The Tax Deferred Exchange
The tax deferred exchange, as defined in §1031 of the Internal Revenue Code, offers taxpayers one of the last great opportunities to build wealth and save taxes. By completing an exchange, the Taxpayer (Exchanger) can dispose of investment or business-use assets, acquire Replacement Property, and defer the tax that would ordinarily be due upon the sale. To fully defer the taxes on capital gain or depreciation, the Exchanger must (a) acquire “like kind” Replacement Property that will be held for investment or used productively in a trade or business, (b) purchase Replacement Property of equal or greater value, (c) reinvest all the equity into the Replacement Property, and (d) obtain the same or greater debt on the Replacement Property. Debt may be replaced with additional cash, but cash equity cannot be replaced with additional debt. Additionally, the Exchanger may not receive cash or other benefits from the sale proceeds during the exchange.
Effective January 1, 2018, IRC §1031 applies only to real property assets. It does not apply to exchanges of personal property, stock in trade, inventory, or property held for sale, such as property acquired and developed or rehabbed for purposes of resale.
An exchange is rarely a swap of properties between two parties. Most exchanges involve multiple parties: the Exchanger, the buyer of the Exchanger’s old (Relinquished) property, the seller of the Exchanger’s new (Replacement) property, and a Qualified Intermediary. To create the exchange of assets and obtain the benefit of the “Safe Harbor” protections set out in Treasury Regulations 1.1031(k)-1(g)(4) which prevent actual or constructive receipt of exchange funds, prudent taxpayers use a professional Qualified Intermediary and Real Estate Brokers with experience and expertise in facilitating IRS Code Section 1031 Exchanges.
The Exchange Process
Timing is important. Certain actions must be taken in sequence and exchanges must be completed within strict time limits.
- Prior to the transfer of the Relinquished Property, the Exchanger and a Qualified Intermediary, must enter into an Exchange Agreement which requires the Qualified Intermediary to (a) acquire the Relinquished Property from the Exchanger and transfer it to the buyer (by direct deed from Exchanger to buyer), and (b) to acquire the Replacement Property from the seller and transfer it to the Exchanger (by direct deed from seller to Exchanger).
- Also prior to the transfer of the Relinquished Property, the Exchanger must assign rights under the Relinquished Property sale contract to the Qualified Intermediary and provide notice of assignment to the buyer.
- At closing, net proceeds from the Relinquished Property sale (exchange funds) are paid directly to a Qualified Intermediary, to be held in a separate account for the benefit of the Exchanger until used to purchase Replacement Property.
- The Exchanger has 45 calendar days, from the date the Relinquished Property is transferred, to identify potential Replacement Properties. Identification must be specific and unambiguous, in writing, signed by the Exchanger, and delivered to the Qualified Intermediary or another party to the transaction as permitted by Treas. Reg. §1.1031(k)-1(c)(2) prior to the end of the 45-day Identification Period. The list of identified potential Replacement Properties cannot be changed after the 45th day; the Exchanger may only acquire from the list of identified properties. If no property is identified, the exchange funds will be returned to the Exchanger after the 45th day.
- Prior to the transfer of the Replacement Property, the Exchanger must assign rights under the Replacement Property purchase contract to the Qualified Intermediary and provide notice of assignment to the seller.
- The Exchanger authorizes a Qualified Intermediary, to wire funds directly to the seller or closing agent for purchase of Replacement Property, and the seller transfers title directly to the Exchanger, completing the exchange.
- Acquisition of Replacement Property must be completed by the earlier of the 180th day after transfer of the first Relinquished Property or the due date (including extensions) for filing Exchanger’s tax return. Any unspent exchange funds will be returned to the Exchanger at termination of the exchange.
When selecting a Qualified Intermediary and Real Estate Broker, the Exchanger must feel confident that their Qualified Intermediary and their Real Estate Brokers are professional companies with the competence and commitment to provide high quality service and security for exchange funds. The Von Raven Group has that experience and expertise to guide your through your 1031 exchange to a successful close.
A successful IRC §1031 exchange transaction requires planning, expertise, and support. The Von Raven Group can assists our clients by explaining the various types of exchanges, providing exchange documents, and helping you locate a qualified Intermediary. Laying the proper groundwork before entering into an exchange will avoid unnecessary obstacles and lead to a smooth transaction.
