|
WHAT IS A 1031 EXCHANGE?
Internal Revenue Code Section 1031 provides that no gain or loss will be
recognized on the exchange of any type of business use or investment
property for any other business use or investment property. 1031 Exchanges
are not really exchanges in the context of two-party barter. Instead, they
are typical sales and purchases that involve the same exact ingredients as
any other sale or purchase, without the capital gains. The only real
difference is the investor is increasing his selling and buying power by
electing to avoid the drain of taxes under Section 1031 regulations. No
other aspects of the transaction are affected.
WHO SHOULD CONSIDER A 1031
EXCHANGE? Anyone who is thinking about selling a business use or
investment property should consider effecting a 1031 Exchange. An Exchange
offers the astute investor an opportunity to reinvest the federal capital
gains that would normally be handed over to the IRS and put that money to
work for himself. You work too hard to simply pay the tax without carefully
considering this reinvestment option. Essentially, 1031 Exchanges should be
thought of as an interest free loan from the IRS; one in which the principal
may be increased through subsequent exchanges and may never require
repayment, if you plan properly.
MISCONCEPTIONS ABOUT
EXCHANGING
1. Many still believe that you
must swap properties. Although this was required in the original code, this
is rarely done in present times. 1031 Exchanges now enable one to sell their
property to someone totally unrelated to the person from whom they are
purchasing their replacement
2. Many believe only investors
of large commercial properties can utilize the benefits of Section 1031. The
great thing about 1031 Exchanges is that it applies to all investment
properties, large and small. It will work the same way for a corporation
selling a large shopping center as it would for an individual selling a
single family home used as a rental property in a vacation area.
3. Many believe you must acquire
a property of "similar use or service." While 1031 exchanges are also known
as "like-kind" exchanges, like-kind simply applies to real property held for
business use or investment. Therefore, an investor may sell raw land and
acquire a five-unit apartment building or sell a warehouse and acquire raw
land. He can sell one property and acquire three or sell four and acquire
one. Virtually any type of real property used for business use or investment
will qualify.
4. Many believe 1031 exchanges
are very complicated and not worth doing. The fact is that when working with
a qualified intermediary who specializes in Section 1031 tax deferred
exchanges, the exchange process is very simple. The intermediary will keep
you aware of your time deadlines and ensure you do everything in strict
compliance with IRS regulations.
ADVANTAGES OF EXCHANGING
1. The Exchanger will have more
buying power because the federal income taxes are deferred. This will enable
him to leverage himself up greater than he could had he paid the tax
liability. The additional equity to reinvest will make him a more solid
buyer and help him get easier financing.
2. Investors can do exchange
after exchange to create a pyramiding effect. This tax liability is forgiven
upon the death of the investor as the heirs get a stepped up basis on the
inherited property.
3. The Exchanger will have
greater selling power because he does not have to inflate the sales price to
try to cover some of the capital gains that would normally be due upon the
sale of an investment property. It will enable him to be more flexible with
the selling price.
4. The Exchanger can acquire a
replacement property with greater income potential. He can sell raw land and
acquire income producing property. Perhaps, he wants to acquire a building
with additional units or in an easier to rent location.
5. The Exchanger has the
opportunity to consolidate several hard to manage properties in one easy to
manage property or diversify several small properties into one large
property. It provides an excellent opportunity to relocate or expand a
current business or investment. 6. An exchange can also help an investor
acquire a less management intense property.
BESIDES TAX REDUCTION, 1031
EXCHANGES CAN ACCOMPLISH MANY INVESTMENT GOALS
Estate preservation Increased
buying power because of greater cash flow Increased selling power because
the federal capital gain tax liability is deferred Exchange for property
with an increased income (more rental units, higher rental income per unit,
lower operating expenses, easier to rent location, etc.) The need or desire
to relocate a business or investment property Exchange for property that
requires less management Exchange for property that is easier to finance
Consolidate smaller properties into a larger property Diversify a large
property into several smaller properties The need or desire to expand a
business into a larger space All of the above culminates into one
significant power- The ability to create pyramiding wealth accumulation in
real estate ownership. SLIGHT DISADVANTAGE The basis of your replacement
property will be lowered by the amount of gain deferred on the sale of your
relinquished property. However, when weighing this against the deferred
gain, the astute investor can clearly see he is still significantly ahead.
