1031 Tax Exchange

Tax Exchange refers mainly to Section 1031 of the Internal Revenue Service Code. It is also known as “1031 Tax Exchange.” This section outlines the tax status of “like-kind” real estate exchanges. It helps one in structuring the sale or disposition of real estate (including personal property) and the acquisition of similar real estate as a tax-deferred exchange transaction, in order to defer certain federal taxes and in many cases even capital gain and depreciation recapture taxes.

As far as the meaning of “like kind” is concerned, in the context of a 1031 exchange it means that when it comes to real estate, all forms are “like kind” to all other forms. In other words, an office building can be exchanged for a trailer park.

There are certain properties that are known as 1031 properties. To reap benefits according to Section 1031 in IRS, one can purchase any of these properties. A large number of real estate consultants and law firms also help the buyers in sorting out certain complex issues that are associated with Section 1031. The 1031 properties can also be viewed online. The exchanges under the Tax Exchange law can take place in virtual dealing rooms that are also operating on the web.

Several types of 1031 exchange methods are in use. These include reverse exchanges, simultaneous exchanges, and delayed exchanges. To complete a transaction under 1031 exchange, one needs a qualified intermediary (QI). So once an investor has made an exchange decision, it is advisable to contact a QI as soon as possible. The most difficult part of this transaction is to find a replacement property. However, large numbers of property owners are taking advantage of this tax benefit by reinvesting their sale proceeds from a property in a like-kind property.

1031 Tax Exchange Opportunities

The best thing about Section 1031 is that its benefits are available to large, medium, and small investors. The general misconception is that this section only provides opportunities to defer taxes on capital gains for owners of large commercial properties. But the fact is that if one has a qualified intermediary, then all kinds of investors can benefit from this section.

There is no dearth of real estate firms that provide an exhaustive list of 1031 properties. These firms generally also provide the services of a qualified intermediary. There are “simple gains” calculators available on the Internet that can help one to calculate the capital gains tax one would be able to save through the tax exchange transaction of a real estate property. Over the last one and one-half decades, there has been a phenomenal growth in transactions that qualify under the tax exchange laws. The IRS has also tried to make things easier by simplifying this law and plugging loopholes. Those who have lost out on the opportunity of utilizing this provision to save taxes can attend any of the seminars, which are regularly held in various cities to explain how to avail the opportunities under this section.

Prior to 1990, this section was quite complex and difficult to understand. But now, an individual can easily make out how this section operates. It is still advisable, however, that before you go for exchange you should consult your attorney or a qualified intermediary. There are certain issues pertaining to the partnerships, tenants-in-common, and transaction between spouses that need to be taken care of before you make a final decision.

However, large numbers of properties are now available in the markets that qualify under this section, and there are several firms that are exclusively dealing with the sale and purchase of such properties.

1031 Tax Exchange Forms

There are several forms that are required to be filled while carrying out transactions under Section 1031. Some of the important forms include IRS Form 8824 for like-kind exchanges and IRS Form 4797 for the sale of business property.

There are several agreements that need to be taken care of in terms of paperwork and documentation such as the purchase agreement and sale agreement, earnest money agreement, and offer and acceptance agreements. There are several formats of tax exchanges such as the two-party swap, Alderson exchange, safe harbor, multiple sales/acquisitions, reverse exchange, and improvement exchange. The documentation differs according to these formats.

There are several legal firms as well as real estate firms that help the individuals as well as companies to fill the forms required for availing themselves of the benefits of Section 1031. If one is not aware of the various rules and regulations under this section, then it is better to consult an expert in the matter, as the IRS is quite strict about the documentation part under tax exchange laws.

There are several online consultants that are available to help you in filling out these forms. Ever since Section 1031 came into existence around five decades ago, the U.S. Department of the Treasury has been trying to simplify the procedures and reduce the documentation as much as possible. The efforts specially gained momentum in 1990s. However, certain forms are still mandatory. This requirement also helps ensure that you are not taken advantage of. Most of the real estate consultants and attorneys provide these forms to their clients and help them in filling out these forms as well. Any incorrect information given in these forms could jeopardize not only the transaction itself, but could also have serious legal consequences.

1031 Property Exchange

Property Exchanges conforming to IRC section 1031 offer wonderful opportunities to defer tax liability and maximize profits while helping to continue with the investment of the capital.

