THE ABC's OF 1031 EXCHANGES
I. WHAT I S AN EXCHANGE?
A tax-deferred exchange is a transaction involving the transfer of one piece of investment or income property and receipt of a like-kind property which will be used as income or investment property. When certain criteria are met, as set forth in Section 1031 of the Internal Revenue Code the income taxes on any gain realized from the sale of the relinquished property are deferred.
 
Il. WHY SHOULD YOU CONSIDER AN EXCHANGE?
The investor who intends to continue to own real property would naturally want to use all of their equity from the sale of the relinquished property to acquire the replacement property, rather than paying up to 37% in income taxes (combined federal & State) .
 
III. TYPES OF EXCHANGES
A. Simultaneous
Prior to 1984, when Congress modified the code on exchanges and formally approved the Starker concept of delayed exchanges, virtually all were of the simultaneous type. To qualify as a simultaneous exchange, both the ownership of the relinquished property and the replacement property must close escrow or transfer at the same time. Some Real Estate agents and also some investors still try to accomplish simultaneous exchanges, primarily to avoid the payment of fees to an intermediary. There is significant danger in this attempt since many unforeseen events can cause the closing and recordation to be delayed on one of the properties, leaving the investor with a failed exchange and the obligation of income taxes that would otherwise be deferred. For example, if the properties are located in different counties, it is highly unlikely that the transfers of title will take place on the same day. If two different title companies are involved, it is virtually impossible for both to have the funds to close escrow on the same day. Additionally, in directing the title company to disburse funds for the purchase of the replacement property, it could be contended successfully by the IRS that the investor had constructive receipt of the proceeds of the sale, and therefore income taxes on the gain would be due. The regulations under Section 1031 provides a Safe Harbor for simultaneous exchanges where a "qualified intermediary" is used.
 
B. Delayed
Generally, when one discusses exchanges, the type of exchange referred to is the delayed, or Starker exchange. This is the most common type of exchange and there are several types of delayed exchanges which will be discussed herein. In this exchange, the relinquished property is sold at Time I, and the replacement property is acquired at Time 2. The time constraints and other basic rules for the exchange are set forth in Section IV.
 
C. Improvement &Construction
In some cases, the replacement property is unimproved land or an existing building which requires the construction of improvements. New construction or improvements can be added as part of the exchange with title passing to the intermediary and the intermediary making payments to contractors and other suppliers out of the exchange funds. Thus, if the replacement property is of lesser value then the relinquished property the improvement or construction costs can bring the value up to an amount which is equal to or exceeding that of the relinquished property .(See Section IV)
 
D. Reverse
The reverse exchange is one in which the investor finds the replacement property and wants to acquire it before the relinquished property is sold. Since the investor cannot buy the property and later exchange into property that is already owned, a reverse exchange becomes an option. In a reverse exchange, the intermediary acquires the replacement property and warehouses it until the relinquished property sells, at which time a simultaneous exchange is structured. It also may be possible for the intermediary to become an interim or "straw" buyer for the relinquished property and immediately structure a simultaneous exchange into the replacement property. In either event, there are exchange possibilities for investors who have located the replacement property before their relinquished property is sold.
 
E. Business & Personal Property
Internal Revenue Code Section 1031 permits the exchange of property other than Real Estate. For example, investors may exchange business assets, valuable paintings, livestock or other personal property. Therefore, business or business asset exchanges are common. While the basic rules are the same, the sales price of the business must be allocated among the asset classes as set forth in the regulations. While this is a simple enough process for the experienced intermediary, it can be thoroughly confusing to the investor, making the selection of the intermediary extremely important to the exchange. (See Section VI)
 
IV Basic Exchange Rules
Two basic rules must be met to completely defer income taxes on the gain realized from the sale of the relinquished property:
 
1. The purchase price of the replacement property must be equal to or greater than the net sales price of the relinquished property, and
2. All cash or other proceeds received from the sale of the relinquished property must be used to acquire the replacement property.
 
Property that qualifies for deferred gain treatment under Section 1031 must be "like kind", as defined under the Code as follows:
 
1. Property held for productive use in a trade or business, or
2. Property held for investment.
 
Therefore, not only does rental or other income property qualify, but unimproved real property held for investment qualifies. Unimproved property can be exchanged for improved or unimproved property as desired. One property may be exchanged for several, or several properties may be consolidated into one. This means that almost any property that is not a personal residence or second home will qualify under Section 1031. Even a vacation home that is used part personal and part income producing may be exchanged. However, this "mixed use" property must be exchanged for other "mixed use" property.
 
The investor has a maximum of 180 days from the close of escrow or transfer of title of the relinquished property to acquire the replacement property. The first 45 days of that period is called the Identification Period. During the 45 days, the investor must identify the replacement property. The identification must be in writing, signed by the investor, and received by the intermediary or other qualified party, faxed, postmarked or otherwise identifiably transmitted (such as Federal Express or other dated courier service) within the 45 day period. Failure to meet the identification requirements will result in the transfer of the relinquished property being taxable.
 
The investor may identify three properties of any value, one or more of which must be acquired (Three Property Rule). If more than three properties are identified, the aggregate fair market value of all properties may not exceed 200% of the value of the relinquished property (Two Hundred Percent Rule).
 
V. Mechanics of a Delayed Exchange
It is important that any exchange be carefully planned with the assistance of an experienced and competent intermediary, preferably one who is completely familiar with the tax code in general, not just Section 1031. There is no substitute for good tax planning.
 
Once the planning is complete, structure and timing are implemented, the relinquished property is sold, escrow is closed, and the intermediary becomes the repository for the proceeds of the sale. The funds are kept in the intermediary's interest-bearing trust account until the replacement property is located and instructions are received to complete the exchange and acquire the replacement property. The funds are wired to the title company and the property is acquired in the name of the investor. The exchange agreement, assignment agreement and supplemental escrow instructions are prepared and delivered to escrow by the intermediary.
 
VI. Selecting an Intermediary
It should be noted that there are no state or federal regulations governing the conduct of intermediaries, other than the fiduciary responsibilities that govern entities that are entrusted with holding funds of others. For this reason, selecting an intermediary for your or your client's exchange is an important process. Select the intermediary as you would an attorney or physician. Look for experience and reputation in the legal, real estate and title company communities. Speak with escrow officers who handle exchanges and get their opinion. Choose an intermediary who is' thoroughly familiar with the tax code, since many times other sections of the code will bear significantly on your exchange. Ask the intermediary if the firm handles reverse exchanges. Ask about security of funds, and what options are available to safeguard the funds during the period the intermediary holds the proceeds of the sale. Although the fees charged by the intermediary are insignificant when compared with the income tax savings, they are important. Ask about fees and how they are paid. With a few notable exceptions, fees are very similar, from one intermediary to the next. What is of far greater importance is the experience, knowledge, background and expertise of the intermediary company and its personnel.
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