THE PROPERTIES IN THE
EXCHANGE RELINQUISHED PROPERTY
The relinquished property is the
business use or investment property the Exchanger owns and wants to sell via
the 1031 Exchange. REPLACEMENT PROPERTY: The replacement property is the
business use or investment property the Exchanger wants to acquire to
complete the 1031 Exchange. There can be more than one of each of the
relinquished and replacement properties. For example, an Exchanger can sell
three small properties and purchase one large property or sell one large
property and acquire four smaller ones. An Exchanger does not have to
purchase the same type of property. For example, he can sell a storage
facility and acquire an apartment building or sell a raw piece of land and
acquire a shopping center.
THE PARTIES INVOLVED IN THE
EXCHANGE EXCHANGER
BASIC REQUIREMENTS OF
EXCHANGES
1. BOTH PROPERTIES MUST BE
"LIKE-KIND". Like-kind simply means real property. Like-kind refers to the
nature or character, not its grade or quality. Like-kind is a very broad and
liberal category where just about any type of investment or business use
property would qualify. Properties can be located anywhere within the United
States with Exchanges taking place in one or more states. Examples of
like-kind: rental properties (single family homes, duplexes, triplexes,
apartment buildings and complexes, etc.), raw land, office buildings,
shopping centers businesses, marinas, golf courses, a lease of at least 30
years including options, parking lots, farms, factories, trailer parks,
storage facilities, retail stores, interest in a co-tenancy. Examples of non
like-kind: stocks, bonds, notes, interest in a partnership, personal
property, certificates of trust, chooses in action. Investors can "mix and
match" their properties. For example, an investor can sell a duplex and
acquire raw land or sell a parking garage and acquire a multi-unit apartment
building and a warehouse.
2. BOTH PROPERTIES MUST BE HELD
FOR INVESTMENT OR BUSINESS USE. Your use of both the relinquished property
and replacement property must be investment or business use; each for a
minimum of one to two years. Properties must not be used for personal use
for more than 14 days per year or 10% of the actual number of days the
property has been rented in a given year. Replacement property cannot be
purchased with the intent to sell immediately.
3. EXCHANGER MUST USE A
QUALIFIED INTERMEDIARY OR FACILITATOR. One of the safe harbors of the
regulations is the use of a qualified Intermediary to facilitate the
Exchange. The sale of the relinquished property and the acquisition of the
replacement property must "flow" through the Intermediary. This is done
through direct deeding to avoid duplicate transfer taxes. The qualified
Intermediary may not be the taxpayer or an agent of the taxpayer (realtor,
attorney, tax advisor, banker, accountant, employee, etc.) or lineal
descendant of the Exchanger.
4. EXCHANGER MUST USE A
QUALIFIED ESCROW AGENT AND HAVE NO ACTUAL OR CONSTRUCTIVE RIGHTS TO THE SALE
PROCEEDS OF THE RELINQUISHED PROPERTY. The qualified Escrow Agent may not be
the taxpayer or an agent of the taxpayer (realtor, attorney, tax advisor,
banker, accountant, employee, etc.) or lineal descendant of the Exchanger.
The Exchanger must not have access to the sale proceeds of the relinquished
property. The Exchanger is entitled to all earnings on the escrow funds.
These taxable funds must also be restricted in the same manner as the
principle. The Exchanger chooses the Escrow Agent. The Exchanger is entitled
to obtain security for his funds.