The IRC clearly states the main qualifying parameter of the exchange as a like-kind exchange. “In a like-kind exchange, the property you give up and the property you receive must be held by you for investment or for productive use in trade or business.” Thus, 1031 Exchanges can involve only like-kind of properties.

In all, there are five types of 1031 Exchanges. In Simultaneous Exchange one property is sold and the next is bought exactly the same time.

In Delayed Exchange, property is sold and the replacement property is bought within 180 days. Reverse Exchange has the replacement property bought before the initial property is sold.

Improvement Exchange uses some of the capital to improve the property, as in building a road. Personal Property Exchange can also come under ‘like-kind’ exchanges other than real estate. That includes cattle, aircraft, mineral rights, etc.

Just as there are several types of 1031 Exchanges, the processes in each of them vary substantially. Delayed Exchange is the most common type, and also the most popular.

In Delayed Exchange, the first step is planning out the whole transaction by talking to a qualified intermediary, otherwise called a facilitator. The facilitator then ascertains the investment objectives of the seller or exchanger and suggests the right option after estimating the amount of potential capital gains and the resultant tax outgo involved.

Drafting a standard purchase and sale agreement is the second step, stating the exchanger’s intent to exchange the property and obtaining the buyer’s consent to cooperate. The facilitator then suitably converts the sale transaction into an exchange deal through specialized documentation.

Having decided to perform an exchange, parties are then notified about the transaction and the intent to exchange. The parties involved are the real estate agent, closing agent, accountant and attorney.

The facilitator then collects the information required to prepare the exchange documents. The originals are then forwarded to the closing agent for execution during closing. All parties get the documents for review. After closing, the exchanger will transfer the relinquished property to the QI, who would then simultaneously sell the property to the buyer. The proceeds go to the QI and held by him until the acquisition of the replacement property is over.

In the Delayed Exchange, from the date of closing the relinquished property the exchanger gets 45 days to identify the replacement property and 180 days to complete the exchange. The identified replacement property is purchased by the QI and transferred to the exchanger in the stipulated time, making the exchange complete.

It is the facilitator, or QI, who answers all questions from the exchanger’s accountant or attorney. The exchanger’s funds are deposited in separate and insured accounts to ensure security, sometimes in a $1,000,000 fidelity bond account.

The exchange has to be done diligently so that it survives the audit and scrutiny of the IRS.

1031 Exchange

Section 1031 in the Internal Revenue Service is a boon for a prospective investor, selling an investment property and wanting to make a profit by reinvesting in a similar property elsewhere in the country. This wonderful concept works on the principle of gain rolling from the old to the new.

There is widespread ignorance on the modalities about this exchange; as a result, 30-40 percent of property owners end paying tax during the sale. Exchange 1031 not only fructifies into essential tax savings, but also makes possible the swapping of property in the fairest manner at places of choice. No wonder that the 1031 Exchange excites the property market so much.

The new income-generating replacement property gives the investor the double gain of added income and savings from tax that would have otherwise gone to the IRS coffers.

Besides saving the buyer from a huge tax burden coming in the guise of capital gains, the instrument offers maximum immunity and flexibility in reinvesting the money gained from the sale in a replacement property within a given period.

The exchange being time-bound is no kid’s play either. In every exchange of this kind, Qualified Intermediaries (QI) plays a crucial role connecting the buyer and seller. The Federal Tax Code makes service of QI mandatory since 1991 in any exchange.

The federal nature of the 1031 Exchange regulations make the Qualified Intermediary play a wizard in guiding and structuring the exchange, satisfying all parameters and suiting the goals of the clients. It is the QI who does the paperwork required by the IRS to document the exchange. The QI carefully prepares all documents and serves the parties with copies of the exchange agreement, novation agreement and escrow instructions.

The Exchange Agreement reads like a contract between the Exchanger and a Qualified Intermediary. The Exchanger explicitly agrees to transfer his old property to the Intermediary, in lieu of a new property to be supplied by the latter within 180 days. The contract outlines all terms and conditions under which the exchange of properties should take place.

For a 1031 Exchange to take effect, both the old property as well as the new property should be in the category of investment property, capable of generating income. The examples could be rental property, bare land, vacation homes or more.

