In some cases, the replacement property requires new construction or significant improvements to be completed in order to make it viable for the specific purpose the Exchanger has intended for the property. Such construction or improvements can be accomplished as part of the exchange process, with payments to contractors and other suppliers being made by the facilitator out of funds held in a trust account. Therefore, if the replacement property is of lesser value than the relinquished property at the time of the original transaction, the improvement or construction costs can bring the value of the replacement property up to an exchange level or value which would allow the transaction to remain completely tax deferred.
The reverse exchange is actually a misnomer. It represents an exchange in which the Exchanger locates a Replacement Property and wants to acquire it before the actual closing of the Relinquished Property. Since the Exchanger cannot purchase the Replacement and later exchange into property that he already owns, he must find a method to acquire the Replacement Property and still maintain the integrity of his exchange.
The most current Reverse Exchange approach is for the Exchanger to arrange the acquisition of the Replacement Property by adding enough cash (or arranging suitable financing) to buy the new property. The title for the new property is then held by an Exchange Accommodation Titleholder (an LLC created by the Qualified Intermediary). The EAT holds title to the Replacement property until such a time within the 180 day exchange period that the Relinquished Proeprty is sold. At that time either the Replacement Property is deeded to the Exchanger by the EAT, or the EAT itself is transferred to the Exchanger.
Replacement Title with EAT
Delayed or Deferred Exchanges
Generally, when one discusses exchanges, the type of exchange referred to is the delayed or Starker exchange. This term comes from the name of the Exchanger who was first challenged for a delayed exchange by the IRS. From this tax court conflict came the code change in 1984 that formally recognized the delayed exchange for the first time. As mentioned earlier, this is now the most common type of exchange.
In a delayed exchange, the Relinquished Property is sold at Time 1, and after a delay of up to 180 days, the Replacement Property is acquired at Time 2.
The following will represent the traditional rules and time constraints for completing a qualifying delayed exchange:
Property that qualifies for exchange under Section 1031 must be "like-kind", which is defined in the Regulations as follows:
1. Property held for productive use in a trade or business, such as income property, or
2. Property held for investment.
Therefore, not only is rental or other income property qualified, so is unimproved property which has been held as an investment. Such unimproved property can be exchanged for improved property of any type, or vice versa. Also, one property may be exchanged for several, or vice versa. This means that almost any property that is not a personal residence or second home is eligible for exchange under Section 1031.
The Exchanger has a maximum of 180 days from the closing of the Relinquished Property or the due date of that year's tax return, whichever occurs first, to acquire the Replacement Property. This is called the Exchange Period. The first 45 days of that period is called the Identification Period. During these 45 days, the Exchanger must identify the candidate or target property which will be used for the Replacement Property. The identification must:
Be in writing,
Signed by the Exchanger, and,
Received by the facilitator or other qualified party (faxed, postmarked or otherwise
identifiably transmitted through Federal Express or other dated courier service, or digital signature).
This must all occur within the 45 day period. Failure to accomplish this identification will cause the exchange to fail.
Three rules exist for the correct identification of replacement properties.
1) The Three Property Rule dictates that the Exchanger may identify three properties of any value, one or more of which must be acquired within the 180 Day Exchange Period.
2) The Two Hundred Percent Rule dictates that if four or more properties are identified, the aggregate market value of all properties may not exceed 200% of the value of the Relinquished Property.
3) The Ninety-five Percent Exception dictates that in the event the other rules do not apply, if the replacement properties acquired represent at least 95% of the aggregate value of properties identified, the exchange will still qualify.
As a caveat it should be mentioned that these identification rules are absolutely critical to any exchange. No deviation is possible and the Internal Revenue Service will grant no extensions.
* Ironically, although only approximately 3-5 percent of exchanges are audited, the few exchanges which don't pass upon audit, typically they fail because of discrepancies in identification.
