FREQUENTLY ASKED QUESTIONS
ABOUT REAL ESTATE TAX DEFERRED EXCHANGES
PER THE INTERNAL REVENUE CODE
SECTION (IRC) 1031
FREQUENTLY ASKED QUESTIONS
DISCLAIMER:
PLEASE NOTE: THIS IS NOT INTENDED TO BE TAX ADVICE IN ANY CONCEPTION OF THE TERM. YOU ARE
ADVISED TO CONSULT WITH YOUR LEGAL AND/OR TAX ADVISOR BEFORE ATTEMPTING ANY SALE, PURCHASE
OR EXCHANGE OF REAL PROPERTY.
All of the information presented herein is specifically intended to give
the reader a better understanding of the exchange process. This information is designed to
only provide information concerning IRC. Section 1031 Tax-Deferred Exchanges. It is not
intended to provide or replace legal, accounting or other professional Counsel.
IT IS STRONGLY RECOMMENDED THAT YOU CONSULT WITH YOUR LEGAL COUNSEL, TAX
ADVISOR AND YOUR COMPANY MANAGEMENT REGARDING ANY SPECIFIC SITUATIONS OR HOW THE
INFORMATION CONTAINED IN THIS MATERIAL RELATES TO YOU, YOUR COMPANY’S POLICY AND/OR
ALL TAX, LEGAL AND LOCAL PRACTICES.
ALL INFORMATION CONTAINED HEREIN IS FROM RELIABLE SOURCES AND IS DEEMED
TO BE ACCURATE, BUT IS IN NO WAY GUARANTEED TO BE ACCURATE . ALL OF THE INFORMATION
HEREIN, IS CURRENT AS OF 2-1-1996. BE SURE TO CONTACT YOUR LEGAL AND TAX ADVISORS FOR ANY
CHANGES AND UPDATES.
Click any question and it will
jump to the answer. Then just click "back", in top left corner of your Browser
to come back to these questions.
1) WHAT IS "INTERNAL REVENUE CODE SECTION 1031"?
2) HOW DO I KNOW IF MY TRANSACTION IS A 1031
EXCHANGE?
3) WHY SHOULD A REAL ESTATE BROKER OR AGENT
UNDERSTAND EXCHANGING?
4) WHAT IS 1031 "LIKE KIND" PROPERTY?
5) WHAT IS A IRC SECTION 1034 PROPERTY?
6) WHY EXCHANGE PROPERTY INSTEAD OF JUST SELLING
IT?
7) WHEN IS A 1031 TAX-DEFERRED EXCHANGE
APPLICABLE?
8) WHO ARE THE PRINCIPALS IN AN EXCHANGE?
9) WHAT IS THE CURRENT IDENTIFICATION PERIOD,
AND CLOSING TIME TO ACCOMPLISH A DELAYED 1031 TAX DEFERRED EXCHANGE?
10) WHAT HAPPENS TO THE MONEY?
11) WHAT HAPPENS WHEN THE EXCHANGER OBTAINS A
NEW LOAN FROM AN
INSTITUTIONAL LENDER?
12) WHAT IS A "QUALIFIED
INTERMEDIARY"?
13) WHO IS, AND WHAT CAN I EXPECT TO PAY, A
"QUALIFIED INTERMEDIARY"?
14) WHY A "QUALIFIED INTERMEDIARY"?
15) WHAT VERBIAGE IS NECESSARY TO CHANGE THE
TRANSACTION FROM A NORMAL BUY/SELL TO AN EXCHANGE?
16) WHAT IS DIRECT DEEDING?
17) WHAT HAPPENS WHEN BOTH THE SELLER AND BUYER
ARE WANTING AN EXCHANGE?
18) HOW DO I PREPARE A 1099 FORM?
19) WHEN CAN THE EXCHANGER GET CASH FROM THE
EXCHANGE?
20) WHAT IS NEEDED WHEN THE EXCHANGER IS A
PARTNERSHIP, CORPORATION OR TRUST?
21) HOW SHOULD THE EXCHANGER’S NAME BE
VESTED IN THE DEED?
22) IS A 1031 EXCHANGE ALWAYS 100% TAX
DEFERRED?
23) WHAT IS BOOT?
1) WHAT IS "INTERNAL REVENUE
CODE SECTION 1031"?
Section 1031 of the Internal Revenue
Code relates to the disposition of property that is held for use in productive trade or
business or held for investment. If performed properly, code section 1031 provides an
exception to the rule requiring recognition of gain upon the sale or exchange of property.
