1031 Exchange

The fundamental advantages of a tax deferred exchange may be utilized to diversify, consolidate or leverage your investment portfolio. With respect to real property, the broad definition of like kind provides investors with numerous options to accomplish their investment goals.

Properties that qualify for IRC §1031 treatment

IRC §1031 provides that, to qualify for tax deferred treatment, the relinquished property must be exchanged for replacement property that is like kind. Like kind means similar in nature and character notwithstanding differences in grade or quality. The fact that any real estate involved is improved or unimproved is not material for that fact relates only to the grade or quality of the property and not its kind or class. As such, raw land held for investment may be exchanged for single family rentals used for a trade or business or any combination of the following:

Single Family Rentals
Farms/Ranches
Office/Commercial
Motels/Hotels
Golf Courses
Some Recreational Properties
Multi-Family Rentals
Raw Land
Retail/Industrial
Leasehold Interest of 30 years or more

While the definition of like kind is stricter when it comes to personal property – investors may still take advantage of tax deferred treatment in an IRC § 1031 exchange in the sale of investment personal property. The personal property exchange can be utilized to relocate a business, to upgrade equipment, or to streamline production by replacing outdated technology and machinery with more efficient models.

Like kind personal property includes:

Livestock of the same sex
Automobiles for automobiles
Buses for buses
Corporate aircraft for corporate jet
Doctor practice for doctor practice
Manufacturing equipment for manufacturing equipment
Restaurant equipment for restaurant equipment

The Delayed Exchange:

The most 5 commonly utilized tax planning strategy available to investors is the delayed exchange. A delayed exchange results when there is a time delay between the sale of the relinquished property and the purchase of the replacement property. Also referred to as a "Starker Exchange" because of the landmark 1979 federal case entitled, Starker v. U.S., 602 F2d 1341 (9th Cir. 1979), wherein the court substantiated the validity of the delayed exchange process. Prior to the Starker case, §1031 of the Internal Revenue Code (promulgated in 1924) authorized tax-free exchanges of real and personal property. Thereafter, Congress, in the 1984 Tax Reform Act, adopted subsection 1031(a)(3) which created the 45 day identification period and the 180 day exchange period. Finally, on April 25, 1991, the IRS promulgated the final regulations under section 1.1031(a)-1, et. seq. which provide specific rules for deferred like kind exchanges.

The delayed exchange provides investors up to 180 days to purchase replacement property once the relinquished property is sold. And, the use of a Qualified Intermediary is required to facilitate a valid delayed exchange. The delayed exchange occurs in three fundamental steps:

STEP ONE: Sale of the Relinquished Property: Before closing on the sale of the relinquished property, the Exchanger retains a Qualified Intermediary that prepares an exchange agreement, assignment of sale contract and closing instructions to the escrow/closing agent. They then instruct the escrow/ closing agent to direct deed the relinquished property to the buyer and to deliver sale proceeds directly to the Imtermediary – thereby preventing the Exchanger from having actual or constructive receipt of the funds. Once the funds are delivered, access to the funds is restricted for the remainder of the exchange period. In short, IRC §1031 provides strict rules pertaining to the release of funds to the Exchanger even where the Exchanger decides not to proceed with the exchange.

STEP TWO: Identification of the Replacement Property: The Exchanger must identify replacement property within 45 calendar days of the close of the relinquished property. The identification is proper only if the replacement property is designated as replacement property in a written document signed by the Exchanger and hand delivered, mailed, telecopied, or otherwise sent to the person obligated to transfer the replacement property to the Exchanger (i.e., the seller of the replacement property) or to any other person involved in the exchange other than the Exchanger or a disqualified person. Three identification rules apply:

3 PROPERTY RULE: Three properties no matter what the fair market value; or
200 PERCENT RULE: Any number of properties as long as the aggregate fair market value does not exceed 200% (2x) of the fair market value of all the relinquished properties; or
95 PERCENT RULE: Any number of properties without regard to value – provided 95% of the value of the identified properties are acquired.

STEP THREE: Purchase of Replacement Property: Within 180 calendar days from the sale of the relinquished property, or the Exchanger's tax filing date, whichever is earlier, the Exchanger must acquire like kind replacement property and the property acquired must be one or all of the previously "identified" replacement properties. The Exchanger again assigns the purchase and sale contract to a Qualified Intermediary, who purchases the replacement property with the exchange proceeds and causes the transfer of the replacement property to the Exchanger by way of a direct deed from the seller.

