1031 Exchange Basics
What property qualifies?
To be a successful tax-deferred exchange, certain criteria must be met for the real estate to be like-kind. Basically, these are:
- Both properties must be in the United States.
- The Relinquished Property currently must be used by the exchanger for investment, business, rental or production of income.
- The exchanger must hold the new Replacement Property for investment, business, rental or production of income.
- The Replacement Property must be identified within 45 days.
- The Replacement Property must be received within 180 days (or the federal tax due date, including extension, if earlier).
Examples of Properties that do qualify:
- Commercial Property
- Rental Property
- Apartment Buildings
- Delaware Statutory Trusts (DST)
Properties that do not qualify:
- Principal Residences
- Second Homes
- Dealer Property
- Partnership Interests
- Reverse Starker Exchanges
- Related Party Property
- Vacation Rentals
Principal Residences do not qualify. Nor does a property to be immediately converted to a principal residence qualify as a like-kind replacement property. However, a property which includes both a principal residence and business property may be sold and the appropriate value assigned to the business portion. A good example is a farm property, that includes both a principal residence and a working farm investment property.
A second home does not qualify as an investment property. While a second home may be rented out, if you use it for personal purposes more than 14 days or more than 10% of the days actually rented, whichever is greater, then it is treated as a second home for that tax year. Based on use a vacation property can change from business rental property status to second home status from tax year to tax year.
Dealer Property, which is property held as inventory. A few examples of this include properties purchased for the purpose of resale and land that you developed to sell.
Partnership interests may not be exchanged. Many small investment or business properties are owned by partners. If title to the property is in the name of the partnership (example: “Smith Properties Partnership”), then the entire partnership must do the exchange. Individual partners may not exchange their interest because they have an interest in the partnership, not in the real estate. However, if the property is deeded to individuals, as say “tenants-in common,then each partner may exchange their separate interest in the real estate, or pay the tax as they desire. Also, partners may use Section 761 (a) to elect out of the partnership and become eligible to exchange their interest in the property. Investors in a partnership should get tax and legal advice before engaging in an exchange.
Reverse Starker exchanges are not covered under Section 1031. A reverse Starker exchange occurs when the replacement property is transferred before settlement of the relinquished property. While a replacement property may be placed under contract at any time, it is essential that the exchanger not go to settlement on the replacement property until settlement on the relinquished property. In October 2000 the IRS published Revenue Procedure 2000-37, which provides safe harbor procedures for the accommodation of reverse exchanges. For a full explanation see our Reverse Exchange page.
Purchase of the replacement property from a related party, such as a member of your immediate family, should be avoided. However, if the exchanged property is held for two years, direct exchanges between related parties and the transfer of the relinquished property to a related party remain valid transactions.
If you own a vacation property that you rent out, you are limited to two weeks or ten percent of total time rented of personal use. If you use it more than these limits specify than the property will not qualify as investment property and does not qualify for an exchange.
Identification and Time Limits:
From the day after you close on your relinquished property, you have 45 days to identify replacement properties. This identification must be in writing, signed, and be unambiguous. There are multiple rules that you can use to identify properties, the rule that most exchangers use is the three property rule: You can identify up to three properties of any value and buy any or all of them. Once you have identified, you have committed to purchase those properties, we must either buy those properties on your behalf or hold your funds up to the 180 day time limit.
From the day after closing you have 180 days to settle on a replacement property that you have identified. If you do not close on a property or use all of the funds by that time limit, we will return any funds still in the escrow account and you will owe taxes on any funds that were not used up to your total gain on the property you sold.
How much tax will I have to pay if I do not do an exchange?
One of the primary objectives of a tax-deferred exchange is to defer paying any tax on the gain realized when you sell the relinquished property.
- Rule 1: The replacement property must have an equal or greater acquisition
cost than the adjusted sale price for the relinquished property.
- Rule 2: The exchanger may not receive cash – all the proceeds in the qualified escrow account must be reinvested.
- Rule 3: The new or assumed mortgage total should be equal to or greater than the debt paid off on the relinquished property, or the Exchanger must add new cash to offset the difference.
- Rule 4: Taxpayer may not receive non-like property — including owner held notes, cash or personal property.
The following example shows the reinvestment requirements for the gain to be totally tax-deferred.
|Contract Sales Price||$180,000|
|Less: Selling Expenses||-$15,000|
|Equals: Adjusted Sales Price||$165,000|
|Less: Balance Due on Loans||-$65,000|
|Equals: Cash Proceeds (exchange escrow funds)||$100,000|
To be totally tax free and to defer all of the gain, the following requirements must be met:
- The replacement property or properties must total an acquisition cost of at least $165,000;
- All of the $100,000 in cash proceeds must be reinvested (down payment);
- New or assumed mortgages must be at least $65,000.
NOTE: The exchanger must add or substitute new cash to reach that amount.
The acquisition cost is the contract price plus the acquisition expenses which are part of the cost to acquire the property. Normally these are shown on the settlement statement. The acquisition expenses do not include prepaid items, such as real estate taxes and hazard insurance, or expenses associated with obtaining financing,such as points.
- Cash Boot: Cash proceeds received at settlement or at the end of the exchange process are taxable income up to the amount of the total realized gain.
- Mortgage Boot: Mortgage relief (the mortgages on the replacement properties are less than the total mortgages on the relinquished properties) also becomes boot and taxable income.
NOTE:New cash can offset mortgage boot.
- Non-Like Property Boot: If the exchanger were to receive non-like property in the transaction, such as an automobile, it is considered as taxable income at market value.
More common is when the exchanger takes back financing on the relinquished property. The value of the note received is considered boot and is taxable gain. With proper planning the note will be treated as an installment sale and will be taxed as the gain is received over the term of the loan (contact us to discuss how a note taken back on the relinquished property may be handled to reduce taxable income).
It the exchanger decides to buy down, that is to purchase a replacement property that has an acquisition cost less than the adjusted sale price of the relinquished property, the exchanger will have some taxable income.
If the the relinquished property had an adjusted sale price of $165,000 and the taxpayer purchased a replacement property that cost $150,000, there will be $15,000 of recognized capital gain.
Tax on Boot:
How will the $15,000 of capital gain be taxed? Unfortunately any gain recognized in an exchange will be first taxed at the 25% federal rate until all the Section 1250 depreciation taken has been recaptured.