It is very common to channel monies from investment properties through a 1031 Exchange company. This is the way to avoid paying large capital gains taxes. It is very important that you make sure that the rules for a 1031 exchange are followed so that you don't end up paying the capital gains taxes and penalties. Brad Jorgensen, President of Summit 1031 Exchange,LLC and Ryan T. Peel esq., the Utah Corporate Counsel for Summit 1031 Exchange, LLC have compiled this quick reference that will answer questions regarding the proper way to use a 1031 exchange.
Important Points About 1031 Exchanges
By Brad Jorgensen and Ryan T. Peel
Section 1031 of the Internal Revenue code allows for taxpayers to defer the payment of capital gains taxes on the sale of investment or business property -provided, however, that certain requirements are followed:
Buy up in value.
In order to defer all of the capital gains taxes (and often state taxes and taxes on depreciation recapture) on the sale of their property, a taxpayer must purchase replacement property valued at or above the net sales price of the relinquished property. When calculating the net sales price of a property, one deducts the real estate commissions, closing costs, escrow fees and exchange fees, but not any mortgages or loans being paid off, which were secured by the property.
Spend all the proceeds.
A taxpayer must spend all of the proceeds of the sale of the relinquished property towards to purchase of replacement property. If a taxpayer receives any proceeds at the closing of his relinquished property (including retaining any earnest money deposits), the IRS terms that amount as "boot" and the taxpayer must pay taxes on any boot received. Additionally, any remaining proceeds at the end of the exchange not used towards the purchase of replacement property would also be taxable "boot."
Exchange with an investment or business property.
1031 Exchanges only pertain to property that has been and will be held for business or investment purpose. It is important to note that the IRS defines "investment" different than the ordinary use of the word. 1031 Exchange property cannot be held for personal use, such as a primary residence or second home, nor can a taxpayer exchange out of or into an ownership interest in a partnership or other business venture. Additionally, a taxpayer cannot exchange out of or into property which the taxpayer's primary intent is to quickly resale or "flip;" the code also prohibits 1031 Exchanges with property where a taxpayer had created inventory, such as a sec home which was built for resale.
Involve a Qualified Intermediary (Q.I.).
1031 Exchange regulations require a third party to act as the Q.I. for the 1031 Exchange. Often termed as the "Accommodator," the Q.I.'s role is to hold the taxpayer's proceeds during the term of the exchange and to help facilitate the taxpayer's sale of relinquished property and purchase of replacement property. Any person or entity that is related to the taxpayer or who has had a fiduciary relationship with them in the past two years cannot act as the Q.I.; this would include the taxpayer's attorney, CPA, real estate agent or broker, but does not include any previous Q.I. Since the 1031 Exchange industry is an unregulated business, the Q.I. should be bonded and covered by an errors and omissions insurance policy. It is strongly encouraged by the Q.I. have a legal, accounting and/or tax background to assist the taxpayer.
Exchange for "like kind" property.
The IRS requires that a taxpayer exchange into "like kind" property. In actuality, the "like kind" requirement is extremely broad--any type of real property is "like kind" to other real property (commercial, residential, vacant land, agricultural, etc.) as long as the taxpayer receives a deeded interest in the replacement property and it is their intent to hold the property for business or investment purpose. Also, leases with a remaining term of at least 30 years and, in certain circumstances, water rights would also qualify as "like kind" property.
Identify all replacement property within 45 days.
The taxpayer has 45 calendar days from the date that title to the relinquished property transfers to identify all the replacement property. Formal identification does not require any offers to be made nor purchase agreements finalized between the parties by the 45 th day. However, it does require the taxpayer to sign a document which unambiguously identifies all replacement property and deliver that document to the Qualified Intermediary by midnight on the 45 th day.
Close on the purchase of all replacement property within 180 days.
The taxpayer has 180 calendar days from the date that title on the relinquished property transfers to close on the purchase of all the replacement property. If either the 45 day deadline or 180 day deadline falls on a Saturday, Sunday or legal holiday, the taxpayers does not have additional time until the next business day. Additionally, there is a seldom-known provision of the 1031 Exchange code which requires that a taxpayers must complete his exchange by the earlier of 180 days or closing on his sale or by the due date of his federal income tax return. If a taxpayer sells his relinquished property after October 17, he must complete this exchange by April 15 of the following year, the due date for an individual's tax return. A taxpayer can always request an extension to filing his tax return, thus allowing him the full 180 days.
Take title to the replacement property the same as the relinquished property's title.
The manner in which a taxpayer holds title to their relinquished property must be consistent with the manner in which they take title to their replacement property in order to complete a valid exchange. Example: if the titleholder on the relinquished property is Wasatch Holdings, LLC, the title to the replacement property must also be Wasatch Holdings, LLC
Do not purchase from or sell to a related party.
If a taxpayer intends to either sell to or buy from a related party, there is the potential for this to invalidate their 1031 Exchange. Furthermore, there are stringent rules regarding the exchange of properties between related parties and if a taxpayer enters into such an exchange, among other negative issues, they must disclose it to the IRS with a high likelihood of an audit to determine if they violated any of the strict related party rules.
Plan ahead when considering a 1031 Exchange.
The IRS requires that certain actions be taken and documents signed by the closing on the sale of the relinquished property. A taxpayer who has closed on the sale of relinquished property and then decides to do a 1031 Exchange will find that it might be too late. It is always recommended to contact the Q.I. sooner rather than later to review the exchange process and to address any issue specific to the taxpayer. Some Q.I.s will welcome and appreciate strategizing with a taxpayer about a proposed 1031 Exchange even before the relinquished property is on the market.
Suggest the taxpayer speak with their CPA or tax advisor.
Since undertaking a 1031 Exchange is a significant tax event, most Q.I.'s urge that the taxpayer consult with their CPA or tax advisor before ultimately deciding to do a 1031 Exchange. The CPA or tax advisor would be most familiar with the taxpayer's individual circumstances and would be in an excellent position to either recommend or oppose a proposed exchange. Real estate professionals should consider acquiring a working knowledge of the 1031 Exchange process in order to benefit their investor clients. A 1031 Exchange can be an excellent tool to utilize for active real estate investors who are disposing of and acquiring properties on a regular basis. By deferring the taxes and converting tax dollars into equity in replacement properties, investors build net worth and a greater portfolio of holdings.
Brad Jorgensen is the President of Summit
1031 Exchange, LLC and an Affiliate Member of the Salt Lake Board of
Realtors Ryan T. Peel, Esq. Is the Utah Corporate Counsel for Summit
1031 Exchange, LLC. This article originally appeared in the June 2007
Salt Lake Realtor Magazine.