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Frequently Asked Questions
What is a 1031 Deferred Exchange and what are the general requirements?The Tax-Deferred Exchange, as defined in Section 1031 of the Internal Revenue Code of 1986, as amended, offers real estate investors one of the last, great investment opportunities to build wealth and save taxes. By completing an exchange, the investor (Exchange Party) can dispose of investment property, use all of the equity to acquire replacement investment property, defer the capital gain tax that would ordinarily be paid, and leverage all of the equity into the Replacement Property. Two requirements must be met to defer the capital gain tax: (a) the Exchange Party must acquire "like-kind" Replacement Property, and (b) the Exchange Party cannot receive cash or other benefits (unless the Exchange Party pays capital gain taxes on this money). In any exchange, the Exchange Party must enter into the exchange transaction prior to the close of the Relinquished Property. The Exchange Party and the Qualified Intermediary enter into an Exchange Agreement, which essentially requires that (a) the Qualified Intermediary acquires the Relinquished Property from the Exchange Party and transfers it to the buyer by a direct deed from the Exchange Party, and (b) the Qualified Intermediary acquires the Replacement Property from the seller and transfers it to the Exchange Party by a direct deed from the seller. The cash or other proceeds from the Relinquished Property are assigned to the Qualified Intermediary and are held by the Qualified Intermediary in a separate, secure account. The exchange funds are used by the Qualified Intermediary to purchase the Replacement Property for the Exchange Party. What are some important considerations for an exchange?Exchanges must be completed within strict time limits with absolutely no extensions. The Exchange Parties has 45 days from the date the Relinquished Property closes to identify potential replacement properties. This involves a written notification to the Qualified Intermediary listing the addresses or legal descriptions of the potential replacement properties. The purchase of Replacement Property must be completed within 180 days after the close of the Relinquished Property. After 45 days have passed, the Exchange Party may not change the Purchase Identification list and must purchase one of the listed replacement properties or the exchange fails. To avoid the payment of capital gain taxes, the Exchange Party should follow three general rules:
The Exchange Party can offset the amount of debt obtained on the Replacement Property by putting the equivalent amount of additional cash into the exchange. In the case of real property exchanges, the Exchange Party must sell property that is held for income or investment purposes and acquire Replacement Property that will be held for income or investment purposes. This is the "like-kind" property test. IRC Section 1031 does not apply to exchanges of stock in trade, inventory, property held for sale, stocks, bonds, notes, securities, evidences of indebtedness, certificates of trust, or beneficial interests or interests in a partnership. What is the role of the Qualified Intermediary?The use of a Qualified Intermediary is essential to completing a 1031 Tax-Deferred Exchange. Unlimited Exchange, as a Qualified Intermediary, performs several vital functions in an exchange. The Qualified Intermediary acts as a principal. The IRS stipulates that a reciprocal trade or actual exchange must take place in each IRC Section 1031 transaction. This means the Exchange Party must assign to a Qualified Intermediary (a) the interest as seller of the Relinquished Property and (b) the interest as buyer of the Replacement Property. By becoming an actual party to the exchange, a reciprocal trade takes place even when there are three or more parties involved in an exchange transaction (i.e., when the Exchange Party is purchasing the Replacement Property from someone other than the buyer of the Relinquished Property). The Qualified Intermediary holds exchange proceeds. If the Exchange Party actually or constructively receives any of the proceeds from the sale of the Relinquished Property, those proceeds will be taxable as boot. A Qualified Intermediary will hold the proceeds from the sale in a separate exchange account until the funds are used to purchase the Replacement Property. What documents are needed as part of a 1031 Deferred Exchange?Several legal documents are necessary in order to properly complete an exchange. The Qualified Intermediary will prepare an Exchange Agreement, two Assignment Agreements and Exchange closing instructions for each closer. Although the process of a Section 1031 exchange is relatively simple, the rules are complicated and filled with potential pitfalls. Therefore, it is critical that the proper documentation be completed for each transaction. How do you initiate an Exchange?Step 1: Find a Qualified Intermediary to assist you with the exchange as early in the sale process as possible. Key points to consider in selecting a Qualified Intermediary are knowledge and experience of its