Section 1031 Exchanges

What you need to know about Section 1031 Exchanges

Created January 23, 2002


1. Background/History of Section 1031.

2. Deferral. Section 1031 is a tax deferral mechanism – NOT avoidance.

3. Ingredients of an Exchange.

a. “like-kind” real properties;
b. “investment” or business property;
c. “held” for investment;
d. “timing” requirements.

4. Terminology.

a. Exchanger – the property owner seeking to defer capital gains tax by utilizing Section 1031 (in the Code, referred to as “taxpayer”).
b. Relinquished property (or exchange property) – the property that is sold/exchanged by the Exchanger.
c. Replacement property – the property that is acquired by the Exchanger. (Note: there can be more than one replacement property.)
d. Boot – if the replacement property is not worth as much as the relinquished property, then the difference received by the taxpayer is called “boot”. Boot is taxable in its entirety. (e.g., $300,000 exchange property; $270,000 replacement property = $30,000 “boot”.)
e. Constructive receipt – this term refers to control of proceeds by an Exchanger, even though funds may not be directly in his possession.
f. Like-kind property – this term refers to the nature or character of the property, not its grade or quality. Generally, all real property is “like-kind” as long as the Exchanger’s intent is to hold the property as an investment or for productive use in a trade or a business.
g. Direct deeding – IRS recognizes that a seller of replacement property may deed directly to the Exchanger rather than through the qualified intermediary as long as there is appropriate documentation to reflect this. Similarly, the taxpayer may deed directly to its purchaser rather than deed to the qualified intermediary.
h. Qualified intermediary – an individual on institution unrelated to the Exchanger who becomes an integral part of an exchange.
i. Safe harbors – those prescribed methods of exchanges which are specifically approved by the IRS. If not structured as a safe harbor, an exchange may be “outside the envelope”.
j. Identification period – the period in which an Exchanger must identify replacement property in the exchange. This identification period starts on the day of exchange and transfer (closing) of the first relinquished property and ends at midnight on the 45th day thereafter.
k. Exchange period – the period during which the Exchanger must acquire replacement property in the exchange. The exchange period starts on the date of closing and ends on the earlier of 180 days thereafter OR on the due date (including extensions) of the Exchanger’s tax return for the year of the transfer of the relinquished property.

5. Delayed Exchanges.

a. Timing – the original Section 1031 provisions of the Internal Revenue Code required a simultaneous exchange. That was the law for years. It made it difficult to achieve the desired benefits as everything has to be timed for the same date. For a variety of reasons, including a series of lawsuits by a gentleman named Starker, in 1991 the IRS adopted regulations which specifically allowed for delayed exchanges. These are the most common exchanges utilized today. The delayed exchange rules of Section 1031 are as follows:

i. Taxpayer must identify potential replacement property within 45 days of the closing of the relinquished property. (Note: closing, NOT contract.)
ii. Identification of replacement property must be in writing.

1. 200% rule
2. three property rule
3. 95% rule.

iii. Exchange period – 180 days (But Note: October 18 or after…BEWARE)
iv. Qualified Intermediary to be used.

6. Common Misconceptions and Red Flags about 1031 Exchanges.

a. Taxpayer makes decision to exchange after the sale.
b. Taxpayer or his closing attorney holds the money “in trust”.
c. You can only exchange a lot for a lot, condo for a condo, etc.
d. Second home – does it qualify?
e. Length of time to hold investment property.
f. Refinancing – let’s pull out the equity.
g. Ultimate move to a principal residence
h. Foreign property.
i. Related parties.

7. Specific Situations.

a. Exchange of Investment Property for Residence to be Constructed. A “ticklish” situation arises when the replacement property desired by the taxpayer does not exist yet – it is to be built or it may be under construction. Keeping in mind that the basic rule of the delayed exchange is that the closing must occur within 180 days from the first closing, this can create a problem. There are specific guidelines in the IRS regulations relative to replacement property being under construction.
b. “Reverse Exchange (Parking or Warehousing). Taxpayer finds replacement property before selling his exchange property or something happens to the sale of the exchange property – what now? This is a situation which, until in the fall of 2000, had no IRS guidelines. The concept of a “reverse exchange” was often talked about. However, the reality was that no such exchange previously existed under Internal Revenue Service guidelines. Now Rev. Proc. 2000-37 creates a new safe harbor for reverse like-kind exchanges known as a qualified exchange accommodation arrangement (“QEAA”). Taxpayer must find a third party (Accommodator) to actually acquire the replacement property for the taxpayer, hold that property until the taxpayer had the ability to sell the exchange property. Once that sale could take place, then a normal exchange would work. This methodology involves expense and some practical considerations:

i. Who is the Accommodator?
ii. How does the Accommodator pay for this replacement property?
iii. What are the fees of the Accommodator?
iv. The replacement property then has to be closed twice –first when the Accommodator buys the property from the seller, and then when the Accommodator conveys the property to the taxpayer (double transfer fees – in Hilton Head Island, that amounts to $6.20 per $1,000).

8. Non-Tax Reasons to Exchange.

a. Exchange from a fully depreciated property to a higher value property that can be depreciated.
b. From a non-income producing property to improved property generating cash flow.
c. For a low cash flow property to a higher cash flow property.
d. Slowly appreciating property to a fast appreciating property.
e. Exchange for properties that may be easier to sell in coming years.
f. Meet clients’ location requirements or lifestyle requirements.
g. Exchange from several smaller properties into one larger property – reduced management responsibility.
h. Change from a larger property to several smaller properties to ultimately divide the estate among several children or for retirement purposes.
i. Exchange from a management intensive property to a triple net lease property where the lease is long-term and there are minimal management requirements of the landlord.

This outline was created by David J. Tigges and Cary S. Griffin, reproduced by Tracy A. Santosuosso, and represents a summary of certain aspects of an IRC §1031 Exchange. It is not intended to be a complete or all inclusive report on this technical section of the Internal Revenue Service Code. Individual circumstances may vary. Caution should be given to any potential tax deferred exchange and competent tax and real estate advice should be sought from qualified professionals.

Bethea, Jordan & Griffin, P.A.
Attorneys and Counselors at Law
Shelter Cove Executive Park
23-B Shelter Cove Lane
Suite 400
Hilton Head Island, South Carolina 29928-3588
www.BJGLaw.com
CGriffin@BJGLaw.com

For more information please contact Tracy@WorryFreeRealEstate.com or call 843-247-3770.


Information is deemed reliable, but must be verified by all parties.

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