Section 1031 of the Internal Revenue Code relates to the disposition of property that is held for use in productive trade or business or held for investment. If performed properly, code section 1031 provides an exception to the rule requiring recognition of gain upon the sale or exchange of property. In other words, if the requirements of a valid 1031 exchange are met, capital gain recognition can be deferred until the taxpayer chooses to recognize it. The current Federal tax rate (maximum) on long term capital gains is 28%, plus any applicable state taxes. Long term capital gains are not taxed as ordinary income. For an exchange to be 100% tax deferred, the Exchanger must acquire replacement property that is of equal or greater value and spend all of the net proceeds from the relinquished property. Many specific requirements must be satisfied in order to complete the exchange properly. With the recent IRS Regulations in place, an experienced qualified Broker, Intermediary and Escrow/title Officer, can accomplish an exchange with ease.

The best way to confirm if you have an exchange is to ask the principals involved. Here are some helpful hints to determine if someone "may" be wanting to do an exchange.

If yes, then the Buyer will not be eligible for a 1031 Exchange.Is the property intended for investment purposes?
If yes, then either the Seller or Buyer could be wanting to do an Exchange.

In today's real estate climate, it is imperative that Real Estate Brokers and Agents understand the options a 1031 Exchange can offer their clients. Without such knowledge brokers and their agents are open to potential liabilities, due to lack of knowledge. Unfortunately, you can be as liable for what you don't say, as well as for what you do say. Simply offering the option of a Tax-deferred Exchange can eliminate potential liability on the Broker's part. The "Exchange Agent" can have more satisfied clients by offering them the option to save substantial tax dollars, through exchanging. The Exchange Agent can also increase their income with the additional knowledge of exchanging.

The IRS Code Section 1031 states that property held for use in productive trade or business or property held for investment , is potentially exchangeable. One can therefore qualify for non recognition of gain upon the disposition of such property, assuming all other requirements are met. This means that business property or property held for investment, may be disposed of to a buyer (sold), set up with a "Qualified Intermediary", put into escrow, which will document the transaction as an exchange, and within the codified time frame, repurchase replacement property of "like kind" thereby completing the exchange. It is not required that exactly the same type of property is acquired. In 1989 the IRS attempted to change the meaning of "like kind" to "similar use", and unfortunately many people believe that is the case. The attempt was defeated. "Like kind" property that can be exchanged under the current meaning of Code Section 1031 can include: PROPERTY THAT IS HELD FOR PRODUCTIVE USE IN A TRADE OR BUSINESS, OR, PROPERTY THAT IS HELD FOR INVESTMENT. "Like kind" property can include, but is not limited to any of the following, provided it is held for investment : commercial, single family rental property, condos, raw land, apartments, vacations home, second home, duplexes, industrial properties and a Leasehold Interest of 30 years or more.

A persons PRIMARY RESIDENCE does NOT come under the rules of Section 1031, and is specifically EXCLUDED, as is property held "primarily for resale" or dealer property.

A common misconception to "like kind" is that the properties being exchanged be of "similar use". This is simply not true. A commercial property can be exchanged for an apartment complex or bare land exchanged for a single family rental.

IRC Section 1034 encompasses a primary residence only. A taxpayer is only allowed one primary residence, therefore, by reason of default, any other real property could be considered possible 1031 property. The only condition is that it meets the guidelines of Section 1031.

The most important reason is to able to defer potentially taxable gain one may realize from a sale of the property. This way one may be able to use All OF THEIR EQUITY to acquire another property, instead of the amount of equity left over after paying applicable Federal and State income taxes on their gain. Additionally, the ability to go from one type of property to another allows an investor to utilize these other concepts: Leverage, Diversification, Cash Flow, Consolidation, Management relief, and possibly Increase their Depreciation.

It is possible, under the current IRS Section 1031 rules, to continue to exchange properties, using all of your equity, thus increasing your portfolio Net Worth much faster than were you to sell properties, pay the taxes, and then acquire another property with the remaining equity.

It is applicable when the property in question falls within the "like kind" definition and the principal intends to BUY another property of "like kind" within 180 calendar days following the close of escrow from the SALE, and when the Investor has a recognizable gain.

CAUTION must be exercised in this area. Property does not have to appreciate in value to have a gain!! The property may have a "built in" gain as a result of a previous exchange or from depreciation taken. Be sure to consult with your legal and/or tax advisor.

Remember, under the delayed exchange parameters, there is a maximum of 180 calendar days to purchase replacement property. Therefore, if the principal is not sure at the time of closing the sale property, it is imperative that it be structured as an exchange rather than a sale. Otherwise, if the escrow Is closed without the exchange in place, the principal will have receipt of proceeds and cannot perform an exchange.

The worst case is that if the exchange is "set up" and the principal decides not to buy replacement property and takes the proceeds, the principal just pays taxes as they normally would. Without the exchange being "set up", the principal does not have that option. An informed Client, Seller, will appreciate the flexibility.