In other words, if the requirements of a valid 1031 exchange are met, capital gain
recognition can be deferred until the taxpayer chooses to recognize it. The current
Federal tax rate (maximum) on long term capital gains is 28%, plus any applicable state
taxes. Long term capital gains are not taxed as ordinary income. For an exchange to be
100% tax deferred, the Exchanger must acquire replacement property that is of equal or
greater value and spend all of the net proceeds from the relinquished property. Many
specific requirements must be satisfied in order to complete the exchange properly. With
the recent IRS Regulations in place, an experienced qualified Broker, Intermediary and
Escrow/title Officer, can accomplish an exchange with ease.
2) HOW DO I KNOW IF MY TRANSACTION
IS A 1031 EXCHANGE?
The best way to confirm if you have
an exchange is to ask the principals involved. Here are some helpful hints to determine if
someone "may" be wanting to do an exchange:
Is the property the Seller’
residence?
If yes, then the Seller will not be eligible for a 1031 Exchange.Does the Buyer intend to
live at the property?
If yes, then the Buyer will not be
eligible for a 1031 Exchange.Is the property intended for investment purposes?
If yes, then either the Seller or Buyer could be wanting to do an Exchange.
3) WHY SHOULD A REAL ESTATE BROKER
OR AGENT UNDERSTAND EXCHANGING?
In today’s real estate climate,
it is imperative that Real Estate Brokers and Agents understand the options a 1031
Exchange can offer their clients. Without such knowledge brokers and their agents are open
to potential liabilities, due to lack of knowledge. Unfortunately, you can be as liable
for what you don’t say, as well as for what you do say. Simply offering the option of
a Tax-deferred Exchange can eliminate potential liability on the Broker’s part. The
"Exchange Agent" can have more satisfied clients by offering them the option to
save substantial tax dollars, through exchanging. The Exchange Agent can also increase
their income with the additional knowledge of exchanging.
4) WHAT IS 1031"LIKE KIND"
PROPERTY?
The IRS Code Section 1031 states
that property held for use in productive trade or business or property held for investment
, is potentially exchangeable. One can therefore qualify for non recognition of gain upon
the disposition of such property, assuming all other requirements are met. This means that
business property or property held for investment, may be disposed of to a buyer (sold),
set up with a "Qualified Intermediary", put into escrow, which will document the
transaction as an exchange, and within the codified time frame, repurchase replacement
property of "like kind" thereby completing the exchange. It is not required that
exactly the same type of property is acquired. In 1989 the IRS attempted to change the
meaning of "like kind" to "similar use", and unfortunately many people
believe that is the case. The attempt was defeated."Like kind" property that can
be exchanged under the current meaning of Code Section 1031 can include: PROPERTY THAT IS
HELD FOR PRODUCTIVE USE IN A TRADE OR BUSINESS, OR, PROPERTY THAT IS HELD FOR INVESTMENT.
"Like kind" property can include, but is not limited to any of the following,
provided it is held for investment : commercial, single family rental property, condos,
raw land, apartments, vacations home, second home, duplexes, industrial properties and a
Leasehold Interest of 30 years or more.
A persons PRIMARY RESIDENCE does NOT
come under the rules of Section 1031, and is specifically EXCLUDED, as is property held
"primarily for resale" or dealer property.
A common misconception to "like
kind" is that the properties being exchanged be of "similar use". This is
simply not true. A commercial property can be exchanged for an apartment complex or bare
land exchanged for a single family rental.
5) WHAT IS A IRC SECTION 1034
PROPERTY?
IRC Section 1034 encompasses a
primary residence only. A taxpayer is only allowed one primary residence, therefore, by
reason of default, any other real property could be considered possible 1031 property. The
only condition is that it meets the guidelines of Section 1031.
6) WHY EXCHANGE PROPERTY INSTEAD OF
JUST SELLING IT?
The most important reason is to able
to defer potentially taxable gain one may realize from a sale of the property. This way
one may be able to use All OF THEIR EQUITY to acquire another property, instead of the
amount of equity left over after paying applicable Federal and State income taxes on their
gain. Additionally, the ability to go from one type of property to another allows an
investor to utilize these other concepts: Leverage, Diversification, Cash Flow,
Consolidation, Management relief, and possibly Increase their Depreciation.
It is possible, under the current
IRS Section 1031 rules, to continue to exchange properties, using all of your equity, thus
increasing your portfolio Net Worth much faster than were you to sell properties, pay the
taxes, and then acquire another property with the remaining equity.
7) WHEN IS A 1031 TAX-DEFERRED
EXCHANGE APPLICABLE?
