What you need to know about a 1031 Tax Deferred Exchange

In July of 1991, the IRS finalized the rules governing Delayed Exchanges. This gives everyone the opportunity to use purchase and sale techniques to structure tax deferred exchanges. The deferred exchange is an alternative to a common sale and purchase transaction. If you wish to keep your investment money in real estate, you should consider the tax advantages of a deferred exchange.

A. Definition of some Common Terms

Relinquished Property: This is the property you now own and are planning to sell or exchange.

Replacement Property: This is the property or properties (there can be more than one) that you are planning to purchase.

Non-recognition of gain: IRS terminology that means you don't have to pay the Capital Gains Tax on the transaction.

B. Exchange Requirements for Non Recognition of Gain

There are three conditions that must be met to accomplish non-recognition of gain:

1. The properties exchanged must qualify, and be of "like-kind".

2. There must be an actual exchange, not a transfer of property for money only.

3. The time requirements must be strictly followed.

The details of these conditions & requirements are described on the following pages.

II. QUALIFIED PROPERTIES

The classification of properties exchanged determines if the property qualifies for Section 1031 treatment.

A. The IRS Classifies Real Estate Into Four Classifications:

1. Property held for personal use. (Personal Property)

2. Property held primarily for sale. (Dealer Property)

3. Property held for productive use in a trade or business. (Business Property)

4. Property held for investment. (Investment Property)

The last two qualify for Section 1031 tax deferral; the first two do not. Both the property received and the property sold must be of "Like Kind". It is your use of the property that determines its classification. What the other party does with the property does not affect your tax status.

B. Like-Kind Property

1. Like-kind refers to your use of the property and not to its grade or quality.

2. "1031" property may be mixed as to type and still be like kind. As an example, you may exchange land for a duplex, or a commercial building for a retail store, etc. (See page 14.)

3. Property held outside the USA and its territories does not qualify for exchange with property held within the USA.

C. Partnership Interests

Your interest in a partnership cannot be traded for an interest in another partnership.

Exception: The partnership as an entity can exchange real estate it owns for other like-kind real estate.

D. Transfer Between Spouses

There are no income tax consequences in entering into financial transactions between spouses. In addition, most transfers incident to a divorce are tax-free. However, transactions with a former spouse are normally subject to tax unless they qualify for non-recognition under the provisions of Section 1031.

E. Sale/Lease Back As An Exchange

A lessee's interest in a lease with a term of 30 years or longer in real property is considered like kind to other real property. In addition, property which is subject to a lease can be, even if the lease is for a term of 30 years or longer, the subject of a tax free exchange. However the receipt of prepaid lease payments in an exchange for a 30-year or longer lease is taxed as ordinary income and will not qualify for tax-free exchange treatment.

F. Business Assets

The personal property assets of one business can be exchanged for like-kind assets of another business and will be held as a like-kind exchange under Section 1031. The real property is treated the same as any other exchange. The like-kind requirements for personal property are much more stringent than for real property (e.g., a truck cannot be exchanged for a car, nor can a barge be exchanged for a cargo ship).

G. Vacation Homes & Properties

This type of property does not qualify if it is used solely for personal use.

It may qualify if rented, and must pass a use test each year.

III. TIME RESTRICTIONS

A. Introduction

In 1984, Congress amended the IRS code adding an identification and exchange period for like- kind exchanges. This signaled their approval for delayed multi-party exchanges. However it was not until the spring of 1990 that the IRS issued their regulations defining delayed exchanges.

B. Identification and Exchange Periods

The "1031 Exchange" rules have two Time Limitations:

1. The period of time to "Identify" the replacement property begins on the date of closing of the exchange property and ends 45 days later. The replacement property must be identified in writing, and delivered to the facilitator by midnight of the 45th day after the closing of the relinquished (exchange) property. In identifying, the replacement property must be unambiguously described. We recommend that you use either a legal description or a specific street address.

2. The period of time in which the replacement property must be received by the exchanger begins on the date of closing of the exchange property and ends on the date that the tax return of the taxpayer is due, including extensions, or in 180 days, whichever is earlier.

IV. REPLACEMENT PROPERTY

The term "REPLACEMENT PROPERTY" simply means the property or properties to be purchased with the funds that are received from the sale of the relinquished property.

A. Number of Replacement Properties

Meeting the technical requirements of identification is critical. You must satisfy one of these rules:

1. You may identify not more than three replacement properties of any value.

2. You may identify any number of replacement properties so long as the total value of all property identified does not exceed twice the value of the relinquished property.

