Why does the government allow tax deferred exchanges?
One common belief is that the government will ultimately receive more tax revenue. It is suggested that a taxpayer is more willing to dispose of and acquire property if there is an opportunity to participate in a tax deferred exchange. This means more business owners and investors are replacing worn or inadequate properties without incurring a large capital gain tax. As a result of these reinvestment activities, more people are employed, who, in turn, employ others through their spending. This cycle brings in additional income tax for the government.
What tax is "deferred" in a Section 1031 exchange?
Capital gains tax is comprised of two components: the tax due on the profit earned on the sale of the investment or income property (the profit earned is the appreciation in value of the property and is determined by gross sale price minus the adjusted basis and the cost of sale), AND the tax due on the recapture of depreciation previously taken by the taxpayer during the time the taxpayer owned the property.
Why do I need a Qualified Intermediary (QI)?
A QI provides many helpful functions during a 1031 exchange, including two that are absolutely necessary. First, the QI provides the taxpayer with the required documents to establish the taxpayer's intent to do an exchange. This paperwork creates the structure of an exchange and insures that the end result complies with the laws and rulings. Secondly, the QI acts as the accommodator for proceeds to protect the taxpayer from direct (actual) or indirect (constructive) receipt of the funds, either of which would invalidate the exchange. The use of a QI also satisfies one of the safe harbors set forth under IRC 1031.
What are the 45 day and 180 day rules?
Generally a taxpayer has 45 days from the transfer date of the relinquished property to properly identify the replacement property, and up to 180 days from the transfer date to acquire one or all of the identified properties. The 180 day period can be shortened. The 180 day rule is actually 180 days after the transfer of the relinquished property, or the date of taxpayer's federal tax return (including extensions), whichever event occurs first.
Do I still need a QI if I am involved in a simultaneous exchange where more than two parties are involved and all the deeds and proceeds are transferred within minutes?
Yes. Tax law provides that all exchange structures (except a two-party direct swap) need a party separate from the transaction to receive the cash proceeds. Today, the separate party is referred to as a Qualified Intermediary.
Can I do an exchange with a relative?
Yes. A taxpayer can do a direct exchange with a related party but both taxpayer and the related party must retain their respective replacement properties for at least two years after the exchange.
When is an exchange not appropriate?
An exchange is not appropriate when the taxpayer does not want like kind property, wants a higher depreciable basis in the replacement property or desires a substantial amount of cash.
Can real estate be exchanged for anything other than real estate?
Generally no. All real estate can be exchanged for all other real estate EXCEPT when:
- The real estate is held as your primary residence or is held for personal use
- The real estate is held primarily for sale or as inventory
- The real estate located in the U.S. is exchanged for foreign real estate, or vice versa
- The real estate is not identified or acquired within the time frames provided in the Internal Revenue Code (IRC)
Do second homes qualify for exchange treatment?
Yes, as long as the primary purpose for the vacation home is not for personal use. If you are contemplating such an exchange, we strongly urge you to contact a knowledgeable tax advisor before proceeding.
Do real property leases qualify for Section 1031 exchange treatment?
Yes. With the requirement that leases must have at least 30 years (including unexercised options) remaining at the time of the exchange to qualify as like kind property to real estate. Unexercised options to renew can be included in the 30-year calculation.
Do the names on the replacement property and the relinquished property have to be the same?
Yes. Exceptions include single member limited liability companies and grantor trusts which pass through entities for federal income tax purposes.
Can I offer an exchange to my lender in lieu of foreclosure?
Theoretically, yes, however it is still likely that there is a taxable capital gain and depreciation recapture even if there is no remaining equity. Because there are several complexities to consider, it is best to consult your CPA or tax advisor.
Are partnerships allowed to do exchanges?
Yes. All tax-paying entities are entitled to the benefits of Section 1031; however, the Code is clear that individual partners may not exchange their partnership interest for another partnership interest or for real property.
Can I finance the purchase of the relinquished property?
Yes. If the taxpayer desires to use the note to purchase the replacement property, then the note should be issued by the buyer to the Qualified Intermediary (QI). The taxpayer cannot receive any installment payments during the exchange period. The note can be used to purchase the replacement property, or the QI can sell the note to a third party. If at the end of the exchange period the note has not been sold or satisfied in full, the QI will distribute the note to the taxpayer and it will be taxable boot.
When is a reverse exchange appropriate?
Your CPA or tax advisor can provide the best guidance. Some common examples of when a reverse exchange is appropriate are:
- Market conditions arise where the value of replacement properties is rapidly accelerating or desirable properties are becoming less available. A reverse exchange allows you to acquire the right property before values get out of reach or the property is removed from the market
- You are ready to close on the replacement property, but the buyer of your relinquished property is unable to close on time. If you cannot extend the closing of the replacement property, then a reverse exchange may be your only option for tax deferral
- You have several relinquished properties to dispose of in order to complete a typical deferred exchange within the statutory 180 days. Unfortunately, only some of the properties can be disposed of within that time. By using these proceeds to acquire a fractional interest in the replacement property, you can do a reverse exchange for the remaining fractionalized interest, providing an additional 180 days to dispose of the remaining relinquished properties
Can I exchange unimproved real property for improved real property?
Yes. Improved real property is like kind and can be exchanged for unimproved real property and vice versa. Real estate is like kind to real estate so long as it is held for productive use in a trade or business or for investment purposes.
