Questions About 1031 Exchanges
Q: What property is like kind to my property?
A: When it comes to real estate, all property is like kind to all other real estate. For example, farmland can be exchanged for an office building or a condominium can be exchanged for a trailer park. The state law of the jurisdiction in which the property is located will define the definition of real estate. Our business focuses on exchanges of real estate. Certain other tangible personal property can be exchanged, like airplanes and equipment. Whether this property is like kind is determined by reference to certain industrial classifications. We can handle exchanges of real estate or personal property.
Q: What must I do to have a fully deferred exchange?
A: The general rule is that, in order to have a fully tax deferred exchange, the exchanger must trade equal or up in equity and equal or up in fair market value. The effect of this rule is that the exchanger must use the entire net proceeds from the relinquished property as down payment on the replacement property. Also, the exchanger must replace any mortgage paid off at the sale of the relinquished property with an equal or greater mortgage on the replacement property. Any cash received by the exchanger whether at the sale of the relinquished property or at the purchase of the replacement property will be deemed “cash boot” and tax will be recognized to the extent of gain. This rule applies regardless of the exchanger’s cash position in the relinquished property. Regardless of the size of the exchangers down payment, principal pay down, or capital improvements on the relinquished property, the exchanger will be treated as having received “cash boot” if cash is received as part of the exchange. The fair market value of the relinquished property can be calculated from the selling price by subtracting from the selling price the transaction costs of the sale. These transaction costs are limited to those costs directly related to the sale of the relinquished property. The most common transaction costs are brokerage fees, title insurance fees, exchange service fees, and recording fees.
Q: May I have a partially tax deferred exchange?
A: If the rule described in the answer above is violated, a partially tax deferred exchange is the likely outcome. If the exchanger trades down in either fair market value or equity then some gain is likely to be recognized. If the exchange is otherwise valid, a partially deferred tax exchange is the result.
Q: What is boot?
A: “Boot” is anything of value received by the exchanger, which is not “like-kind” to the relinquished property.
• Cash Boot
If the exchanger receives cash upon sale of the relinquished property this will be treated as “cash boot” and tax will be recognized to the extent of gain in the transaction. For example, if the QI receives $40,000 upon sale of the relinquished property and the exchanger elects to receive $10,000 in cash at closing, the exchanger will pay tax on $10,000 while the exchange is completed with the remainder of the funds held by the QI.
• Mortgage and other boot
If the exchanger fails to purchase a replacement property of equal or greater value than the relinquished property there is a strong possibility that he will be deemed to have received “mortgage boot.” For example, if the exchanger relinquishes a property valued at $100,000 and deposits $50,000 with their QI and a $50,000 mortgage is paid off, then replaces with a property valued at $90,000 with $50,000 cash down and a replacement mortgage of $40,000 the exchanger will pay tax on $10,000. This is an example of the receipt of “mortgage boot.” An exchanger can also receive other property, which will be deemed boot. For example, if the exchanger receives an automobile, artwork, or any other thing of value as part of an exchange, that other non-like kind property will be deemed boot and taxed on the fair market value of the other property received.
Q: Can I refinance a property immediately prior to the exchange?
A: Recent tax authority suggests that a refinancing of the relinquished property prior to sale with receipt of cash by the exchanger may not be deemed “cash boot” under certain limited circumstances. This course of action is not generally recommended. In the event the exchanger needs cash for an independent business purpose, it is strongly recommended that the exchanger refinance the replacement property after acquisition and when the independent need for cash arises.
Q: How long do I have to identify, how do I identify, what constitutes sufficient
identification, is there any leeway?
A: The replacement properties must be identified within 45 days after the transfer of the relinquished property. This requirement is strictly enforced, even if the 45th day falls on a holiday. Identification must be in writing, signed and dated by the exchanger and received by the QI no later than 45 days after the sale of the relinquished property. Replacement property must be identified unambiguously. Usually either a legal description or a mailing address is sufficient. Beware of an exchange where an exchanger identifies a property in whole and then closes on only a part of the whole. If challenged, this may not be sufficiently unambiguous identification for a successful exchange.
Q: How long do I have to purchase my replacement?
A: The replacement property must be purchased within 180 days after the transfer of the relinquished property.
Q: May I do a multiple leg exchange?