It is applicable when the property
in question falls within the "like kind"definition and the principal intends to
BUY another property of "like kind" within 180 calendar days following the close
of escrow from the SALE, and when the Investor has a recognizable gain.
CAUTION must be exercised in this
area. Property does not have to appreciate in value to have a gain!! The property may have
a "built in" gain as a result of a previous exchange or from depreciation taken.
Be sure to consult with your legal and/or tax advisor.
Remember, under the delayed exchange
parameters, there is a maximum of 180 calendar days to purchase replacement property.
Therefore, if the principal is not sure at the time of closing the sale property, it is
imperative that it be structured as an exchange rather than a sale. Otherwise, if the
escrow Is closed without the exchange in place, the principal will have receipt of
proceeds and cannot perform an exchange.
The worst case is that if the
exchange is "set up" and the principal decides not to buy replacement property
and takes the proceeds, the principal just pays taxes as they normally would. Without the
exchange being "set up", the principal does not have that option. An informed
Client, Seller, will appreciate the flexibility.
8) WHO ARE THE PRINCIPALS IN AN
EXCHANGE?
The first Epson to identify is the
one wanting to effect a 1031 Tax-Deferred Exchange. This person will be your Exchanger. If
your Exchanger is the SELLER, you are handling a PHASE I EXCHANGE. If your Exchanger is
the BUYER, you are handling a PHASE II EXCHANGE.
PHASE I CLIENT =
SELLER & PHASE II CLIENT = BUYER
In a Phase I Exchange, your Buyer
will be treated normally, as if there is no exchange involved in the transaction. You will
only have to obtain the Buyer’s signature to one document, the Amendment to
Escrow/Closing Instructions. Otherwise, the Buyer does nothing different.
In a Phase II Exchange, the Seller
will be treated normally, as if there is no exchange involved in the transaction. Again,
you will only have to obtain the Seller’s signature to one document, the Amendment to
Escrow/Closing Instructions. Otherwise, the Seller does nothing different.
In a PHASE I Exchange a QUALIFIED
INTERMEDIARY will be substituted into the transaction as the Seller.
In the PHASE II Exchange, a
QUALIFIED INTERMEDIARY will be substituted into the transaction as the Buyer.
9) WHAT IS THE CURRENT
IDENTIFICATION PERIOD, AND CLOSING TIME TO ACCOMPLISH A DELAYED 1031 TAX DEFERRED
EXCHANGE?
After an exchange has been "set
up", by contacting a Qualified Intermediary prior to closing a sale, the Seller,
Exchanger, must identify up to three (3) potential properties they MAY intend to acquire,
within 45 days of the close of the "sale" escrow. It is immaterial what the
value is of the potential properties.
One can list, or identify, four (4)
or more, properties, however these properties cannot have an aggregate value of 200% or
more of the sale property. If more than three (3) properties are identified, and the value
exceeds 200% of the sale price, then you must close escrow on 95% of the list. Escrow must
close, on at least one of the identified properties, within 180 calendar days from the
date of the close of the sale escrow. Be sure to check with your legal and/or tax advisor.
10) WHAT HAPPENS TO THE MONEY?
In a Phase I Exchange, it is
imperative that the Exchanger (who is the owner of the property) does NOT receive any
money. The Seller’s net proceeds are wired to the Intermediary into a separate,
interest bearing account. Each exchange has its own account, therefore, you must call the
Intermediary BEFORE wiring to obtain the account number. If not, the wire will probably be
returned to you due to insufficient information.
In a Phase II Exchange, the funds
required to close the transaction will be sent to you from the exchange account held by
the Intermediary. You will need to contact the Intermediary to find out exactly how much
money is in the exchange account. In the event there is insufficient funds in the exchange
account to close your escrow/ closing, then the Exchanger will have to deposit the
additional funds required to close the escrow/closing.
11) WHAT HAPPENS WHEN THE EXCHANGER
OBTAINS A NEW LOAN FROM AN INSTITUTIONAL LENDER?
The Intermediary does not need to
see or sign any of the lender’s documents. This is the Exchanger’s loan and only
the Exchanger should be signing. Most lenders do not have a problem with the Qualified
Intermediary inserted as the Exchanger’s Name on Instructions or Settlement
Statements. However, if the lender does not want to see a Intermediary’s name on your
statements or instructions, you can eliminate their name on items sent to the lender.
12) WHAT IS A "QUALIFIED
INTERMEDIARY"?
Paramount to any exchange is a
competent Qualified Intermediary. The Intermediary is the entity which structures,
consults, guides and documents the exchange transaction from beginning to end. A sound
Intermediary will provide safety and security for the funds held and provide the technical
experience needed to maintain the integrity of the exchange. They do not replace competent
tax or legal advise. Quite the contrary, they are not allowed to give tax or legal advise,
this could disqualify them as an Intermediary.