The Reverse Exchange

A reverse exchange results when the replacement property is acquired prior to the sale of the relinquished property. The IRS formally acknowledged reverse exchanges effective September 15, 2000. (See, Rev. Proc. 2000-37.) The Exchanger utilizes the Qualified Intermediary ("QI") to purchase the replacement property and hold title while the Exchanger markets the relinquished property. As with delayed exchanges, the reverse exchange must be completed within 180 days. In order to accomplish this scheme, the Exchanger retains the services of an exchange accommodation titleholder ("EAT"). Many QI's – through various title holding entities – perform this service.

TWO METHODS FOR REVERSE EXCHANGES:

1). Exchange Last aka PARK TITLE TO REPLACEMENT PROPERTY: Title to the replacement property is parked with the EAT. In that case, the Exchanger enters into a written agreement with the EAT – who acquires title to the replacement property and holds it until a buyer is found for the relinquished property. Once the relinquished property is ready to close, the EAT enters into a simultaneous exchange with the Exchanger, transferring title to the replacement property to the Exchanger in exchange for causing the transfer of the relinquished property to a third party buyer.

2). Exchange First aka PARK TITLE TO RELINQUISHED PROPERTY: The Qualified Intermediary acquires the right to purchase the replacement property and causes it to be deeded directly from the seller to the Exchanger in exchange for the Exchanger's transfer of the relinquished property to the EAT. The relinquished property is held by the EAT until a buyer is found. Once the buyer is found, the relinquished property is sold to the third party buyer by the EAT.

In either scenario, the EAT will enter into a management agreement or master lease with the Exchanger to allow the Exchanger management responsibilities over the property for the duration of the parking period. And, in a transaction involving financing, the EAT may become the borrower under a non-recourse loan. Upon the expiration of the exchange period or the sale of the relinquished property and transfer of the replacement property to the Exchanger, the Exchanger assumes the loan. Likewise, the EAT will require hazard and liability insurance during the holding period.

Timeline: No later than five business days after the EAT acquires its ownership interest in the parked property, the EAT and the Exchanger must enter into a written qualified exchange accommodation agreement. The Exchanger then has 45 days to identify one or more relinquished properties. Written identification of the relinquished properties must be delivered to the EAT or to another party to the exchange. The exchange must be completed within 180 days (i.e., relinquished property must be conveyed to third party buyer and replacement property must be conveyed to the Exchanger).

The Simultaneous Exchange

A simultaneous exchange occurs when the relinquished and replacement properties close at the same time. This seemingly simple transaction is littered with pitfalls. The use, however, of a Qualified Intermediary assures the Exchanger that he does not have constructive receipt of his funds, thus ensuring the preservation of safe harbor treatment under the Treasury Regulations. In the simultaneous exchange, the Qualified Intermediary transfers the property to the proper entity and instructs the escrow/closing agent with respect to the disposition of sale proceeds. It is incumbent upon the Exchanger to contact the Qualified Intermediary prior to closing on the purchase and sale of the relinquished and replacement properties.

The Improvement Exchange

The Improvement, Construction or Build to Suit Exchange occurs when the Exchanger uses exchange proceeds to improve (i.e., make capital improvements) existing property or to improve or develop new replacement property. The improvement exchange can occur in the context of a delayed or reverse exchange. In the context of the delayed exchange – the Exchanger first sells the relinquished property using a Qualified Intermediary. Once the sale of the relinquished property is complete, the Exchanger has 45 days to identify the replacement property. * Thereafter, the Exchanger enters into a purchase and sale contract for the replacement property and enters into a written Qualified Exchange Accommodation Agreement ("QEAA") with the QI's Exchange Accommodation Titleholder ("EAT"). The Exchanger then assigns the rights to the purchase and sale agreement to the EAT who uses the exchange proceeds to acquire title to the replacement property and complete the identified improvements. Upon completion of the improvements, or at the end of the 180th day, whichever is earlier, the EAT will transfer title to the newly improved replacement property to the Exchanger. If – in addition to the exchange proceeds – construction financing is required to complete the improvements, the EAT will become the borrower under a non-recourse loan. When the EAT transfers the property to the Exchanger, the Exchanger is substituted as the borrower and assumes the construction financing.