A: Yes, several relinquished properties may be exchanged for a single replacement property. One relinquished property may be exchanged for several replacement properties. The important thing is that the exchange be part of a unified exchange agreement from the beginning. The 45-day identification rule and 180-day replacement rule will start running from the date of the sale of the first relinquished property. Sometimes because of this timing issue it is better to structure the exchange as a series of exchanges rather than a multiple leg exchange.
Q: May I exchange less than 100% of my interest?
A: Yes, a fractional part of the relinquished property may be exchanged and/or a fractional part of the replacement property may be acquired.
Q: How should I take title to replacement property?
A: Title to the replacement property must be taken in the same name in which the relinquished property was held. Caution dictates that this rule is followed even when husbands and wives are involved.
Q: What is a related party and can I do an exchange with them?
A: This is an evolving area in 1031 exchanges. Generally speaking, if an exchange occurs involving related persons or entities then all exchanged properties must be held by the exchanger and the related party for a period of two years after the date of the last transfer or the exchange will not qualify for tax deferral. Related parties are defined as: lineal ancestors and descendants, brothers and sisters and other entities, which the exchanger owns at least a 10% interest. In a deferred exchange, the exchanger cannot buy from a related party unless tax savings is not an issue.
Q: Do I receive a tax basis in my replacement property?
A: No, tax basis from the relinquished property is carried forward into the replacement property. Any additional cash or increase in mortgage by the exchanger increases tax basis in the replacement property. Once a depreciation allowance is taken on the relinquished property it may not be used a second time on the replacement property. This rule is generally regarded as a negative consequence of a 1031 exchange. Both investors and brokers frequently misunderstand it.
Q: Can an entity do an exchange? Corporation, partnership, LLC, trust
A: Yes, title to the replacement property must track with the relinquished property. A partnership interest in one partnership may not be exchanged for a partnership interest in another partnership. A share of stock in one company may not be exchanged for a share of stock in another company. However, legal entities may perform exchanges under 1031.
Q: Can I receive title to replacement property before giving up title to
A: Reverse 1031 exchanges are permitted. However, the exchanger may not hold title to both properties at the same time. Instead an Exchange Accommodation Titleholder must hold title to one of the properties. Contact us for more details.
Q: Can I use exchange funds to pay down mortgage on property I already own?
A: No. The IRS does not consider this a like kind exchange.
Q: Can I use exchange funds to do fix up on replacement property?
A: It is generally best to have the owner of the replacement property perform the fix up prior to acquisition of the replacement property. As a second alternative, it is better to use funds other than exchange funds to perform the fix up on the replacement property. Finally, exchange funds can be used to perform fix up on the replacement property if the fix up is accomplished prior to the exchanger actually acquiring title.
Q: Can I use exchange funds to build improvements on replacement property?
A: Generally speaking the best way to accomplish this goal is to have a “Special Purpose Entity” acquire title to the replacement property, have the Special Purpose Entity build the improvements, and have the exchanger acquire the replacement property from the Special Purpose Entity under the regulations for exchanges. Please contact us if you are asked to perform a construction exchange.
Q: As an closing agent, what do I do when I am notified that a party to a transaction I
will be closing, intends to do a 1031 Tax Deferred Exchange?
A: If you are notified, either verbally or in the Buy-Sell Agreement, that a party to the Agreement wants to do an exchange, you must include the “language” in your closing escrow instructions to the effect that Buyer agrees to cooperate with Seller, or Seller agrees to cooperate with Buyer, or Buyer and Seller agree to cooperate with each other. American Exchange Corporation is pleased to provide you with sample language if your company needs it.
Remember, if you have placed “exchange intent language” in your closing escrow instructions and are subsequently notified that the party will not be doing an exchange, you must prepare an amendment deleting that clause so it does not appear as if you closed and forgot to do the exchange.
Q: When do I need to notify the Exchange Intermediary Company of my involvement
in a transaction?
A: Typically you will contact American Exchange Corporation after sale or purchase contingencies (i.e. physical inspection, environmental assessments, title review, etc.) have been removed. If you have a very quick closing escrow, do not wait for the contingency period to be removed, notify our office immediately. Otherwise, after contingencies are removed, you need to immediately furnish our office with a copy of the Buy-Sell Agreement, Title Commitment, and info on who will be the closing agent on the transaction.