3. You may identify as many properties as you desire so long as you close and take title on 95% of the value of such properties.

B. Trade Even or Up in Value

The property you wish to acquire ("replacement property") should have a value equal to, or more than, the relinquished property. All of the proceeds from the relinquished property sale should be invested in the replacement property. The capital gain will be taxable only to the extent that these goals are partially achieved. If all the goals are accomplished, the entire gain will be deferred.

C. Incidental Property

For purposes of completing a proper identification within the 45-day identification period, it should be noted that property which is incidental to Real Estate property, such as furniture, laundry machines, appliances, pumps, etc. is not treated as separate property from the real estate property if:

In standard commercial transactions the property is typically transferred together with the real estate property, and

The aggregate market value of the incidental property does not exceed 15% of the market value of the real estate property.

For description purposes, the legal description or street address of the real estate property can be used to describe the entire property. There is no need to list the particular incidental property attached to it. For example: The Exchange or Replacement property is an apartment house complex worth one million dollars. The furniture, laundry machines, and other items that go with the apartment complex should not then exceed $150,000 in value, which is 15% of one million dollars. For purposes of identification the entire apartment complex, including furniture, laundry machines, etc., will be treated as one property.

"Note: The foregoing discussion relates to the identification of replacement property during the 45 day identification period. However, any non-like-kind property that is received will be treated as taxable boot unless the taxpayer acquires like-kind replacement personal property.

D. Revocation of Replacement Properties

Replacement properties can be revoked as long as it is done within the 45-day identification period. This revocation must be done in writing and could include a recession of a purchase and sale agreement, if one was written.

E. Receipt of Replacement Property

Replacement property is treated as received before the end of the exchange period if:

You actually acquired the replacement property. That is, closed the transaction prior to the end of the exchange period (180 days, or the due date of the taxpayers tax return, whichever is earlier), and

The Replacement property acquired is substantially the same as identified during the 45- day identification period.

F. New Construction Replacement Property

One of the more interesting stipulations is the regulation that permits you to exchange for real property that has not yet been built. A transfer will still qualify for Section 1031 treatment if the new construction is identified within the 45-day period, and received within the 180-day exchange period. This property must be carefully identified. This identification should include the legal description of the underlying ground and as much other description as possible for the property to be constructed. Also, the new construction must be completed and received in substantially the same form as described in the identification documents. You cannot exchange for services. Partially completed real property can be received in a like kind exchange if properly identified. {IRC 1.1031(k)-1(e)(3)(iii)}

V. EXCHANGE OR SALE

A. Introduction

The intent of the delayed property exchange is that you have an actual continuation of your old property investment into your new replacement property. To qualify, you must follow the rules and requirements of Section 1031 of the Internal Revenue Code. Intent does not count. What you actually do is what determines if you qualify. However, if the transaction is ambiguous, the courts will usually look to the intent of the parties.

B. Exchange Requirements

Section 1031 requires an actual exchange of properties. If you simply sell your property and reinvest the money in another property, you will not qualify for exchange treatment, even though it is a simultaneous close. This type of transaction will result in "Constructive Receipt". Constructive receipt occurs when you have the funds in a position in which you may draw on them, direct their usage, or give notice of intention to withdraw. In other words, you must not have control of the funds. If you have any type of control on the funds or control over the person holding the funds, you will be considered to have constructive receipt. One of the primary ways that you avoid constructive receipt is with a written contractual agreement with a Qualified Intermediary.

You are not in constructive receipt if your control over this money is subject to a substantial limitation or restriction. You are in constructive receipt at the time such limitations or restrictions lapse, expire, or are waived. Additionally, you are in constructive receipt if your agent accepts the money.

C. Safe Harbors

Although there is more than one type of safe harbor, the only practical safe harbor for most exchangers is a Qualified Intermediary. The other two safe harbor arrangements call for establishing special trusts or special security and guarantee arrangements, which are quite complicated and usually are beyond the range of the average exchanger. Qualified Intermediaries act on your behalf in accordance with a specific written contract. The Qualified Intermediary, for a fee, acts to facilitate the deferred exchange by entering into an agreement to exchange the properties. Under this agreement, the Qualified Intermediary sells the relinquished property, acquires the replacement property, and transfers the replacement property to the exchanger. The exchanger, or a related party, cannot act as a Qualified Intermediary of his or her own exchange.