Mechanics of a Deferred or Delayed Exchange
It is important that any exchange be carefully planned with the help of an experienced, competent and creative legal and exchange professional. Preferably one who is completely familiar with the tax code in general, not just Section 1031, and who has extensive experience in doing many different kinds of exchanges. Thorough planning can help avoid many subtle exchanging pitfalls and also ensure that the Exchanger will accomplish the goals which the transaction is intended to facilitate.
Once the planning is complete, the exchange structure and timing are decided, and the Relinquished Property is sold and the transaction is closed, the facilitator becomes the repository for the proceeds of the sale. The money is kept in the Exchanger's Qualified Escrow Account until the Replacement Property is located and instructions are received to fund the Replacement Property purchase. The funds are then wired or sent to the closing entity in the most appropriate and expeditious manner, and the Replacement Property is purchased and deeded directly to the Exchanger. All the necessary documentation to clearly memorialize the transaction as an exchange is provided by the facilitator, such as exchange agreement, assignment agreement and appropriate closing instructions.
The issue of constructive receipt is one that continues to concern taxpayers, their accountants and tax advisers alike. Over the years that the public has benefited from tax deferred exchanges, various elements of control have been reviewed by the courts in attempting to determine whether the taxpayer has in fact exercised sufficient control over the proceeds from the disposition of the Relinquished Property so as to be considered in receipt of such funds and thereby taxed. Clearly if a taxpayer receives the proceeds from the disposition of his Relinquished Property, the use of terms "exchange" or "Relinquished Property" have no meaning since the transaction will be viewed as a sale and the taxpayer taxed accordingly. Where someone other than the taxpayer receives and controls the use of the proceeds from the disposition of the Relinquished Property, the relationship between that person or entity and the taxpayer is closely scrutinized to determine whether or not it is so closely related to the taxpayer that it can be considered that the taxpayer has constructively received the funds.
Selecting Your Facilitator or Qualified Intermediary
There are relatively few federal regulations governing the function of facilitators, other than the fiduciary responsibilities that govern the conduct of any entity holding or handling other people's money. For this reason, care in selecting a facilitator for you or a client's exchange is an important process of evaluation. Select the facilitator as you would an attorney for personal representation or a physician to treat your children. Look for experience in doing exchanges and reputation in the real estate, legal or tax communities. Talk to escrow and closing professionals that handle exchanges and get their opinion. If possible choose a facilitator who is thoroughly familiar with the process, since many times other aspects of the process will bear significantly on your exchange. For instance, the handling of Promissory Notes, bulk transfers or other variations to the overall transaction. Ask about the security of your funds, and what options you as an Exchanger may have to assure that your funds will be safeguarded. Although the costs and fees for an exchange are relatively insignificant, ask about them, and get a clear explanation of what you will be charged. With a few notable exceptions, fees are very similar, one facilitator to the next. What is of far greater importance is the competence and ability of the facilitator and its personnel to complete your exchange promptly, professionally and legally.
Tax Consequences of Exchanging
In order to assess the tax consequences inherent in any exchange transaction, it is first necessary to understand the definition and exchange related meaning of terms such as Cost Basis, Adjusted Basis, Capital Gain, Net Sales Price, Net Purchase Price and Boot.
Cost Basis: This is where all tax related calculations in an exchange begin. Cost Basis essentially refers to your original cost in acquiring a given property. Therefore, if the original purchase price of the property you anticipate exchanging was $175,000; your Cost Basis is $175,000.
Adjusted Basis: At the time of your exchange it is necessary to determine your current or adjusted basis. This is accomplished by subtracting any depreciation reported previously, from the total of the original cost basis, plus the value of any improvements.
Capital Gain: "Realized Gain" and "Recognized Gain" are the two types of gain found in exchange transactions. Realized Gain reflects the difference between the total consideration or total value received for a given property and the adjusted basis.
Recognized Gain reflects that portion of the Realized Gain, which is ultimately taxable. The difference between realized and recognized gain exists because not all realized gain is ultimately determined to be taxable and issues such as boot can affect how and when gain is recognized.