13) WHO IS, AND WHAT CAN I EXPECT
TO PAY, A "QUALIFIED INTERMEDIARY"?
You should contact your local Title
and Escrow Companies, local Attorney’s and tax practitioners for references to a
"QUALIFIED INTERMEDIARY".
A "QUALIFIED
INTERMEDIARY"that you can also contact is ASSET PRESERVATION INCORPORATED, (API) A
STEWART TITLE COMPANY subsidiary. They are qualified to take care of Real Estate Exchanges
Nationwide. They are located at 8700 Auburn - Folsom Road, Suite 600, Granite Bay, Calif.,
95746. Their phone is (800) 282-1031 and fax is (916) 791-6003 and their local phone is
(916) 791-5991.
You will want to check their
current rates, but at last communication their rates were as follows: $350.00 for the
first "SALE" property escrow/closing; $200.00 for each subsequent
"SALE" property escrow/closing (within the same exchange transaction); PLUS
$350.00 for the first "PURCHASE" property escrow/closing, and $200.00 for each
subsequent "PURCHASE" property escrow/closing (within the same exchange
transaction). These are their fees for either a Delayed or Simultaneous Exchange. No other
hidden or extra fees, they say. Please contact them directly for additional information as
to how interest on "Qualified Escrow Accounts" are handled, and other specific
questions.
They are quite knowledgeable and
glad to help. The majority of the information contained in these FAQ’s was furnished
by ASSET PRESERVATION INCORPORATED.
See their web site
at: http://www.apiexchange.com
14) WHY A "QUALIFIED
INTERMEDIARY"?
In the regulations of 1991, many of
the "grey areas" were clarified in Section 1031 of the Internal Revenue Code,
and established the Safe Harbor provisions.
Safe Harbors include:
1) The use of a Qualified Intermediary;
2) Receipt of interest or "Growth Factor" by the Exchanger;
3) The use of a Qualified Escrow Account; and
4) The use of security instruments in an Exchange (such as the use of a Qualified
Intermediary; qualified escrow/closing and trust accounts; third party guaranty).
15) WHAT VERBIAGE IS NECESSARY TO
CHANGE THE TRANSACTION FROM A NORMAL BUY/SELL TO AN EXCHANGE?
The usual recommended procedure is
to set out the Exchanger’s intent to perfect a 1031 Tax-Deferred Exchange in the
purchase agreement (contract) between the Seller and Buyer. The following is an
"example" of language that is currently satisfactory to establish the
Exchanger’s intent:
PHASE I (SALE):
Buyer is aware that Seller is to
perform a 1031 Tax-Deferred Exchange. Seller requests Buyer’s cooperation in such an
exchange and agrees to hold Buyer harmless from any and all claims, liabilities, costs or
delays in time resulting from such an exchange.
PHASE II (BUY):
Seller is aware that Buyer is to
perform a 1031 Tax-Deferred Exchange. Buyer requests Seller’s cooperation in such an
exchange and agrees to hold Seller harmless from any and all claims, liabilities, costs or
delays in time resulting from such an exchange.
It is advisable to also have
communicated with a Qualified Intermediary and include the following in a purchase, or
sale, contract as well:
"Seller, (or Buyer) has entered into an agreement with (name of the Intermediary), to
act as their Qualified Intermediary in facilitating said exchange".
Provided the Exchanger’s
intent to perfect a 1031 Tax-Deferred Exchange is established in the Purchase, or Sale,
Agreement and the Intermediary’s documents are executed, it is not necessary to
prepare separate "EXCHANGE" Instructions.
This may be contrary to what is
expected in your area. By all means, make the Client happy. However, the IRS will look to
the Purchase or Exchange Agreement to validate the exchange and not necessarily the
Exchange Instructions. Be sure to contact your legal and/or tax advisor.
16) WHAT IS DIRECT DEEDING?
Pursuant to Revenue Ruling 90-34,
IRS. 1990-16 (December 16, 1990) and I. R. S. Regulations 1.1031(k)-1(g)(4)(v), it is no
longer necessary to do "sequential" deeding. That is, deed from the Seller to
the Intermediary and then the Intermediary deeds to the Buyer.
It is now an accepted practice to
deed directly, that is, the Exchanger deeds directly to the Buyer in a Phase I Exchange or
the Seller deeds directly to the Exchanger in a Phase II Exchange.
