1031 Exchanges

Frequently Asked Questions

Equity & Gain

Is my tax based on my equity or my taxable gain?

Your tax will always be based upon calculations of the taxable gain. Contrary to misconceptions, gain and equity are two separate and distinct items. When determining your gain, you should identify your original purchase price. From that, deduct any previously reported depreciation and then add the value of any improvements, if any, which have been made to the property. The resulting figure is your cost or tax basis. To calculate your gain, subtract the cost basis from your original net sales price.

Deferring All Gain

Is there a simple rule for structuring an exchange where all the taxable gain will be deferred?

If the following actions are performed, all taxable gain on your property is to be deferred.

1) A replacement property equal to or greater in value than the net selling price of the relinquished (exchange) property purchased.

2) Equity is move from one property to the other.

Definition of Like-Kind

What are the rules regarding the exchange of like-kind properties? May I exchange a vacant parcel of land for an improved property or a rental house for a multiple-unit building?

If properties are of the same nature or character, regardless of whether or not they differ in grade or quality, they are “like-kind” properties. The two properties must be of the same type, disregarding any improvements made. To clarify, two residential pieces of real estate are “like-kind” towards one another. A residential piece of real estate and a car would not be.

Four most common 1031 exchange misconceptions:

Is there a simple rule for structuring an exchange where all the taxable gain will be deferred?

All 1031 exchanges must involve swapping or trading with other property owners…… (NO)

Well before delayed exchanges were codified (by IRS) in 1984, all simultaneous exchange transactions of Real Estate required the actual swapping of deeds plus the simultaneous closing among all parties to a 1031 exchange. In most cases these type of exchanges are comprised of many of exchanging parties, as well as numerous exchange real estate properties. Now today, there’s no such requirement to swap your own property with someone else’s property, in order to complete an IRS approved exchange. The rules have been refined and ratified to the point that the current process is much more indicative of your qualifying intent, rather than the logistics of the Real Estate property closings.

It’s required that all types of 1031 exchanges must close simultaneously……. (NO)

There was a time when all types of exchanges had to be closed on a simultaneous (same day) basis, now they (1031) are rarely completed in this type of format any longer. As a matter of fact, a majority of the exchanges executed are closed now as delayed exchanges.

“Like-kind” means purchasing the same type of property which was sold……. (NO)

Often the definition of “like-kind” has been misinterpreted or misunderstood to mean “The requirement of the acquisition of property to be utilized in the same form as the exchange property”. In laymen’s term, hotels are for hotels, apartments are for apartments, farms are for farms, etc. This is all true, however that the exact definition is again more reflective of intent than its use. As a result, there are currently only 2 types of properties that qualify as a ‘like- kind’:

— Property held for investment and/or
— Property held for a productive use, as in a trade or business.

1031 Exchanges must be limited to 1 exchange and 1 replacement property……. (NO)

This statement is a perfect example of another 1031 exchanging myth. Let me repeat, there are no provisions within either the IRS Code or the US Treasury Regulations that can restrict the amount and number of real estate properties that can be involved in an exchange. Thus, in exchanging out of several properties into one replacement property or the vice versa of selling of one property and acquiring several other properties, are perfectly acceptable strategies and uses of a 1031.

Identification

Why are the rules of identification so time restrictive? Is there any flexibility within them?

The current identification rules represent a compromise which was proposed by the IRS and adopted in 1984. Prior to that time there were no time-related guidelines. The current 45-day provision was created to eliminate questions about the time period for identification and, unfortunately, there is absolutely no flexibility written into the rule and no extensions are available.

In a delayed exchange, is there any limit to property value when identifying by using the Two Hundred Percent Rule?
Yes. Although you may identify any three properties of any value under the Three Property Rule, when using the Two Hundred Percent Rule there is a restriction. When identifying four or more properties, the total aggregate value of the properties identified must not exceed more than 200% of the value of the relinquished property.

There is an additional exception for those whose identification does not qualify for either of Three Property or Two Hundred Percent rules. The Ninety-five Percent Exception allows the identification of any number of properties, provided the total aggregate value of the properties acquired totals at least 95% of the properties identified.

Should identifications be made to the intermediary or to an attorney or escrow or title company?

Identifications may be made to any party listed above. On many occasions, however, the escrow holder is not equipped to receive your identification if they have no yet opened an escrow. Therefore, it is easier and safer to identify through the intermediary, provided the identification is postmarked or received within the 45-Day Identification Period.

Simultaneous Exchange Pitfalls

Is it possible to complete a simultaneous exchange without an intermediary or an exchange agreement?

It is possible to complete an exchange without an intermediary or an exchange agreement, yet is not recommended. In addition, it is very difficult to perform this process due to the Safe Harbor addition of qualified intermediaries in the Treasury Regulations and the recent adoption of good funds laws in several states. As two closing entities cannot hold the same exchange funds on the same day, the Exchanger is left with serious constructive receipt and other legal issues for attempting such a simultaneous transaction.

The main reason for the addition of the intermediary Safe Harbor was to suppress the practice of attempting such marginal transactions. Many tax professionals believe that an exchange that is completed without an intermediary or exchange agreement will not qualify for deferred gain treatment. If such a transaction had already been completed, it would not pass an IRS examination due to constructive receipt and structural exchange discrepancies. As you may have hesitation to invest in a qualified intermediary, we advise you to do so, as in comparison to the tax risk that is associated with attempting this exchange, the investment is easily insignificant.