As soon as the old property is sold, within 45 days the seller has to come out with a list containing two or three probable properties fit for replacement. And the whole process of purchasing the new property or replacement property from the list must be over in a period of 180 days.

The exchange becomes bona-fide only when the title stays intact and whosoever held title to the old relinquished property gets the title of the new property.

In between the sale and purchase of property, the seller of the old property would get no access to the money he accrued from the sale, as the money will be vested with the ‘Qualified Intermediary’ till the exchange gets over.

This 1031 Exchange process has matured and had many names in the past including Like Kind Exchange, Deferred or Delayed Exchange, Simultaneous or Concurrent Exchange, Starker Trust or Exchange, Alderson Exchange, Reverse Exchange, Two, Three, or Four Party Exchange and Baird Exchange.

1031 Exchange Services

In a 1031 Exchange, the main services come from a qualified intermediary (QI), also known by names like facilitator or accommodator. The services are offered on fee-for-service basis. The services from the QI include paperwork, oversight, escrow services and making a bona-fide exchange agreement under section 1031 of the Internal Revenue Code.

For Deferred Exchange treatment, the IRS and the Treasury Department have very rigid requirements. Therefore, to pass these requirements, the services from an experienced professional are essential.

To get the services right, it is essential to ascertain the credentials of the service provider before hiring. In a 1031 Exchange, physical possession or receipt of the money resulting from sale of the property is not allowed, and money is held by the QI only. Therefore, his credibility in terms of bonding, background, reputation and financial strength of are crucial.

The QI is supposed to put the exchange fees in a separate account for the taxpayer, and not commingle that money with any other exchange.

There are several private agencies that maintain a database of qualified intermediaries across the United States. They can be of use in selecting the right intermediary with a good reputation, high level of bonding, competitive fee schedule, financial strength, expertise and integrity.

In the exchange process, the quality of the services is marked by speed, accuracy and safety. A good QI will have concern for the safety of the client’s funds. Through unique exchange accounts he can ensure that the funds cannot be deposited or withdrawn without signatures from both the exchanger and the company. Many taxpayers had the bitter experience of exchange funds misused by unscrupulous intermediaries. Every aspect of the exchange has to be managed according to the IRS rules and regulations.

The build-to-suit exchange is now becoming popular, where the QI is a major player. Also called construction or improvement exchange, this variant has the QI himself acquiring fee ownership of the replacement property and making improvements to it.

After the necessary improvements are done, within the exchange period of 180 days, the ownership is then transferred to the Exchanger.

This new variant of the exchange gives the investors a high degree of flexibility and the opportunity to improve upon an existing property or construct a new replacement property itself. Thus, the range of services provided by the QI and associates are unlimited from the word go.

1031 Exchange Rules

In a 1031 Exchange an investor sells his property, called “Relinquished Property,” to acquire a “Replacement Property” without attracting tax on capital gains.

The whole exchange is overseen by a Qualified Intermediary (QI), a middle-man who provides services of paperwork, oversight, escrow and expertise to ensure that the transaction conforms to Rules under Section 1031 of the Internal Revenue Code.

Now, let us see what all properties qualify for 1031 Exchange. Real estate in general, for income tax purposes, has been divided into four categories- business use, investment, personal use and outright sale. Of them, the last two are unfit for 1031 Exchange.

Then comes the foremost stipulation: the new investment must be in a like-kind property. But this is not a blanket barrier either. It does not restrict that the exchanged properties must be like the photocopy of the other property in all respects, as in a bare land for bare land situation. It can be any real property held for investment or trade or business that can qualify for this exchange with a similar kind of real property used in trade or business.

After the sale of the first property or relinquished property, the investor must identify the replacement property in 45 days from the date of transfer of the relinquished property. This period is called “Identification Period” and the whole exchange must be over in 180 days, known as the Exchange Period.

A maximum of three properties can be identified for possible exchange. The binding Rule is that their aggregate fair market value (FMV) at the end of the identification period should not exceed 200 percent of the aggregate fair market value of all relinquished properties on the date of transfer of the relinquished properties.

There are exceptions too. In some cases, if a replacement property is received before the end of the identification period, that too will be treated as properly identified even if the three-property Rule and 200% Rule are being violated.

In that case, the fair market value of that replacement property must be at least 95% of the aggregate fair market value of all the identified replacement properties. This is known as the “95 percent Rule.”