Q: What does American Exchange Corporation do after they receive the Buy-Sell
Agreement & Title Commitment from the Closing Agent?
A: Upon our receipt of the Buy Sell Agreement and Title Commitment, we will then prepare our Exchange Agreement and Substitution of either Buyer or Seller for your use in the escrow. Our exchange file is then set up to coincide with how your escrow is structured (see notes below as to the percentage interests; Purchase Money Mortgages etc.). We then forward the documents to the Closing Agent. Please return the documents to our office as soon as the signatures are obtained. From the point in which the Substitution of Buyer or Seller has been prepared, American Exchange Corporation is then your Buyer or Seller. This means that any subsequent amendments, etc. that require the party’s signature must show American Exchange Corporation in addition to the original parties. If American Exchange Corporation is not specified in the documents, you are jeopardizing the exchange transaction.
So remember, place American Exchange Corporation’s name in place of the Exchanger’s, as the principal, and have the Exchanger merely “acknowledge receipt” of all subsequent instructions. This rule applies if you are canceling or superseding your escrow instructions.
Q: As the Closing Agent, how do I handle the estimated closing statements?
A: American Exchange Corporation will show as either the Buyer or Seller. You will send us the Estimate for our approval with a copy of the Exchanger’s acknowledgement of same on the bottom. We cannot sign until this acknowledgement is received. Additionally we must receive the final closing statement immediately upon escrow closing showing our name as principal together with any other documentation requested in our instruction letter. We cannot complete our exchange file without these items.
Q: As the closing agent, how do I handle the money received and/or disbursed from the
closing escrow transaction?
A: In the event your Buyer is the one doing an exchange that means that American Exchange Corporation is already in receipt of exchange funds. You must contact our office to see if the initial deposit is coming from us as Intermediary or if the Exchanger/Buyer will be depositing it directly. Often the Buyer will need to come up with money in addition to the exchange proceeds to complete the purchase. If American Exchange Corporation gives you the initial deposit, you should show us on the receipt and your original Closing Escrow Instructions. However, most of the time, you will be receiving an initial deposit directly from the Exchanger/Buyer and they will be shown as the Buyer until American Exchange Corporation has been substituted in as Buyer at a later date.
CAUTION: In this event, your closing statement will need to show a line item as “return of initial deposit to Exchanger” in order to clarify to IRS that the Exchanger did not have any constructive receipt of funds. Furthermore, any and all proceeds and/or refunds that you prepare in your escrow must be made payable to American Exchange Corporation, even if they are after the close of escrow or you will jeopardize the exchange. Remember that once American Exchange Corporation is substituted in as either buyer or seller, American Exchange Corporation is the principal. This is very important to remember so that you always keep our office informed.
Q: How do we handle the situation where the Seller is doing an Exchange and they will
be carrying back a note and deed of trust or mortgage?
A: In this situation, you must communicate clearly with the Exchanger/Seller, their tax advisor, and our office as to the proper structure of the transaction. If the trust deed or mortgage is to be part of the Exchange, you will show American Exchange Corporation as your Beneficiary. Then, through our exchange file, we will handle the assignment of same to the Exchanger/Seller or to whomever it will eventually be assigned. Sometimes the trust deed or mortgage will roll into the Exchanger’s “replacement property.” If the trust deed or mortgage is not to be a part of the Exchange (typically because the Exchanger/Seller elects installment sale treatment for the trust deed or mortgage) then it is very important that your closing statement reflect the percentage interests and that you prepare an amendment in your closing escrow regarding same.
Q: What is the Qualified Holding Period for a property that was purchased through a
A: There is no hard & fast role on this subject. Many people believe two years is necessary. The taxpayer has to intend to hold the property for investment or income producing purposes when the property is acquired. If there is a bona fide intent to meet the holding requirement, the qualified use period may be less. The taxpayer should consult with their tax advisors on their issue.
Q: How much do I need to spend of the exchange value to receive full non-recognition of
A: To receive full non-recognition of capital gain you need to spend equal or greater the amount of the exchange value.
Q: When selling a piece of property can it be vested differently than when buying a piece
A: No, when doing a 1031 exchange the vesting in the replacement property must be the same as the vesting in the relinquished property.