IRC Section 1031 delayed exchange rules state that a related party is anyone with a direct relationship to the exchanger. Examples include a brother, sister, husband, spouse, child, or anyone acting as an agent, including an employee, or an Attorney, Real Estate Broker, or CPA who has been employed by the taxpayer in those capacities within the last two years prior to the exchange. Also included as related parties is a corporation of which 10% or more of the outstanding stock is owned directly or indirectly by the exchanger.

VI. PROPERTY BASIS

A. Introduction

For the purposes of a 1031 exchange, basis is the term we give to the price that was originally paid for the relinquished property, less any depreciation, plus any costs to improve that property. The basis of the replacement property is the same as the basis of the relinquished property, plus any increase paid. That is, the value of the relinquished property is increased by any additional consideration you give for the replacement property. An example would be a property you bought ten years ago for $30,000 that you've been depreciating at $1,000 a year for the last ten years. Your basis on that property is now $20,000. Basis is used as the base point for the calculation of capital gain on a transaction. Capital gain is described as the difference between the basis and the adjusted sales price of a property. The adjusted sales are the price the property sold for, less the selling cost, and less any other cost to make the property ready to sell.

Do not confuse capital gain with equity. There is no comparison between the two. Equity is the amount of money you have in your pocket after you have sold the property and paid off all of the mortgages. As an example lets consider the property that you bought for $30,000 ten years ago, which now has a basis of $20,000. If you sold that property for $115,000, and paid out $15,000 in sales and other costs to prepare the property for market, you have an adjusted sales price of $100,000. Your capital gain on this property is the difference between your basis of $20,000 and your adjusted sales price of $100,000, or a capital gain of $80,000. If you do not do a 1031 Exchange, you could be obligated to pay a capital gains tax of $16, 500 ($10,000 depreciation X 25% = $2,500 plus $70,000 X 20% = $14,000).

If you have borrowed some money on this property, particularly if you have borrowed this money after you purchased the property, you may have to repay this loan at the time of closing. This will result in the relief of debt, which is the same as the receipt of cash according to IRS rules. Let's assume you have borrowed $92,000 on the property. Your equity on the adjusted sale price is now $8,000, but you have an obligation for capital gains tax of $16,500. It is in this area that you must be extremely careful not to trap yourself with a regular sale. You are almost bound to exchange in a case like this unless you have the additional funds to pay the taxes. In larger transactions with larger dollars and leveraging, the situation only gets worse.

Let's talk a little further about basis, and how it's transferred to the replacement property. If you pay an additional amount (over the adjusted sale price of the relinquished property) for the replacement property, the amount paid is added to the transferred basis of the exchange property. Example: The basis of your original property was $20,000, and you bought a replacement property for $150,000. You paid $50,000 more for the new property, so the basis on your new property is now $70,000. Also any selling expenses that you pay to acquire the replacement property are added to the new basis. These costs would include the real estate commission, and other regular closing/selling costs.

B. Figuring Basis Where the Property is Subject to A Mortgage

The primary rule to consider when the property has a mortgage is that the IRS considers the relief of debt the same as receipt of cash. The second primary rule is that mortgages are netted against each other. If the exchanger's property is mortgaged, the mortgage is counted as money received and reduces the substituted basis of the replacement property. This rule applies whether or not the mortgage is assumed by the other party or whether it's paid off. When both properties are mortgaged, the differences in the mortgages are netted and must be taken into account. If the mortgage you assume is larger than the mortgage transferred, the difference is added to the basis of the new replacement property. If the mortgage assumed is smaller than the mortgage transferred, the difference is deducted from the basis of the new replacement property.

C. Boot and Taxable Gain

Money and unlike property in an exchange is called boot. Receiving boot does not defeat the non-taxable provisions of Section 1031. If you receive money or unlike property, you may have a taxable gain to pay. However, you are only taxed on the gain that comes from the money and unlike property you receive. If the other party assumes any of your liability as part of the exchange, it will be treated as if you received cash.

In order to figure your taxable gain, you first determine the fair market value of the boot you received. Then you figure what your gain would have been had you sold the property outright for cash. Your taxable gain is the smaller of these two amounts.

The only practical safe harbor for the majority of investors is the use of a "Qualified Intermediary" such as Realty Exchangers, Inc. As a qualified Intermediary, we operate under a specially drawn contract between Realty Exchangers, Inc. and the EXCHANGER. This contract agreement enables us to purchase and sell properties on behalf of the EXCHANGER. We charge a fee for our services. Although delayed exchanges have become popular since the IRS published its rules, proper documentation of the exchange is still very crucial. Realty Exchangers, Inc. will structure your delayed exchange to ensure a smooth and accurate transaction.