In the exchange, it is compulsory that the investor has to reinvest all the proceeds from the sale of the relinquished property. If the exchanger fails to do so, the balance “cash boot” becomes taxable as capital gain.

The investor must always acquire the replacement property with equal or greater debt. If the exchanger does not acquire a replacement property with equal or greater amount of debt, the IRS deems it as reduction in debt and a benefit accruing to the exchanger, hence taxable, until and unless it is offset by adding equivalent cash to the replacement property purchase.

So it turns out that it is the qualified intermediary who holds the key to the entire transaction and makes sure that all proceeds of the sale of first property is reinvested and all Rules are strictly followed and equity is preserved. Having the best QI at your service then becomes the key to a successful 1031 exchange.

1031 Exchange Requirements

In a 1031 Exchange, the primary requirement is meticulous planning on the part of the exchanger. The preparedness involves talking to the accountant, attorney, broker, lender and a Qualified Intermediary, the legally mandated middle-man who carries out the exchange process until completion.

First of all, the Exchanger has to be sure that the relinquished property he owned had been in use for investment or productive purposes in trade or business, and the replacement property he is going to acquire would also be in use for similar purposes.

The main beneficiaries of this facility are taxpayers within the United States who want to literally “carry ” their investment properties while relocating. Thus, the Exchanger may live in Los Angeles and wants to relocate to Montana, and the exchange helps him in acquiring similar property in Montana, relinquishing the property he was holding in Los Angeles.

However, exchange properties outside the USA have been nullified, after the Revenue Reconciliation Act of 1989 and subsequent amendment to IRC 1031, which made real property in the United States and real property outside as “not of like-kind” and hence unfit for exchange.

In enduring this exchange process, the taxpayer must be willing to conform to the tight deadlines, such as the Identification Period and Exchange Period. Failure to comply with them will throw the exchange haywire.

The main deadlines to be met are-the 45-day Identification Period, given to identify the replacement property from the date of transfer of the relinquished property, and the 180-day Exchange period, from the date of transfer of the first property.

In the matter of replacement property, the rule and implications of “like-kind” have to be borne in mind. Also, the knowledge that selling and investing the proceeds in a property one already owns does not translate into exchange at all. Funds applied to property already owned are only purchase of “goods and services,” and not exchange of “like-kind” property.

Since the exchanger’s legal relationship with the relinquished property is very important, one should not try to dissolve partnerships or change the manner of title-holding during the exchange process.

The principal requirements for complete tax deferral in the 1031 Exchange involve ensuring that proceeds from relinquished property are invested in purchasing the replacement property. The second is to make sure that the debt on replacement property is equal to or greater than the debt on the relinquished property.

For smooth sailing, it is advisable to identify the replacement property beforehand and then proceed to locate a suitable buyer for the property to be relinquished.

1031 Exchange Forms

Typically, the 1031 Exchange involves forms like brokers’ price opinion, exemption and nonresident waivers, affirmation of residency, declaration of trust, IRS 8824 like kind exchanges, lien waivers, mortgage interest deductions, multifamily mortgage applications, notice of trustees sale, personal financial statements, power of attorney, promissory note, quit claims, schedule of income property, signature affidavit AKA statement or tax information release forms.

IRS Form 8824 has three purposes. It is not very complicated to fill if the three main purposes are understood correctly. The first one is to help the taxpayer report the dates of sale and replacement property closings, together with identification dates. This is to verify 45/180 date requirements. This information has to be in Part One.

Second is for the taxpayer to highlight their sale and purchase numbers (sale price, selling expenses, adjusted basis, depreciation taken, cost of replacement property) in order to make clear whether there was a full or partial exchange. This information should go in Part Three.

The third purpose is to show the new tax basis of the replacement property. The exchange being a deferral of taxes, the gain incurred by the taxpayer in the old property has to show up in the new property through an equal amount of lesser basis. This information must be there in Part Four.

The information in IRS Form 8824 makes the job of the IRS easy, to review a taxpayer’s prior 8824 Forms to ascertain the appropriate amount of taxable gain and see whether taxes are paid as and when the taxpayer decides to sell and not exchange.

But the exchanger or investor need not be baffled by the forms. The companies hired by the investor would provide the guidance and assist them in filling them out. The follow-up is also their responsibility.