The first Epson to identify is the one wanting to effect a 1031 Tax-Deferred Exchange. This person will be your Exchanger. If your Exchanger is the SELLER, you are handling a PHASE I EXCHANGE. If your Exchanger is the BUYER, you are handling a PHASE II EXCHANGE.

PHASE I CLIENT = SELLER & PHASE II CLIENT = BUYER

In a Phase I Exchange, your Buyer will be treated normally, as if there is no exchange involved in the transaction. You will only have to obtain the Buyer's signature to one document, the Amendment to Escrow/Closing Instructions. Otherwise, the Buyer does nothing different.

In a Phase II Exchange, the Seller will be treated normally, as if there is no exchange involved in the transaction. Again, you will only have to obtain the Seller's signature to one document, the Amendment to Escrow/Closing Instructions. Otherwise, the Seller does nothing different.

In a PHASE I Exchange a QUALIFIED INTERMEDIARY will be substituted into the transaction as the Seller.

In the PHASE II Exchange, a QUALIFIED INTERMEDIARY will be substituted into the transaction as the Buyer.

After an exchange has been "set up", by contacting a Qualified Intermediary prior to closing a sale, the Seller, Exchanger, must identify up to three (3) potential properties they MAY intend to acquire, within 45 days of the close of the "sale" escrow. It is immaterial what the value is of the potential properties.

One can list, or identify, four (4) or more, properties, however these properties cannot have an aggregate value of 200% or more of the sale property. If more than three (3) properties are identified, and the value exceeds 200% of the sale price, then you must close escrow on 95% of the list. Escrow must close, on at least one of the identified properties, within 180 calendar days from the date of the close of the sale escrow. Be sure to check with your legal and/or tax advisor.

In a Phase I Exchange, it is imperative that the Exchanger (who is the owner of the property) does NOT receive any money. The Seller's net proceeds are wired to the Intermediary into a separate, interest bearing account. Each exchange has its own account, therefore, you must call the Intermediary BEFORE wiring to obtain the account number. If not, the wire will probably be returned to you due to insufficient information.

In a Phase II Exchange, the funds required to close the transaction will be sent to you from the exchange account held by the Intermediary. You will need to contact the Intermediary to find out exactly how much money is in the exchange account. In the event there is insufficient funds in the exchange account to close your escrow/ closing, then the Exchanger will have to deposit the additional funds required to close the escrow/closing.

The Intermediary does not need to see or sign any of the lender's documents. This is the Exchanger's loan and only the Exchanger should be signing. Most lenders do not have a problem with the Qualified Intermediary inserted as the Exchanger's Name on Instructions or Settlement Statements. However, if the lender does not want to see an Intermediary's name on your statements or instructions, you can eliminate their name on items sent to the lender

Paramount to any exchange is a competent Qualified Intermediary. The Intermediary is the entity which structures, consults, guides and documents the exchange transaction from beginning to end. A sound Intermediary will provide safety and security for the funds held and provide the technical experience needed to maintain the integrity of the exchange. They do not replace competent tax or legal advise. Quite the contrary, they are not allowed to give tax or legal advise, this could disqualify them as an Intermediary.

You should contact your local Title and Escrow Companies, local Attorney's and tax practitioners for references to a "QUALIFIED INTERMEDIARY".

A "QUALIFIED INTERMEDIARY"that you can also contact is ASSET PRESERVATION INCORPORATED, (API) A STEWART TITLE COMPANY subsidiary. They are qualified to take care of Real Estate Exchanges Nationwide. They are located at 8700 Auburn – Folsom Road, Suite 600, Granite Bay, Calif., 95746. Their phone is (800) 282-1031 and fax is (916) 791-6003 and their local phone is (916) 791-5991.

You will want to check their current rates, but at last communication their rates were as follows: $350.00 for the first "SALE" property escrow/closing; $200.00 for each subsequent "SALE" property escrow/closing (within the same exchange transaction); PLUS $350.00 for the first "PURCHASE" property escrow/closing, and $200.00 for each subsequent "PURCHASE" property escrow/closing (within the same exchange transaction). These are their fees for either a Delayed or Simultaneous Exchange. No other hidden or extra fees, they say. Please contact them directly for additional information as to how interest on "Qualified Escrow Accounts" are handled, and other specific questions.

They are quite knowledgeable and glad to help. The majority of the information contained in these FAQ's was furnished by ASSET PRESERVATION INCORPORATED.

See their web site at: http://www.apiexchange.com

In the regulations of 1991, many of the "grey areas" were clarified in Section 1031 of the Internal Revenue Code, and established the Safe Harbor provisions.

Safe Harbors include:

1) The use of a Qualified Intermediary;
2) Receipt of interest or "Growth Factor" by the Exchanger;
3) The use of a Qualified Escrow Account; and
4) The use of security instruments in an Exchange (such as the use of a Qualified Intermediary; qualified escrow/closing and trust accounts; third party guaranty).