Net Sales Price: This figure simply represents the sales price, less costs of sale.
Net Purchase Price: This figure simply represents the purchase price, less costs of purchase.
Boot: When considering an exchange of real property, the receipt of any consideration other than real property is determined to be "boot". So, essentially, a working definition of boot is: any property received which is not considered like-kind. And remember, non like-kind property in an exchange is taxable. Therefore, boot is taxable.
There are two types of boot, which can occur, in any given exchange. They are mortgage boot and cash boot. Mortgage boot typically reflects the difference in mortgage debt, which can arise, between the exchange of relinquished property and the replacement property.
As a general rule, the debt on the replacement property has to be equal to, or greater than, the debt on the relinquished or exchange property. If it is less, you'll have what is called "overhanging debt" and the difference will be taxable.
Let's assume for example that you are selling your Relinquished Property for $375,000 and that it has a mortgage of $250,000. At closing, the mortgage will be paid off and the balance of $125,000 will be held by your facilitator.
Suppose that you then find a new property costing $350,000, with a mortgage of $225,000 that you will assume. The assumption of this debt, along with your exchange trust fund of $125,000 will complete your purchase. Under this example you would have to pay tax on $25,000 of capital gains because your debt decreased by that amount.
Likewise, cash boot reflects the amount of cash or other value received.
New Adjusted Basis: This figure reflects the necessary adjustments to your basis after the replacement property is acquired. Since the amount of deferred gain must be considered, the calculation below will serve as a method for determining the new adjusted basis on the replacement property.
A Few Common Questions and Answers
Equity and Gain
Is my tax based on my equity or my taxable gain?
Tax is calculated upon the taxable gain. Gain and Equity are two separate and distinct items. To determine your gain, identify your original purchase price, deduct any depreciation, which has been previously reported, then add the value of any improvements, which have been made to the property. The resulting figure will reflect your cost or tax basis. Your gain is then calculated by subtracting the cost basis from the net sales price.
Deferring All Gain
Is there a simple rule for structuring an exchange where all the taxable gain will be deferred?
Yes, if you:
1) Purchase a replacement property which is equal to or greater in value than the net selling price of your relinquished (exchange) property, and
2) Move all equity from one property to the other; the gain will be totally deferred.
3) Replace your debt.
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?
Yes, like-kind refers more to the type of investment than to the type of property. Think in terms of investment real estate for investment real estate, business assets for business assets, etc.
Simultaneous Exchange Pitfalls
Is it possible to complete a simultaneous exchange without an intermediary or an exchange agreement?
While it may be possible it may not be wise. With the Safe Harbor addition of qualified intermediaries in the Treasury Regulations and the recent adoption of good funds laws in several states, it is very difficult to close a simultaneous exchange without the benefit of either an intermediary or exchange agreement. Since two closing entities cannot hold the same exchange funds on the same day, serious constructive receipt and other legal issues arise for the Exchanger attempting such a simultaneous transaction. The addition of the intermediary Safe Harbor was an effort to abate the practice of attempting these marginal transactions. It is the view of most tax professionals that an exchange completed without an intermediary or an exchange agreement will not qualify for deferred gain treatment. And if already completed, the transaction would not pass an IRS examination due to constructive receipt and structural exchange discrepancies. The investment in a qualified intermediary is insignificant in comparison to the tax risk associated with attempting an exchange, which could be easily disqualified.
How long must I wait before I can convert an investment property into my personal residence?
A few years ago the Internal Revenue Service proposed a one year holding period before investment property could be converted, sold or transferred. Congress never adopted this proposal so therefore no definitive holding period exists currently. However, this should not be interpreted as an unwritten approval to convert investment property at any time. Because the one year period may or may not reflect the intent of the IRS, most tax practitioners advise their clients to hold property more than two years before converting it into a personal residence.
