HOW DO I KNOW IF MY
TRANSACTION IS A 1031 EXCHANGE?
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:
Is the
property the Seller's residence?
If yes, then the Seller will not be eligible for a 1031 Exchange.Does the
Buyer intend to live at the property?
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.
WHAT IS 1031 "LIKE
KIND" PROPERTY?
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.
WHY EXCHANGE PROPERTY INSTEAD
OF JUST SELLING IT?
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.
WHEN IS A 1031 TAX-DEFERRED
EXCHANGE APPLICABLE?
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.
WHO ARE THE PRINCIPALS IN AN
EXCHANGE?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.
WHAT IS THE CURRENT
IDENTIFICATION PERIOD, AND CLOSING TIME TO ACCOMPLISH A DELAYED 1031 TAX
DEFERRED EXCHANGE?
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.
WHAT HAPPENS TO THE MONEY?
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.
WHO IS, AND WHAT CAN I EXPECT
TO PAY, A "QUALIFIED 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
WHAT VERBIAGE IS NECESSARY TO
CHANGE THE TRANSACTION FROM A NORMAL BUY/SELL TO AN EXCHANGE?
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.
WHAT IS DIRECT DEEDING?
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 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.
DISCLAIMER:
PLEASE NOTE THIS IS NOT INTENDED TO BE TAX ADVICE IN ANY CONCEPTION OF THE
TERM. YOU ARE ADVISED TO CONSULT WITH YOUR LEGAL AND/OR TAX ADVISOR BEFORE
ATTEMPTING ANY SALE, PURCHASE OR EXCHANGE OF REAL PROPERTY.
IT IS
STRONGLY RECOMMENDED THAT YOU CONSULT WITH YOUR LEGAL COUNSEL, TAX ADVISOR
AND YOUR COMPANY MANAGEMENT REGARDING ANY SPECIFIC SITUATIONS OR HOW THE
INFORMATION CONTAINED IN THIS MATERIAL RELATES TO YOU, YOUR COMPANY'S
POLICY AND/OR ALL TAX, LEGAL AND LOCAL PRACTICES.
ALL
INFORMATION CONTAINED HEREIN IS FROM RELIABLE SOURCES AND IS DEEMED TO BE
ACCURATE, BUT IS IN NO WAY GUARANTEED TO BE ACCURATE . ALL OF THE
INFORMATION HEREIN, IS CURRENT AS OF 2-1-1996. BE SURE TO CONTACT YOUR
LEGAL AND TAX ADVISORS FOR ANY CHANGES AND UPDATES.