Other forms include General Forms and the Official Identification Form to identify Replacement Properties to be returned not later than 45 days after the close of the Relinquished Property. W-9 Form is to request a Taxpayer ID for the investor. Form 593-C is meant for California Residents doing any sort of exchanges.

Forms related to funding issues include Request for Verification of Funds. This is to obtain a statement of the balance in the account, for the client himself or third parties, lenders, etc. The Miscellaneous Disbursement Request form is for releasing disbursements for appraisals, inspection fees, loan fees, etc.

Request for Return of Exchange Funds is for releasing the remaining exchange funds after the exchange is completed, and not for requesting closing money. Earnest Money Deposit Request is for the closing agent, and not for requesting closing money.

There are two major forms of tax-deferred exchanges–simultaneous exchange and delayed exchange. Numerous variations of these two fall into one category or the other.

The most basic type of exchange is the simultaneous exchange, known as In Lieu Exchange. To illustrate, in simultaneous exchange, the seller wants to sell the property A, agreeing to accept Property B in lieu of cash payment. If the Buyer already owns Property B, then the two parties simultaneously transfer their respective properties adhering to the value rules.

In the case of the buyer not owning property B, the buyer must purchase Property B and transfer it to the seller simultaneously with transfer of Property A to the buyer. To preserve the tax-deferred status of the transaction for the seller, he must not receive any cash or debt relief.

The other is delayed exchange known as a Starker exchange. This delayed exchange is done using a Qualified Intermediary (QI). In this type, the seller closes the sale of his property and escrows the proceeds of the sale with a QI. Here the seller is handicapped from taking possession of the proceeds in order to enjoy the tax-deferral status of the transaction.

After closing the sale of his property, the seller gets 45 days to identify the property or properties to be exchanged and should submit that in writing to the QI. The identified properties have to be purchased within 180 days of the sale of the relinquished property.

1031 Exchange Experts

As far as the 1031 Exchange is concerned, it is the Qualified Intermediary who can be called the top “expert” who makes or breaks the deal. The role of the QI is crucial to completing the exchange successfully. It is he who acts as the “glue” that binds the buyer and seller of the property together in the 1031 Exchange process.

Selecting the right QI is most important, otherwise it will be like going to a quack rather than a qualified doctor for treating some serious disease. That means, a taxpayer intending 1031 must be cautious about falling victim to a poor facilitator with disastrous results, as he may not do an exchange at all or does not know how to structure it. And his deal will not pass the muster at IRS audit, leading to a loss of exchange funds due to poor investing or conscious deceit.

Care must be taken to ensure the credentials of a QI as a really experienced, knowledgeable professional who is clear in thought and communication, and transparent in dealings. As the exchange process requires quick decision-making, only a learned facilitator can help and clearly understand the situation and use the options rightly.

What makes a good or bad exchange QI is his level of depth in knowledge and resources. He must be well-versed with all tax code changes and latest rulings. Since the 1031 code has many gray areas, only an experienced facilitator can apply them to situations intelligently. To ensure safety for the money of the taxpayer, the QI ought to maintain a substantial fidelity bond for the benefit of their exchangers.

There are no licensing requirements for Intermediaries. No federal regulations for 1031 Exchange Experts are in place, and only two states have mandated licensing and bonding requirements for them.

To practice, they only need not to be stay qualified as defined by the Internal Revenue Code. Under certain circumstances, the Code prohibits certain ‘agents’ of the taxpayer, such as accountants, attorneys and realtors who have served the taxpayer in their professional capacities within the last two years, from becoming a Qualified Intermediary for the taxpayer in an exchange.

Once in the job, a QI, who is not the taxpayer and not a disqualified person, takes up the assignment and enters into a written agreement called an Exchange Agreement with the taxpayer, acquires the relinquished property from the taxpayer, transfers the relinquished property, acquires the replacement property, and transfers the replacement property to the taxpayer. The whole process involves several time-consuming steps.

The written agreement between the taxpayer and intermediary arrogating the former’s rights to buy and sell, and hold the money or property to the latter, is to take advantage of the qualified intermediary “safe harbor” provision enshrined in 1031.

Thus the main obligations of the this middle-man cum expert can be summed up as receiving the 45-day identification notice for replacement property and delivering escrow funds for replacement property settlement and arranging for direct deeding of the properties and ultimately providing the final accounting.