5. THE PROPER DOCUMENTATION MUST
BE USED IN ORDER TO COMPLY WITH 1031 REGULATIONS. 1031 EXCHANGE AGREEMENT
BETWEEN THE EXCHANGER AND THE INTERMEDIARY This is the most important
document in the Exchange. It is the document in which the Exchanger gives
the Intermediary the right to acquire the relinquished property from the
Exchanger and convey it to the buyer. It also gives the Intermediary the
right to acquire the replacement property from the seller and then convey it
to the Exchanger. 1031 EXCHANGE ESCROW AGREEMENT BETWEEN THE INTERMEDIARY
AND ESCROW AGENT If 1031 Corp. is acting as both your Intermediary and
Escrow Agent, the Escrow Agreement will be incorporated into the 1031
Exchange Agreement between the Exchanger and the Intermediary. 1031 EXCHANGE
AMENDMENT AND ASSIGNMENT FOR THE ROLLOVER OF THE RELINQUISHED PROPERTY
Assigns the Exchanger1s rights in the Agreement of Sale with the buyer to
the Intermediary. Serves as written notification to the buyer of the
relinquished property of Exchanger1s intent to effect a 1031 Exchange and
also provides a hold harmless clause to assure the buyer that there are no
additional liabilities or costs to him. If a 1031 Exchange Clause is
inserted into the Agreement of Sale, this document is unnecessary. 1031
EXCHANGE AMENDMENT AND ASSIGNMENT FOR THE ACQUISITION OF THE IDENTIFIED
REPLACEMENT PROPERTY Assigns the Exchanger's rights in the Agreement of Sale
with the seller to the Intermediary. Serves as written notification to the
seller of the replacement property of the Exchanger1s intent to effect a
1031 Exchange and also provides a hold harmless clause to assure the seller
that there are no additional liabilities or cost to him. If a 1031 Exchange
Clause is inserted into the Agreement of Sale, this document is unnecessary.
6. EXCHANGER MUST ADHERE TO TIME
LIMITATIONS. The 45-Day Identification Period begins at the closing of the
relinquished property and requires the identification of like-kind
replacement property. During this 45-Day Identification Period, you may
revoke an identification and make a new one. * If a like-kind replacement
property has not been properly identified to the Intermediary by midnight of
the 45th day, the Exchange will not work and the taxpayer will be unable to
defer the capital gains. The 180-Day Exchange Period runs concurrently with
the 45-day Identification Period and requires the acquisition of at least
one of the identified replacement properties. * If the settlement of the
relinquished property occurs between October 16 and December 31 of the
current year, the 180-day Exchange Period will be shortened to the income
tax deadline of April 15 of the next calendar year unless a timely and
proper IRS extension is filed for their return. For a corporation, this
filing date is March 15 of the next calendar year unless an IRS extension is
filed.
LIMITATIONS ON THE NUMBER OF
REPLACEMENT PROPERTIES THAT CAN BE IDENTIFIED
1. THREE PROPERTY RULE:
Exchanger may identify up to three properties regardless of their fair
market value. The Exchanger is not obligated to purchase all three
properties but must purchase at least one of the three identified
properties. For example, if selling a relinquished property for $100,000,
three replacement properties can be identified with a combined fair market
of $ 750,000. 2. 200% VALUE RULE: Exchanger may identify more than three
properties but their combined or fair market value cannot exceed double
(200%) the fair market value of the relinquished property. For example, if a
relinquished property was sold for $100,00 and four or more replacements are
identified, their combined fair market value cannot exceed $200,000 with
200% or double the sale price of the relinquished property. Exceptions to
the Three Property Rule and the 200% Value Rule: 1. Any replacement property
acquired within the 45-day Identification Period will be treated as properly
identified, regardless of whether or not it is within the Three Property
Rule or 200% Value Rule.
2. If the Three Property Rule
and 200% Value Rule are violated, the property will still be treated as
properly identified, provided that 95% of the combined fair market value of
the identified replacement property has been acquired. For example, assume a
$100,000 property was sold and five properties with a combined fair market
value of $800,000 are identified. This will be treated as properly
identified provided all five properties are acquired. It is almost
impossible to acquire 95% of the property without acquiring all 100% of the
property. |