Tax Deferred Exchange Terminology
As with any other specific area of law, tax deferred exchanges under IRC §1031 have their own language, which may be confusing to those who are unfamiliar with these transactions. The following are some of the exchange terms and phrases that are often used with their “plain-English” interpretations.
Basis (Adjusted Basis): The amount paid for a property taking into consideration added value for capital improvements and decreased by the amount of depreciation taken (or allowable); it is the value of a property for tax purposes.
Boot: The fair market value of any non-qualified property received in an exchange. While receipt of boot will not necessarily disqualify the exchange, an Exchanger who receives boot in an exchange transaction generally recognizes gain to the extent of the value of the boot received. Some common examples of boot are: cash, debt relief that is not offset with new debt, property intended for personal use, and property which is not like-kind to the Relinquished Property.
Constructive Receipt: A term referring to the control or ability to receive proceeds by an Exchanger even though funds may not be directly in the Exchanger’s possession.
Delayed Exchange: The most common exchange structure is the delayed “forward” exchange in which the Relinquished Property is sold, the proceeds (Exchange Funds) are delivered to the Qualified Intermediary and are subsequently used to acquire Replacement Property from a third-party seller. Two critical requirements in a delayed exchange are that the Replacement Property must be properly identified within the Identification Period and acquired before the end of the Exchange Period. IRC §1031(a)(3); Treas. Regs. §1.1031(k)-1(b)-(e).
Exchange Accommodation Titleholder: The person or entity used to facilitate a “reverse” or “improvement” exchange. The Exchange Accommodation Titleholder (EAT) will hold (park) title to either the Relinquished or the Replacement Property during the exchange.
Exchange Period: The period during which the Exchanger must acquire Replacement Property in the exchange. The Exchange Period starts on the date the Exchanger transfers the first Relinquished Property and ends on the earlier of the 180th day thereafter or the due date (including extensions) for filing the Exchanger’s tax return for the year of the Relinquished Property transfer.
Exchanger or Taxpayer: The property owner seeking to defer taxes on capital gain, depreciation, or other income tax by utilizing an IRC §1031 exchange.
Forward Exchange: The most common form of exchange transaction in which the exchange begins with the transfer of the Relinquished Property to a buyer and concludes with acquisition of Replacement Property from a seller (typically a third party).
Identification Period: The period during which the Exchanger must identify Replacement Property in the exchange. The Identification Period starts on the day the Exchanger transfers the first Relinquished Property and ends at midnight on the 45th day thereafter.
Improvement Exchange: An exchange in which improvements are made to the Replacement Property prior to acquisition by the Exchanger, either using exchange funds or funds lent by the Exchanger (or lender) to the Exchange Accommodation Titleholder (EAT).
Like-Kind Property: Properties having the same or similar nature or character, regardless of differences in grade or quality. Generally, all real property located within the United States is considered to be “like-kind” to all other U.S. real property as long as the Exchanger’s intent is to hold the properties as an investment or for productive use in a trade or business.
Qualified Intermediary: The person or entity that facilitates the exchange for the Exchanger. Although the Treasury Regulations use the term “Qualified Intermediary,” other common terms are “exchange facilitator” or “exchange accommodator”. To be a Qualified Intermediary, the exchange facilitator must meet certain criteria spelled out in Treas. Reg. 1.1031(k)-1(g)(4).
Realized Gain: The amount realized from the sale of property which is potentially subject to tax; it equals the gross sales price minus the closing costs minus the adjusted basis.
Recognized Gain: The amount of the realized gain that is subject to tax. In a taxable sale (no 1031 Exchange) the realized gain is all recognized. In a fully deferred 1031 Exchange, no gain is recognized; the realized gain is deferred.
Relinquished Property: The “old” property divested (sold) by the Exchanger.
Replacement Property: The “new” property acquired (purchased) by the Exchanger.
Reverse Exchange: An exchange involving an Exchange Accommodation Titleholder (EAT) when it is necessary for the Replacement Property to be acquired before the Relinquished Property can be sold to a Buyer, or when improvements must be made to the Replacement Property before it can be acquired by the Exchanger.
Simultaneous Exchange: In a simultaneous exchange, the old Relinquished Property and the new Replacement Property are transferred concurrently between the two trading parties or with the use of a Qualified Intermediary