17) WHAT HAPPENS WHEN BOTH THE
SELLER AND BUYER ARE WANTING AN EXCHANGE?
This is not that unusual of a
situation and is very simple to complete. You would handle the Seller’s Exchange just
like a Phase I Delayed Exchange and you would handle the Buyer’s Exchange just like a
Phase II Exchange.
18) HOW DO I PREPARE A 1099 FORM?
On a Phase I Exchange, you will
prepare a 1099 form showing the Exchanger’s name, address and Tax ID Number (Social
Security Number). The Exchanger is the only one that needs to sign this form.
IT IS IMPERATIVE THAT YOU COMPLETE THE SECTION IN YOUR 1099 FROM THAT INDICATES THAT THIS
PROPERTY IS PART OF AN EXCHANGE.
19) WHEN CAN THE EXCHANGER GET CASH
FROM THE EXCHANGE?
If the Exchanger wants to receive a
portion of his/her proceeds in cash, this must take place BEFORE any funds are sent to the
Intermediary. Once the Exchanger tells you that he/she wants to receive money, contact the
Intermediary right away to avoid any problems. Once the funds are deposited into the
exchange account, the Exchanger cannot receive these funds until the exchange is
completed.
20) WHAT IS NEEDED WHEN THE
EXCHANGER IS A PARTNERSHIP, CORPORATION OR TRUST?
There is nothing different in how
the exchange is handled, but the Intermediary will need to see a copy of the Trust
Agreement, the Partnership Agreement, or a Corporate Resolution.
21) HOW SHOULD THE EXCHANGER’S
NAME BE VESTED IN THE DEED?
To have a valid exchange, the
Exchanger’s vesting should be exactly the same in the Phase II transaction as it is
in the Phase I. Therefore, if the Exchanger owns the relinquished property in his/her
personal names, the Exchanger should not try and put the replacement property into a
family trust until after the exchange is closed.
22) IS A 1031 EXCHANGE ALWAYS 100%
TAX DEFERRED?
No. For an exchange to be 100% tax
deferred, the Exchanger must acquire a replacement property that is of equal or greater
value and spend all of the net proceeds from the relinquished property.
23) WHAT IS BOOT?
Boot is defined as any "NON
LIKE KIND" property received by the Exchanger in the exchange and it is taxable.
1) CASH BOOT:
Cash Boot consists of any funds
received by the Exchanger, either actually or constructively. If an Exchanger does not
spend all of the proceeds from the sale of the relinquished property, he/she will have
actual receipt of the balance not spent and pay taxes on that amount.
Constructive receipt of funds may
occur in a case where the Exchanger carries back a note from his/her Buyer of the
relinquished property, then sells that note at a discount. The Exchanger never actually
receives funds for the discounted amount, however, he/she has constructively received that
discount and pays tax on that amount.
2) MORTGAGE BOOT OR DEBT RELIEF
Mortgage Boot occurs when the
Exchanger does not acquire debt that is equal to or greater than the debt that was paid
off, therefore, they were "RELIEVED" of debt. If the Exchanger does not acquire
equal or greater debt on the replacement property, they are considered to be
"RELIEVED OF DEBT", which is perceived as taking a monetary benefit out of the
exchange. Therefore, the debt relief portion is taxable, unless offset by adding
equivalent cash to the transaction. More to it than just spending all the exchange
equity!!
So an Exchanger must buy of equal
or greater value while spending the NET (after costs) equity. It is absolutely acceptable
to take cash out of the exchange and pay taxes on that amount only.
IMPORTANT: If the Exchanger wants
cash out of the PHASE I exchange, the Intermediary must be notified immediately. The cash
ot must come directly out of the closing of Phase I and not from the Intermediary. Once
the exchange equity is in the "Qualified Escrow Account" at the
Intermediary’s, the Exchanger cannot access the funds until the end of the exchange.
**INDEX PAGE**
**AUTHORIZE FORM**
**1031 GLOSSARY
**ABOUT JIM SMITH**
**OWNER/AGENT PROPERTY DATA FORM**
**WOULDYA TAKE FORM**
** HAVE'S & WANT'S **
**TAX
TIPS**
PROPERTIES CURENTLY AVAILABLE
**UNIQUE
& UNUSUAL HOMES**
**RESIDENTIAL INCOME**
**COMMERCIAL
INCOME**
**SINGLE PURPOSE INCOME**
**INCOME PROPERTY "LOTS" TO DEVELOP**
**INCOME PROPERTY "LAND" TO DEVELOP**
** BUSINESS OPPORTUNITIES **
**OTHER INTERESTING WEBSITES**
REAL ESTATE WANTED