The usual recommended procedure is to set out the Exchanger's intent to perfect a 1031 Tax-Deferred Exchange in the purchase agreement (contract) between the Seller and Buyer. The following is an "example" of language that is currently satisfactory to establish the Exchanger's intent:

PHASE I (SALE):

Buyer is aware that Seller is to perform a 1031 Tax-Deferred Exchange. Seller requests Buyer's cooperation in such an exchange and agrees to hold Buyer harmless from any and all claims, liabilities, costs or delays in time resulting from such an exchange.

PHASE II (BUY):

Seller is aware that Buyer is to perform a 1031 Tax-Deferred Exchange. Buyer requests Seller's cooperation in such an exchange and agrees to hold Seller harmless from any and all claims, liabilities, costs or delays in time resulting from such an exchange.

It is advisable to also have communicated with a Qualified Intermediary and include the following in a purchase, or sale, contract as well:
"Seller, (or Buyer) has entered into an agreement with (name of the Intermediary), to act as their Qualified Intermediary in facilitating said exchange".

Provided the Exchanger's intent to perfect a 1031 Tax-Deferred Exchange is established in the Purchase, or Sale, Agreement and the Intermediary's documents are executed, it is not necessary to prepare separate "EXCHANGE" Instructions.

This may be contrary to what is expected in your area. By all means, make the Client happy. However, the IRS will look to the Purchase or Exchange Agreement to validate the exchange and not necessarily the Exchange Instructions. Be sure to contact your legal and/or tax advisor.

Pursuant to Revenue Ruling 90-34, IRS. 1990-16 (December 16, 1990) and I. R. S. Regulations 1.1031(k)-1(g)(4)(v), it is no longer necessary to do "sequential" deeding. That is, deed from the Seller to the Intermediary and then the Intermediary deeds to the Buyer.

It is now an accepted practice to deed directly, that is, the Exchanger deeds directly to the Buyer in a Phase I Exchange or the Seller deeds directly to the Exchanger in a Phase II Exchange.

WHAT HAPPENS WHEN BOTH THE SELLER AND BUYER ARE WANTING AN EXCHANGE?

This is not that unusual of a situation and is very simple to complete. You would handle the Seller's Exchange just like a Phase I Delayed Exchange and you would handle the Buyer's Exchange just like a Phase II Exchange.

On a Phase I Exchange, you will prepare a 1099 form showing the Exchanger's name, address and Tax ID Number (Social Security Number). The Exchanger is the only one that needs to sign this form.

IT IS IMPERATIVE THAT YOU COMPLETE THE SECTION IN YOUR 1099 FROM THAT INDICATES THAT THIS PROPERTY IS PART OF AN EXCHANGE

If the Exchanger wants to receive a portion of his/her proceeds in cash, this must take place BEFORE any funds are sent to the Intermediary. Once the Exchanger tells you that he/she wants to receive money, contact the Intermediary right away to avoid any problems. Once the funds are deposited into the exchange account, the Exchanger cannot receive these funds until the exchange is completed.

There is nothing different in how the exchange is handled, but the Intermediary will need to see a copy of the Trust Agreement, the Partnership Agreement, or a Corporate Resolution.

To have a valid exchange, the Exchanger's vesting should be exactly the same in the Phase II transaction as it is in the Phase I. Therefore, if the Exchanger owns the relinquished property in his/her personal names, the Exchanger should not try and put the replacement property into a family trust until after the exchange is closed.

No. For an exchange to be 100% tax deferred, the Exchanger must acquire a replacement property that is of equal or greater value and spend all of the net proceeds from the relinquished property.

WHAT IS BOOT?

Boot is defined as any "NON LIKE KIND" property received by the Exchanger in the exchange and it is taxable.

1) CASH BOOT:

Cash Boot consists of any funds received by the Exchanger, either actually or constructively. If an Exchanger does not spend all of the proceeds from the sale of the relinquished property, he/she will have actual receipt of the balance not spent and pay taxes on that amount.

Constructive receipt of funds may occur in a case where the Exchanger carries back a note from his/her Buyer of the relinquished property, then sells that note at a discount. The Exchanger never actually receives funds for the discounted amount, however, he/she has constructively received that discount and pays tax on that amount.

2) MORTGAGE BOOT OR "DEBT RELIEF":

Mortgage Boot occurs when the Exchanger does not acquire debt that is equal to or greater than the debt that was paid off, therefore, they were "RELIEVED" of debt. If the Exchanger does not acquire equal or greater debt on the replacement property, they are considered to be "RELIEVED OF DEBT", which is perceived as taking a monetary benefit out of the exchange. Therefore, the debt relief portion is taxable, unless offset by adding equivalent cash to the transaction. More to it than just spending all the exchange equity!!

So an Exchanger must buy of equal or greater value while spending the NET (after costs) equity. It is absolutely acceptable to take cash out of the exchange and pay taxes on that amount only.

IMPORTANT: If the Exchanger wants cash out of the PHASE I exchange, the Intermediary must be notified immediately. The cash out must come directly out of the closing of Phase I and not from the Intermediary. Once the exchange equity is in the "Qualified Escrow Account" at the Intermediary's, the Exchanger cannot access the funds until the end of the exchange.