staff; local assistance for your real estate agent, CPA and attorney; and, of especially critical importance, the safety of your funds while held by the Qualified Intermediary. Unlimited Exchange would be happy to serve as your Qualified Intermediary - simply pick up the phone and call or fill out one of our online forms and fax or email it to us to get the process started or your questions answered. Step 2: Instruct your real estate agent to include an "Exchange Cooperation Clause" as an addendum to the purchase and sale agreement on the Relinquished Property (the property the Exchange Party is selling to the buyer). An example Exchange Cooperation Clause is: "Buyer hereby acknowledges that it is the intent of the Seller to effect an IRS Section 1031 tax Deferred Exchange that will not delay the closing or cause additional expense to the Buyer. The Seller's rights under this assignment may be assigned to a Qualified Intermediary for completing such an exchange. Buyer agrees to cooperate with the Seller and the Qualified Intermediary in a manner necessary to complete the exchange." Step 3: Contact your Qualified Intermediary as soon as possible after escrow is opened or after entered into the purchase and sale agreement and advise it well in advance of the closing date. The Qualified Intermediary will draft the appropriate Exchange Agreement, Assignment Agreement, and Exchange closing instructions so they can be executed prior to closing on the property being sold. What are some of the exchange terms and phrases that are often used in connection with a 1031 Deferred Exchange?As with any other specific area of real estate law, Tax-Deferred Exchanges under IRC Section 1031 have their own language, which may be confusing to those who are unfamiliar with these transactions. The following are some common exchange terms and phrases.
What are some do and don't items in regard to 1031 Deferred Exchanges?Do advanced planning for the exchange. Talk to your accountant, attorney, broker, lender, and Qualified Intermediary. Do Not miss your identification and exchange deadlines. Failure to identify within the 45-day Identification Period or failure to acquire Replacement Property within the 180-day exchange period will disqualify the entire exchange. Reputable Qualified Intermediaries will not act on backdated or late identifications. Do keep in mind these three basic rules to qualify for complete tax deferral:
Do Not plan to sell and invest the proceeds in property you already own. Funds applied toward property already owned purchase "goods and services," not "like-kind" property. Do attempt to sell before your purchase. Occasionally, Exchange Parties find the ideal Replacement Property before a buyer is found for the Relinquished Property. If this situation occurs, a "reverse" exchange (buying before selling) may be necessary. Exchange Parties should be aware this is considered a more aggressive exchange variation because no clear IRS guidelines exist. Do Not dissolve partnerships or change the manner of holding title during the exchange. A change in the Exchange Party's legal relationship with the property may jeopardize the exchange. What are the deadlines for a 1031 Deferred Exchange?The delayed exchange, which became popular after the well-known Starker decision (Starker v. United States, 602 F2d 1341 (1979)), changes made by Congress in 1984, and the 1991 Final Regulations can provide Exchange Parties the opportunity for simple and defensible exchanges. It is essential when using the delayed exchange to adhere to the Section 1031 guidelines. The Section 1031 exchange Begins on the earlier for the following:
The exchange Ends on the earlier of the following:
The Identification Period is the first 45 days of the exchange period. The exchange period is a maximum of 180 days. If the Exchange Party has multiple relinquished properties, the deadlines begin on the transfer date of the first property. These deadlines may not be extended for any reason. A deadline that falls on a legal holiday or weekend does not permit extension. Identified Replacement Property that is destroyed by fire, flood, hurricane, etc., after expiration of the 45-day Identification Period does not entitle the Exchange Party to identify a new property. Mistakenly identifying a property (such as condominium "A" when condominium "B" was intended) does not permit a change in identification after the 45-day Identification Period expires. Failure to comply with these deadlines may result in a failed exchange. What is "boot" in connection with a 1031 Deferred Exchange?"Boot" is an English term referring to funds or property necessary to even out an exchange. Boot is property that is not "like-kind" as to other property acquired in an exchange transaction. Boot Receipt = Gain Recognition An Exchange Party who receives boot in an exchange transaction generally recognizes gain to the extent of the value of boot received. Some common examples of boot are:
What is "like-kind" property?All real property is "like-kind" with all other property. "Like-kind" refers to how the property is held by the investor, not the type or character of property. The Exchange Party must have held the Relinquished Property for investment, or for "productive use in their trade or business", and intend to do the same with the Replacement Property. The following are examples of "like-kind" properties:
If the Exchange Party is exchanging personal property, the rules are far more restrictive. Definitions of what is considered real property and personal property can vary from state to state. It is essential to consult with a tax advisor when structuring personal property exchanges because one transaction may have multiple exchanges, involving tax deferral on both the personal and real property. Personal property is considered "like-kind" only if it appears in the same General Asset Class or Product Class. Therefore, the Exchange Party may exchange:
What property will qualify for 1031 Deferred Exchange treatment?The Exchange Party must hold the Relinquished Property for investment or for "productive use in their trade or business" to qualify for Section 1031 treatment. The Exchange Party's purpose in holding the property, rather than the type of property, is the critical issue. The following are examples of qualifying properties:
The intent to hold the property for personal use will prevent the property from qualifying for Section 1031 treatment. Therefore, second homes will not qualify for Section 1031 treatment unless the property owner changes how the second home is treated or used. For example, a taxpayer could "convert" his second home to a valid exchange property and establish this intent by properly renting the property and holding it as a legitimate rental property. Consultation with a tax advisor is important whenever a taxpayer changes how he intends to hold property. The intent to hold property "primarily for sale" will prevent the property from qualifying for Section 1031 treatment. Most properties owned by developers, builders, and people who perform rehabilitation work are held primarily for sale and may not be the subject of an exchange. When these properties are sold, they are subject to ordinary income taxes rather than capital gain taxes. Partnership interests, notes secured by real property, contract vendors' interests, and foreign property (under the Revenue Reconciliation Act of 1989) do not qualify for Section 1031 treatment. Can exchanges involving foreign properties qualify for 1031 Deferred Exchange Treatment?Exchange Parties may exchange properties throughout the United States. The Exchange Party may relinquish in California and acquire in Montana, relinquish in Florida and acquire in Texas, etc. When taxpayers relocate within the United States, they can "take" their investment properties with them via an exchange. Prior to 1989, Exchange Parties were able to perform an exchange of a United States property for a foreign investment property, such as a rental unit in France. However, after the Revenue Reconciliation Act of 1989, the Code now states, "real property located in the United States and real property located outside the United States are not like-kind." It is unclear what property is "located in the United States". There is some indication that property in the Virgin Islands may qualify. Perhaps this could be extrapolated to include Guam, Puerto Rico, etc. It is clear that taxpayers may not obtain Section 1031 tax deferrals when they relinquish in Alabama and acquire in Costa Rica or relinquish in Washington and acquire in Canada. However, a taxpayer selling foreign property and buying foreign property, and subject to capital tax gain on his US tax return, may want to consider an exchange. The taxpayer who relinquishes in Canada and acquires in Canada, or relinquishes in Singapore and acquires in Hong Kong, may benefit from an exchange. How must title to the exchanged property be vested at the beginning and the end of the exchange process?To qualify as an exchange under IRC Section 1031, title to the Replacement Property must be held in the same manner as title to the Relinquished Property. Therefore, the entity beginning the exchange must be the entity concluding the exchange. The Qualified Intermediary will prepare the exchange documents to reflect the vesting information as shown on the title commitment or preliminary report for the Exchange Party's Relinquished Property. For example:
An Exchange Party must anticipate these vesting issues as part of the advanced planning for the exchange. Vesting issues are easier to resolve before loan documents are on the closing table. However, business considerations, liability issues, and lender requirements may make it difficult for the Exchange Party to keep the same vesting on the Replacement Property. For example: If a husband as the only Exchange Party is relying on the wife's income to qualify for Replacement Property financing, the lender will require the wife to appear on the deed, which may violate the husband's exchange requirements. Lenders seldom loan to trustees; they loan to individuals, thereby creating difficulties for a trust as an Exchange Party to acquire the Replacement Property in the same trust entity that started the Exchange. Exchange Parties who dispose of Relinquished Property in one entity, such as a corporation, partnership, or multi-member LLC, and who want to acquire the Replacement Property in a different corporation or multi-member LLC for each Replacement Property may not do so within the exchange format. The following changes in vesting usually do not destroy the integrity of the exchange:
To avoid what the IRS may consider as a "step transaction", thereby disqualifying the exchange, the Exchange Party should not make any changes in the vesting of the relinquished or replacement properties prior to or during the exchange. Exchange Parties are cautioned to consult with their tax or legal advisors regarding how their vesting issues will impact the structure of their exchanges before they transfer the Relinquished Property. Proper planning and negotiation can make the difference between a successful exchange and a taxable problem. How and when do taxpayers report a 1031 Deferred Exchange?A taxpayer must report an exchange on the tax return for the year in which the exchange begins. The exchange is reported on Form 8824, "Like-Kind Exchanges". This form requests dates of exchange transactions, the date properties were "identified", and financial information obtained from the closing settlement statement. For the sale of depreciable rental or business property, the taxpayer also will need Form 4797, "Sale of Business Property". For the sale of non-depreciable investment property, the taxpayer will need Form 1041 Schedule D, "Capital Gains and Losses". The basic rule is that closing costs reduce realized gain on the Relinquished Property, reduce boot received, and are added to the basis of the Replacement Property. Remember, if the taxpayer sells the Relinquished Property after October 18 of a particular year, he has less than 180 days within which to complete the exchange. The actual deadline is the date the tax return is due, typically April 15 of the year following the sale of the Relinquished Property. The taxpayer must complete and file an extension to file his tax return in order to obtain a full 180-day exchange period. Be aware that the IRS generally has 3 years within which to audit a tax return. However, the statute of limitations is extended if a taxpayer fails to report more than 25% of gross income. The tax savings from a Deferred Exchange often activates this extension. Can you complete a 1031 Deferred Exchange with a related party?Exchanges between related parties are allowed, but the Exchange Party must follow specific rules before the exchange will qualify for tax deferral. Related parties are defined in IRC Section 267(b) and Section 707(b)(1) as any person or entity bearing a relationship to the Exchange Party, such as members of a family (brothers, sisters, spouse, ancestors, and lineal descendants); a grantor or fiduciary of any trust; two corporations that are members of the same controlled group or individuals; corporations and partnerships with more than 50% direct or indirect ownership of the stock; or capital or profits in these entities. Under IRC Section 1031 1(f), it is clear that 2 related parties, owning separate properties, may "swap" those properties with one another and defer the recognition of gain as long as both parties hold onto their replacement properties for 2 years following the exchange. This rule was imposed to prevent taxpayers from using exchanges to shift the tax basis between the properties with the intended purpose of avoiding paying taxes. The more typical related party exchange scenarios have the Exchange Party using a Qualified Intermediary to create the exchange with either a related party buyer who purchases the Exchange Party's Relinquished Property or a related party seller from whom the Exchange Party acquires the Replacement Property. There is some uncertainty, however, as to whether the IRS will treat these types of related party exchanges favorably. Most tax advisors agree that exchanges in which the buyer is the related party will have better success in qualifying for tax deferral, but only if both the buyer and the Exchange Party hold the properties they receive in the exchange for the 2-year holding period. Most tax advisors, on the other hand, do not recommend exchanges in which the seller is the related party. According to recent IRS opinions, the IRS does not currently favor this type of exchange, even if the Exchange Party uses a Qualified Intermediary to create the "exchange". In this latter exchange scenario, the IRS generally will view the exchange as if it were structured as a 3-party exchange without a Qualified Intermediary. An example would be: the Exchange Party and the related party seller exchanges properties, and then the related party seller immediately sells the Relinquished Property received from the Exchange Party to the unrelated buyer for cash. In this situation, the related party seller would not have held onto the Relinquished Property received in the exchange for the 2-year holding period, thereby causing the exchange to fail. Exceptions to the 2-year holding period are allowed only if the subsequent disposition of the property is due to:
In fact, under IRC Section 103 1(f)(4), a related party exchange will be disallowed if it "is a part of a transaction (or series of transactions) structured to avoid the purposes (of the related party provisions)." It also is important to note that under IRC Section 1031(g) the 2-year holding period is "tolled" for the period of time that:
There are many important issues regarding related party exchanges that are not clearly defined by the IRS. These issues present important tax considerations for the Exchange Party that should be reviewed by tax or legal counsel. How are closing costs handled in a 1031 Tax-deferred Exchange?Exchange Parties, closing agents, escrow officers, and tax advisors have struggled with the many issues presented by the variety of expenses and cash payments associated with closing the properties in exchange transactions. To make matters less certain, there is little authority in the Internal Revenue Code or Treasury Regulations as to how to treat the closing cost items commonly seen on settlement statements. The following are answers based on existing authority to typical issues seen on settlement statements. Given the general rule that an Exchange Party must transfer all equity in the Relinquished Property to the Replacement Property, the issue is whether the Exchange Party will be taxed on the amount of the sale proceeds used to pay typical sale and purchase settlement expenses. Revenue Ruling 72-456 specifies that real estate sale commissions paid are offset against the sale proceeds received provides some guidance. The purchase commissions paid are added to the basis of the Replacement Property. Therefore, payment of brokerage commissions from exchange proceeds does not create taxable boot. Based on this rationale, the same favorable treatment may be accorded other sale and purchase expenses. Payment of the following "non-recurring" costs of sale or purchase from the exchange proceeds should not create taxable boot: real estate commissions, documentary transfer taxes, title insurance premiums, direct legal fees escrow or closing agent fees, agreed property inspections, recording fees, or intermediary fees. However, certain costs may create taxable boot because they are seen as expenditures for benefits other than acquiring the Replacement Property. Loan fees, points, and prorated mortgage insurance are costs to obtain a new loan. Prorated property taxes, insurance payments, and rents usually are considered deductible ongoing operating expenses and not part of the exchange. Payment of appraisal fees, inspections, surveys, and environmental studies are typically considered taxable boot if they are used to obtain a new loan for the Replacement Property. If, however, the Purchase and Sale Agreement for the Replacement Property was specifically made contingent upon the satisfactory completion of these items, the Exchange Party could argue that these expenditures were for the purpose of the property and not to obtain a new loan. The Exchange Party may wish to consider prorated property tax payments or security deposits paid to the buyer of the Relinquished Property as the equivalent of non-recourse debt from which the Exchange Party was relieved. While this treatment initially creates mortgage boot received, this payment can be netted against liabilities assumed (mortgage boot paid) on the purchase of the Replacement Property. See TAM 8328011 regarding prorated rent payments. There is an issue as to whether the Qualified Intermediary's use of exchange funds to pay for the costs and expenses to close on the Replacement Property affect the safe harbor restrictions of Treas. Reg. Section 1.103 1(k)-1(g)(6). The Treasury Regulations are clear that normal costs of sale or purchase, including commissions, fees, and property taxes, may be paid from the exchange proceeds and will not be construed as constructive receipt of funds by the Exchange Party. However, using exchange proceeds for closing expenses unrelated to the direct purchase of the Replacement Property must only be made at the time of closing the Replacement Property when the Qualified Intermediary pays out all of the exchange funds it is holding in accordance with the restrictions for completing the exchange set forth in Section 1.1031(k)-i (g)(6). Are there safe harbor provisions that provide guidance for 1031 Deferred Exchanges?The 1991 Treasury Regulations for Tax-Deferred Exchanges under IRC Section 1031 establish four "safe harbors", the use of which allow a taxpayer (Exchange Party) to avoid actual or constructive receipt of money or other property for purposes of completing a Section 1031 exchange. Although an Exchange Party will not automatically be deemed to have constructive receipt of Relinquished Property sale proceeds if the safe harbor requirements are not met, compliance with the safe harbors should satisfy even a conservative tax advisor. The four safe harbors include:
These safe harbors may be used singularly or in any combination as long as the terms and conditions of each can be separately satisfied. The first 3 of the safe harbors require the exchange agreement between the Exchange Party and the Qualified Intermediary to expressly limit the Exchange Party's right to "receive, pledge, borrow, or otherwise obtain the benefits of money or other property" before the end of the 180-day exchange period, except as permitted by Treasury Regulation Section 1.103 1(k)-1(g)(6)(ii)-(iii). Reg. Section L1031(k)-1(g)(6)(i). The safe harbors are not satisfied if these restrictions are not placed upon the Exchange Party, even if the Exchange Party never actually receives the exchange proceeds. Reg. Section 1.1031(k)-i(g)(8), Example 2(ii). The "cash out" provisions found in the Regulations allow the exchange agreement to remove these restrictions and grant the Exchange Party access to the exchange proceeds before the end of the exchange period, but only under the following circumstances. If the Exchange Party has not identified Replacement Property by the end of the 45-day Identification Period, then the exchange can be terminated and the Exchange Party has the right to the exchange proceeds at any time. For example: On April 1, Exchange Party "E" transfers the Relinquished Property to a buyer. If the Exchange Party fails to identify any Replacement Property on or before May 16, then E may have access to the funds in the exchange account at any time after May 16. If, after the end of the Identification Period, the Exchange Party has identified Replacement Property and receives all of the identified Replacement Property to which the Exchange Party is entitled under the exchange agreement, then the Exchange Party has the right to receive any remaining exchange proceeds even if it is prior to the end of the 180-day exchange period. Using the above example, if E identified a single Replacement Property and acquired that Replacement Property on May 25, then E could demand the balance of the remaining exchange proceeds at any time after that date since E had acquired all of the identified Replacement Property to which it is entitled under the exchange agreement. This provision is more problematic when the Exchange Party identifies multiple replacement properties. For example: On April 1, E transfers the Relinquished Property to a buyer and the Qualified Intermediary "QI" receives $500,000 in exchange proceeds. On or before May 16, E properly identifies a ranch and two vacant lots as Replacement Property although E only intends to acquire the ranch. The 180-day period expires on September 28. On August 28, QI uses $30,000 to acquire the ranch for E as Replacement Property. The answer is unclear as to whether E has an immediate right to the $20,000 balance of the exchange proceeds. Some commentators believe that the QI should be allowed to pay any excess exchange funds to the Exchange Party without having to wait for the expiration of the 180-day period. Other commentators argue that since the Exchange Party has properly identified other properties, which he/she has not acquired, the Exchange Party has not acquired all of the properties to which it is entitled. Therefore, the receipt of the remaining exchange funds prior to the expiration of the 180-day period could constitute constructive receipt and possibly jeopardize the Tax-Deferred nature of the entire transaction. If, after the end of the Identification Period, a material and substantial contingency occurs that:
the Exchange Party has the right to the exchange proceeds. Although the Treasury Regulations provide very few examples, zoning problems or unsatisfactory structural inspections may rise to the level of a "material and substantial contingency". To avoid the possibility of constructive receipt of the exchange funds, the Exchange Party should always consult with his tax advisor as to whether the occurrence of a particular contingency in the purchase contract could be considered a material and substantial contingency. Can a 1031 Deferred Exchange be used to build-to-suit new improvements on Replacement Property?The build-to-suit exchange (also referred to as a "construction" or "improvement" exchange) is a Tax-Deferred Exchange in which improvements are made to the Replacement Property. Once the necessary improvements are completed (within the 180-day exchange time period), ownership is transferred to the Exchange Party and the exchange transaction is completed. This exchange variation gives investors more flexibility, providing the opportunity to either improve an existing property or construct a new Replacement Property. An Exchange Party should consider a build-to-suit exchange when the value of the Replacement Property will not result in complete deferral of the capital gain tax. This situation arises when the purchase of replacement properties will not use all the cash proceeds in the exchange account or there will be insufficient replacement debt. Either exchange proceeds or additional debt can be used to pay for the Replacement Property. If additional debt is used for improvements, loan documents should be executed by the Qualified Intermediary. The regulations require that identification, made no later than the 45th day of the exchange period, specify as much detail regarding construction of the improvements as is practicable at the time the identification is made. Typically, a Qualified Intermediary will request the legal document of the property along with floor plans and