* The same time frames apply to the improvement exchange in that the replacement property and its improvements must be identified within 45 calendar days. If the replacement property is to be produced, the identification requirement is satisfied if a legal description is provided for the underlying land and as much detail is provided regarding construction of the improvements as is practical when the identification is made. It is critical that the Exchanger receive improvements/replacement property that are/is substantially the same as the improvements/replacement property identified. Likewise, the improvements must be completed and title conveyed by the EAT to the Exchanger within the earlier of 180 calendar days from the close of the relinquished property or the tax filing date for the Exchanger.

The Personal Property Exchange

A 1031 tax deferred exchange allows investors to defer capital gain on the purchase and sale of like kind personal property, such as aircraft, automobiles, and business equipment. With respect to personal property exchanges, the like kind requirements are narrower than those for real property exchanges. Generally, to qualify as like kind, the relinquished and replacement depreciable personal property must be in the same General Asset Class or Product Class. There are 13 General Asset Classes:

Office furniture, fixtures and equipment
Information systems (computers and peripheral equipment)
Data handling equipment, except computers
Airplanes, except those used commercially, and helicopters
Automobiles and taxis
Buses
Light general purpose trucks
Heavy general purpose trucks
Railroad cars and locomotives, except those owned by railroad transportation companies
Tractor units for use over-the-road
Trailers and trailer mounted containers
Vessels, barges, tugs and similar water-transportation equipment, except those used in marine construction
Industrial steam and electric generation and/or distribution systems

Although there are no asset classes for non-depreciable tangible property and intangible personal property, such as copyrights and franchise agreements, such property may be eligible for tax deferred treatment when exchanged for like kind property, i.e., property of the same nature and character. Unfortunately, goodwill of a business is not considered like kind to goodwill of another business, even where the businesses are the same.

Under IRC §1031, the following property is not eligible for tax deferred status:

Stock in trade or other property held primarily for sale
Stocks, bonds, or notes
Other securities or evidence of indebtedness or interest
Interest in a partnership
Certificates of trust or beneficial interests
Choses in action

Taxes are paid on capital gain, not equity or profit. It is possible to sell property without realizing much profit and still owe substantial capital gains tax. Capital gain is simply the difference between the sales price and the adjusted basis (i.e., what you paid for the property, plus amounts spent on capital improvements, less depreciation taken) less any closing costs associated with the sale.

To calculate your estimated capital gain – first subtract the adjusted basis from the sales price; then subtract the costs of your transaction, commission, fees, transfer tax, etc.; finally, multiply the capital gain by your combined tax rates (Federal and State) to determine your estimated capital gain tax.

100% Deferral – to fully defer state and federal capital gain taxes, the Exchanger must reinvest all exchange proceeds and either acquire property with equal or greater debt or reinvest additional cash equal to the debt relief.

Determining the Proper Vesting

To correctly exchange your investment property, you must hold title to the replacement property exactly as you held title to the relinquished property. Simply stated, with few exceptions, the person or entity beginning the exchange must be the same person or entity completing the exchange. The most common problem that arises in an exchange occurs when a husband or wife owns property separately and the new lender requires that both take title to the replacement property in order to qualify for the loan. The addition of the spouse on title to the replacement property can jeopardize the exchange. Likewise, often partners who own property in a partnership wish to sell the partnership property and go their separate ways. The partners are disqualified from exchanging their individual share of the partnership property.

The following scenarios are disallowed

Husband relinquishes and husband and wife acquire property of equal value.
ABC Corporation relinquishes and XYZ Corporation acquires.
ABC Partnership relinquishes and partners acquire as individuals.
ABC Partnership relinquishes and XYZ Partnership acquires.
Multi-member LLC relinquishes and members acquire as individuals.
ABC multi-member LLC relinquishes and XYZ multimember LLC acquires.

The following are examples of some of the exceptions that apply

Husband and wife as trustees of a revocable living trust, which is a true pass through trust, relinquish, and husband and wife acquire as individuals.
Single member LLC relinquishes and sole member acquires as an individual.
Individual relinquishes and individual's estate acquires due to the death of the individual.
Trustee of a revocable living trust, which is a true pass through trust, relinquishes, and Trustee acquires as an individual.