Remember, intent is very important. It should be your intention at the time of acquisition to hold the property for its productive use in a trade or business or for its investment potential.
What if my property was involuntarily converted by a disaster or I was required to sell due to a governmental or Eminent Domain action?
Involuntary conversion is addressed within Section 1033 of the Internal Revenue Code. If your property is converted involuntarily, the time frame for reinvestment is extended to twenty-four months from the end of the tax year in which the property was converted. You may also apply for a twelve month reinvestment extension.
Facilitators and Intermediaries
Is there a difference between facilitators?
Most definitely. As in any professional discipline, the capability of facilitators will vary based upon their exchange knowledge, experience and real estate and/or tax familiarity.
Facilitators and Fees
Should fees be a factor in selecting a facilitator?
Yes, however they should be considered only after first determining each facilitator's ability to complete a qualifying transaction. This can be accomplished by researching their reputation, knowledge and level of experience.
Personal Residence Exchanges
Do the exchange rules differ between investment properties and personal residences? If I sell my personal residence what is the time frame in which I must reinvest in another home and what must I spend on the new residence to defer gain taxes?
The rules for personal residence rollovers were formerly found in Section 1034 of the Internal Revenue Code. You may remember that those rules dictated that you had to reinvest the proceeds from the sale of your personal residence within twenty-four months before or after the sale, and you had to acquire a property which reflected a value equal to or greater than the value of the residence sold. These rules were discontinued with the passage of the 1997 Tax Reform Act. Currently, if a personal residence is sold, provided that residence was occupied by the taxpayer for at least two of the last five years, up to $250,000 (single) and $500,000 (married) of capital gain is exempt from taxation.
Exchanging and Improvements
May I exchange my equity in an investment property and use the proceeds to complete an improvement on a vacant lot I currently own?
Although the attempt to move equity from one investment property to another is a key element of tax deferred exchanging, you may not exchange into property you already own. You may however, complete an Improvement Exchange which utilizes an Exchange Accommodation Titleholder (EAT), created by the Facilitator, to hold title while improvements are being completed. SE elsewhere for instructions for Improvement or Construction Exchanges.
Partnership or Partial Interests
If I am an owner of investment property in conjunction with others, may I exchange only my partial interest in the property?
Yes. Partial interests qualify for exchanging within the scope of Section 1031. However, if your interest is not in the property but actually an interest in the partnership which owns the property, your exchange would not qualify. This is because partnership interests are excepted from Section 1031. But don't be confused! If the entire partnership desired to stay together and exchange their property for a replacement, that would qualify.
Are reverse exchanges considered legal?
Yes, although they can sometime become complex and always require appropriate planning.
We have a reverse exchange specialist on our team who can help plan and facilitate even the most complex reverse, build to suit or complex transaction.
Why are the identification rules 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 forty-five day provision was created to eliminate questions about the time period for identification and 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. It is when identifying four or more properties, the total aggregate value of the properties identified must not exceed more than two hundred percent of the value of the relinquished property.
An additional exception exists for those whose identification does not qualify under the 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 total at least ninety-five percent of the properties identified.
Should identifications be made to the intermediary or an attorney, escrow, closer or title company?
Identifications may be made to any party listed above. However, many times the escrow holder or closer is not equipped to receive your identification if they have not yet opened a transaction file. Therefore it is easier and safer to identify through the intermediary or facilitator provided the identification is postmarked or received within the forty-five day identification period.
DISCLAIMER: To ensure compliance with requirements imposed by the IRS, we inform you that the information posted at this website does not contain anything that is intended as legal or tax advice, and that nothing herein can be relied upon as legal or tax advice. Further, the IRS wants us to let you know that nothing herein can be used for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any tax-related matter addressed herein. If assisting with your Section 1031 tax-deferred exchange, Fyntex cannot advise the owner concerning specific tax consequences or the advisability of a tax-deferred exchange for tax purposes. We recommend that anyone contemplating an exchange seek the advice of an accountant and/or attorney.