SUGGESTED EARNEST MONEY CLAUSE

We suggest that you insert language similar to the following clause into your Purchase & Sale agreement so that all parties are aware that the transaction will be a delayed exchange, and there will be no lack of disclosure that may obstruct the transaction. (This is merely a suggestion, and is not required by the "1031" regulations)

"A material part of this transaction is the successful completion of an I.R.S. Code Section 1031 deferred exchange. "Buyer/seller" agrees to cooperate with the "Exchanger" (note: insert the full name of the party doing the exchange in place of the word "Exchanger") in signing those documents necessary to complete the exchange, provided that "buyer/seller" shall incur no additional costs or liabilities in excess of those which would have occurred had this been an outright "purchase/sale," and not an exchange."

FREQUENTLY ASKED QUESTIONS

Do I have to spend all of the proceeds from my relinquished property on replacement property?

No you do not, however you will be taxed on the amount you don't spend. Unused proceeds are known as "boot" and are taxed on their face value at the capital gains tax rate.

If I don't spend all of my proceeds when can I receive the unused amount?

You can receive unused proceeds at anytime after you have acquired each one of the properties identified in your 45-day identification. If you do not acquire all of the properties identified in the 45 day identification, then the unused proceeds cannot be released until the earlier of the due date of your tax return including extensions, or 180 days after the closing of the sale of the relinquished (exchange) property.

Can I take a note on the sale of my relinquished property?

Yes, you can sell your relinquished property using a Note & Trust Deed to finance the sale.

It is possible for the promissory Note and Trust Deed to be made out to the "Exchanger". If this is done the Note is taxable and may not be used to buy replacement property.

However if the Note & Trust Deed is made out in the name of the Qualified Intermediary, You have four choices on how to use it to buy replacement property:

You can use it to acquire replacement property by trading it to the "Seller " for part of the equity in the new property (that is spend it like it was cash).

You can instruct the Qualified Intermediary to sell the note on the open market (you can negotiate this sale or have the Intermediary do it) and add the amount realized to the exchange proceeds. This will give you all cash to negotiate your replacement purchase. It is less desirable because of the discount given on the sale of the note.

A party related to the "Exchanger" such as a closely held corporation or relative can either purchase the Note from the Qualified Intermediary, or provide financing so that the Qualified Intermediary receives all cash at closing. You should consult with your tax advisor regarding structuring this type of transaction.

You can wait until the end of the exchange and receive the note back from the Intermediary. This will result in the note becoming "boot" and it will be taxable. However, you will only have to pay tax on the amount received each year.

What should I know about new construction of replacement property?

There are two ways that new construction is handled in an exchange:

You contract with a builder to purchase a property that will be completed, and closed, prior to the end of the 180-day exchange period. You can purchase the land prior to construction as one of your replacement properties, or you can purchase the land & building from the builder at the time of closing. This is the least expensive and easiest method for the exchanger.

You can contract to do what is known as a "Build-out Exchange". This is where the exchanger finances all or part of the construction. Through a special agreement with the Qualified Intermediary the builder draws on the exchange proceeds as certain steps of the construction are completed. This arrangement is much more complicated and risky for the Exchanger, and the Intermediary, and increases the cost of the exchange by $1,500 or more.

In either case the purchase and sale agreement should have language in it that requires the builder to bear responsibility for the exchangers taxes if the exchange fails due to the completion of the construction later than the required 180 day exchange closing period.

When should I open escrow on my Replacement Property?

The safest way is to wait until after your "Relinquished" property has closed. The opening of escrow (or notification to the closing agent) may constitute identification as the escrow agent is listed by the IRS as a person involved in the exchange {1.1031(k)-1(c)(2)(ii) example}, and if it is done prior to the closing of the "Relinquished" property it can shorten the entire exchange period to 45 days. It is a dangerous practice and does not speed up the "replacement" property closing. Replacement property is identified if it is designated as replacement property in a written document signed by the taxpayer and sent to the Qualified Intermediary prior to the end of the 45-day identification period. We will send you a form to fill in after your relinquished property closes.

This report is designed to provide a general understanding of the tax deferred exchange process. This report is not intended to be tax advice. We recommend you consult you attorney or accountant to discuss the particular benefit of using a tax deferred exchange for you next real estate transaction. Thank you for your interest.

Daniel Holbrook
President, The At|vantage Group Inc.

We hope this information is helpful to you.

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