you may not defer
the gain on the sale of your rental property by purchasing replacement property.
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