IRC Section 1031 Tax-Deferred Exchanges
Typically, tax-deferred exchanges have taken many complex forms. As a result of these complex forms, the tax consequences of the exchanges were often in doubt. Thanks to recent IRS regulations, taxpayers can now qualify to use tax-deferred exchanges with more certainty.
These Internal Revenue Code regulations list procedures for taxpayers to follow to complete nonsimultaneous tax-deferred exchanges. These mandatory procedures give taxpayers specific time lines and steps to follow in order for a nonsimultaneous exchange to be tax-deferred. Nonsimultaneous exchanges are exchanges where a taxpayer disposes of one piece of property and then after a period of time acquires one or more replacement properties.
As a result of these IRS regulations, most exchanges today are nonsimultaneous. Nonsimultaneous exchanges are usually structured using the services of a qualified intermediary. Qualified intermediaries have made completing tax-deferred exchanges less complicated than in the past. In fact, when using a qualified intermediary today, a tax-deferred exchange operates very similar to the sale of one piece of investment property with the reinvestment of the sales proceeds into another piece of investment property.
The Basic Rules
Under Internal Revenue Code Section 1031, an owner generally does not have to recognize gain when the owner exchanges real estate that is (1) held for investment or (2) used in a trade or business for other property that is either (1) held for investment or (2) used in a trade or business. Income property such as apartment buildings, office buildings and shopping centers are examples of properties that are generally considered used in a trade or business and would qualify for tax-deferred exchange treatment.
In order to defer the entire gain on the disposition of a property, the owner must trade into property that is equal to or greater in value than the property disposed of. Additionally, the owner must also transfer all of their equity into the next property to defer gain completely.
If an owner "trades down" into property that is of lessor value than the property they gave up or their equity in the new property is less than their equity in the property they gave up, then the owner generally must recognize gain to the extent of these decreases. These decreases occur when the taxpayer receives "boot". For simplification purposes, "boot" is cash that is received from the disposition or "net debt relief" that is received on the new replacement property. A discussion of "net debt relief" is beyond the scope of this article. If an owner has a loss on their property, the owner should not use a tax-deferred exchange to dispose of the property because losses are not recognized on exchanges.
How Exchanges Work
An owner who wants to exchange a piece of property will generally first put their property on the market for sale. The owner should then choose a qualified intermediary and consult with their tax advisor to determine whether their property qualifies for tax-deferred exchange treatment.
The property is then marketed as "for sale" and the seller's intent to execute a tax-deferred exchange is communicated to all potential buyers. Buyers are usually not bothered by this fact since the seller will be paying the costs of the exchange. A buyer is then found for the property and a contract to purchase the property is entered into between the seller and the buyer. Once the seller is satisfied that the buyer is going to purchase the property, the seller then contacts the qualified intermediary. Before the escrow closes, the seller will assign their rights in the purchase contract to the qualified intermediary. The intermediary will then sell the property, ("the relinquished property",) to the buyer.
The seller can now locate replacement property to purchase. In practice, the seller will already be looking for replacement property before the sale closes on their relinquished property because of the time limits discussed below. Once the replacement property is found, the seller will enter into a purchase contract to buy the property. Just like an ordinary purchase and sale contract, the seller will have the property inspected and apply for a new loan, if necessary. Once the seller decides they want to purchase the replacement property, the seller then assigns their interest in the purchase contract to the intermediary.
The intermediary then completes the purchase of the replacement property using the money from the sale of the seller's relinquished property. The intermediary then completes the exchange by transferring the replacement property to the seller. To reduce costs, the seller will usually deed their relinquished property directly to the buyer and the seller will receive a deed to their replacement property directly from that seller. By "direct deeding", the seller only pays transfer taxes once when they deed their relinquished property to the buyer.
Once the seller closes escrow on their relinquished property, two very important time requirements begin to run.
The first time requirement is the known as the "45 day rule." Under the 45 day rule, a taxpayer has 45 days from the day the escrow closes on their relinquished property to identify the replacement properties they wish to acquire. The taxpayer must identify the properties in writing and send this to the intermediary.
The second time requirement is known as the "180 day rule." Under the 180 day rule, a taxpayer has 180 days from the day escrow closes on their relinquished property to complete the purchase of their replacement properties. One special exception to the 180 day rule occurs when the relinquished property closes late in a tax year which for most people would be October, November and December. If this situation occurs, an owner should contact their tax advisors for more details.
The taxpayer has several options as to how many potential properties they can identify under the above 45 day rule. The first option is known as the "3 property rule." Under the 3 property rule, the taxpayer can identify up to 3 properties of any value within the 45 day period and receive one or more of these properties within the 180 day period to complete the exchange.
The second identification option is known as the "200% rule." Under the 200% rule, the taxpayer may identify any number of properties within the 45 day period as long as the total fair market value of these properties does not exceed 200% of the fair market value of the property relinquished. There is also a third option which is not frequently used and will not be discussed in this article.
The use of qualified intermediaries is specifically allowed and encouraged by the IRS because the IRS has provided a safe harbor for transactions facilitated by an intermediary, but not for transactions accommodated by another party. It is very important that the seller use a qualified intermediary so that the seller is not treated as being in control of the sales proceeds. The IRS calls such control having "constructive receipt" of the money. If the seller is treated as having constructive receipt of the sales proceeds, then the IRS will not treat the transaction as a tax-deferred exchange, but will instead treat the transaction as a taxable sale.
A qualified intermediary is a third party, usually a corporation, that is used to ensure that a taxpayer's transaction is treated as an "exchange" and not as a sale and reinvestment. Qualified intermediaries provide the necessary exchange agreements and accommodate the exchange. To be a qualified intermediary, the intermediary must not be a disqualified person as defined by the IRS. Disqualified persons are generally persons that would be treated as the exchanger's agent. A taxpayer should use a professional intermediary company and not a friend to act as the qualified intermediary.
Intermediaries charge for their services based on the number of properties being exchanged and the complexity of the exchange. For a simple transaction the fees generally are around $1,000. Taxpayers can request that the intermediary pay them interest on their money during the 180 day exchange period. The intermediary will generally call this interest payment a "growth factor."
Restrictions on Use
Generally, both the relinquished property and the replacement property must be qualifying property and of a like kind. To be qualifying property, the property must be either held for investment or used in a trade or business. Properties that generally do not qualify for tax-deferred exchange treatment are: (a) properties that would be considered inventory or properties held primarily for sale. For example, homes sold by a home builder, (b) principal and possibly second residences, (c) properties not treated as like kind, (d) partnership interests, (e) foreign real estate if exchanged for U.S. real estate. Additionally, there are special rules that apply to exchanges between "related persons" as defined by the IRS.
Some taxpayers own mixed use properties. Mixed use properties are properties that are partly used as a personal residence and partly as a trade or business. A good example of a mixed use property is a taxpayer who owns a 4 unit building, lives in one unit, and rents the other 3 units. These taxpayers can use a tax-deferred exchange to defer gain when they dispose of their interest in the 3 rental units and can also use the personal residence rollover rule to defer gain on the unit they occupy.
Many qualifying properties are co-owned by several individuals. Owners of these types of properties can exchange their separate interests into other qualifying property with their current co-owners or they can exchange into a new piece of property that is separately owned by them.
There are many other possible situations where a taxpayer could benefit from using a tax-deferred exchange. An individual owner should consult with their tax advisor to determine if their particular facts and circumstances allows them to use a tax-deferred exchange.
The information provided herein is only a summary and is not a complete explanation of the law and is not intended as legal or tax advice. All parties should consult their own legal and tax advisors before acting upon any information contained herein.
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