specifications for new construction or a complete description of the renovation. As always, advance planning is essential. Weather, local government permits and approvals, normal construction delays, and labor problems can limit the amount of improvements constructed within the exchange period. The tax code provides only 180 days from closing on the Relinquished Property for the acquisition of the Replacement Property, and this deadline applies to build-to-suit exchanges as well. However, not all improvements must be completed within the 180-day period. The general rule for a complete deferral of the capital gain taxes is that the Exchange Party must receive title to Replacement Property that consumed all of the proceeds in the exchange account and is encumbered by debt equal to (or greater than) the debt on the Relinquished Property. What is a Reverse 1031 Deferred Exchange?A "reverse" exchange occurs when the Replacement Property is purchased prior to closing on the sale of the Relinquished Property. The Exchange Party uses the Qualified Intermediary to purchase the property he wishes to acquire while he markets and attempts to close on the Relinquished Property. Most "reverse" exchanges are facilitated through parking the title with a Qualified Intermediary. In one variation of the parking arrangement, the Exchange Party enters into an agreement with a Qualified Intermediary who acquires the Replacement Property and holds title until a buyer is found for the Relinquished Property. When the Relinquished Property is ready to close, the Qualified Intermediary enters into a simultaneous exchange with the Exchange Party, transferring ownership of the parked Replacement Property to the Exchange Party and acquiring ownership of the Relinquished Property, which the Qualified Intermediary then sells to the third-party buyer. Alternatively, the Relinquished Property can be parked with the Qualified Intermediary until a buyer can be found and then sold by the Qualified Intermediary to that buyer with the Exchange Party taking title to the Replacement Property. The Qualified Intermediary typically will enter into a property management agreement or triple net lease, executed between the Qualified Intermediary and Exchange Party, or property management company designated by the Exchange Party, during the period of time the Qualified Intermediary is on title to either the replacement or Relinquished Property. Only a few Qualified Intermediaries will take title to the property and bear the risks of ownership during the parking period. The structuring of "reverse" transactions must be done carefully to avoid agency and constructive receipt issues that can disqualify an exchange. Exchange Parties should always receive the advice of their tax or legal counsel before proceeding with this type of an exchange. Unlike most exchange variations where Exchange Parties can rely on the Treasury Regulations, primary support for this exchange format comes from court cases. In Bernie D. Rutherford v. Commissioner, the Tax Court held that a "reverse" exchange involving heifers qualified for like-kind exchange treatment. A similar positive result was achieved in a real property exchange, Biggs v. Commissioner, in which the Exchange Party loaned funds to a Qualified Intermediary. The Qualified Intermediary used the loan proceeds to purchase the Replacement Property and held it while the Exchange Party located a buyer for the Relinquished Property. Can a 1031 Deferred Exchange take place where there is mixed property?Taxpayers hold properties for various reasons:
Properties held for the first two reasons qualify for IRC Section 1031 Tax-Deferred Exchange treatment. These properties may be real or personal. Sometimes Exchange Parties hold a mix of real and personal properties. In these situations, tax and legal advice is necessary to allocate sale and purchase prices to the appropriate real versus personal elements of the transaction. In Sayre vs. U.S., 163 F Supp 495, the court ruled that any reasonable allocation would be appropriate. An allocation could be determined by an appraisal, the number of units, or the relative square footage of the units. Example A: The Exchange Party relinquishes the family homestead and the surrounding ranch, a mix of personal use and business use. He can take advantage of the new Principal Residence Capital Gains exclusion (subject to specific limitations), while simultaneously pursuing an IRC Section 1031 exchange of the ranch. Replacement Property could be another home and ranch or a separate home and an apartment complex. An IRC Section 1031 Qualified Intermediary is required for the exchange of ranch property and will hold those proceeds for the purchase of the Replacement Property. Example B: An Exchange Party may sell a restaurant involving land/building and substantial personal property. He can acquire a replacement restaurant and have an exchange of the real property for real property and personal property for personal property. Alternatively, he may exchange the real property for apartments and pay tax on the personal property portion of the transaction. |
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