The
tax deferred exchange offers real estate investors one of
the last great investment opportunities to build wealth
and save taxes. By completing an exchange, the investor (Exchanger)
can dispose of their 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
their equity into the replacement property. Two requirements
must be met to defer the capital gain tax: 1) the Exchanger
must acquire "like kind" replacement property and
2) the Exchanger cannot receive cash or other benefits (unless
the Exchanger pays capital gain taxes on this money).
In any exchange
the Exchanger must enter into the exchange transaction prior
to close of the relinquished property. The Exchanger and the
Qualified Intermediary (QI) enter into an Exchange Agreement,
which essentially requires that 1) the Qualified Intermediary
acquires the relinquished property from the Exchanger and
transfers it to the buyer by a direct deed from the Exchanger
and 2) the QI acquires the replacement property form the seller
and transfers it to the Exchanger by a direct deed from the
seller. The cash or other proceeds from the relinquished property
are assigned to the QI and are held by the QI in a separate,
secure account. The exchange funds are used by the QI to purchase
the replacement property for the Exchanger.
Important
Considerations for an Exchange
Exchanges
must be completed within strict time limits with absolutely
no extensions. The Exchanger 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 the replacement property must be completed within
180 days after the close of the relinquished property. After
the 45 days has passed, the Exchanger may not change their
Property Identification list and must purchase one of the
listed replacement properties or the exchange fails!
To avoid the
payment of capital gain taxes the Exchanger should follow
three general rules: a) purchase a replacement property
that is the same or greater value as the relinquished property,
b) reinvest all of the exchange equity into the replacement
property and c) obtain the same or greater debt on the replacement
property as on the relinquished property. The Exchanger 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 Exchanger must sell property
that is held for income or investment purposes and acquire
replacement property that will be held for income and 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.
Non-Tax
Reasons to Exchange
Generally, investor's
complete tax-deferred exchanges to defer the capital gains
tax on the disposition of their investment properties,
however, there are many additional underlying reasons an investor
might want to exchange one property for another. The motives
often fall along standard risk-reward or cash flow appreciation
scales. These are some of the typical non-tax motives to exchange:
Exchange from fully
depreciated property to a higher value property that can be
depreciated. Exchange from property which cannot be refinanced,
such as vacant land, to improved property, which will support
a new loan, thereby giving the client the ability to obtain
cash after the acquisition of the replacement property. Exchange
from non-income producing raw land to improved property to
create a cash flow from the rental income. Exchange from a
property with maximized or minimal cash flow, such as an apartment
building, to a higher cash flow property, such as a retail
shopping center, to generate a large cash flow. Exchange from
a stagnant or slowly appreciating property to a property in
an area with faster appreciation.
Exchange for a property or properties that may be easier to
sell in the coming years. Exchange to meet the client's location
requirements, for example, the client moves to another state
and wants to have their investment property nearby.
Exchange to fit the lifestyle of a client, for example a retiree
may exchange for a property requiring reduced management responsibility
so they can do more traveling. Exchange from several smaller
properties to one larger property to consolidate the benefits
of ownership and reduce management responsibilities. Exchange
from a larger property to several small properties to divide
an estate among several children or for retirement reasons.
Exchange to a property the client can use in their own profession,
for example a doctor may exchange from a rental house to a
medical building to use for their practice. Exchange from
a partial interest in one property to a full interest in another
property.
Exchange from a management intensive fee interest in real
estate to a triple net leased property where the lease, including
options, has 30 or more years remaining.
The
Role of the Qualified Intermediary
The use of a
Qualified Intermediary (QI)is essential to completing
an IRC 1031 Tax Deferred Exchange. The QI performs several
vital functions in an exchange.
Acts
as a Principal
The IRS stipulates
that a reciprocal trade or actual exchange must take place
in each 1031 transaction. This means the Exchanger must
assign to a QI a) their interest as seller of the relinquished
property and b) their 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. Ex: when the Exchanger
is purchasing the replacement property from someone other
than the buyer of his or her relinquished property.
Holds
Exchange Proceeds
If the Exchanger
actually or constructively receives any of the proceeds from
the sale of their relinquished property , those proceeds
will be taxable as boot. The QI will hold the proceeds from
the sale in a separate exchange account until the funds are
used to purchase the replacement property. All exchange proceeds
held by the QI should be covered by a fidelity bond insurance
coverage policy.
Prepares
Legal Documentation
Several legal
documents are necessary in order to properly complete an exchange.
The QI will prepare an Exchange Agreement, Assignment
Agreements, and the Exchange closing instructions for each
closer.
Provide
Quality Service
Although the
process on a 1031 exchange is relatively simple, the rules
are complicated and filled with potential pitfalls. With many
gray areas surrounding IRS codes and legal issues in an exchange,
it's crucial that the QI work closely with all parties involved
ensuring a smooth transaction.
How
to Initiate an Exchange
Find a Qualified
Intermediary to assist you with the exchange as early
in the process as possible. Look for a QI that is knowledgeable
and experienced and of especially critical importance: the
safety of your funds while held by the QI. At a minimum, you
should require a QI to provide insurance bond coverage.
Instruct your
real estate agent to include and "Exchange Cooperation
Clause" as an addendum to the purchase and sale agreement
on the relinquished property. An example might be: "Buyer
hereby acknowledges that it is the intent of the Seller to
effect an IRC 1031 tax deferred exchange which will not delay
the closing or cause additional expense to the Buyer. The
Seller's rights under this agreement may be assigned to a
Qualified Intermediary, for the purpose of completing such
an exchange. Buyer agrees to cooperate with the Seller and
the QI in a manner necessary to complete the exchange."
Contact your
QI as soon as possible after escrow is opened or after
entering into the purchase and sale agreement and advise them
well in advance of closing.
Tax
Deferred Exchange Terminology
Boot Fair
Market Value of non-qualified (not "like kind) property
received in an exchange.
Constructive
Receipt A term referring to the control of proceeds by
an Exchanger even though funds may not be directly in their
possession.
Exchanger
The property owner seeking to defer capital gain tax by utilizing
a 1031 exchange. (The IRS Code uses the term "Taxpayer")
Like-Kind Property
This term refers to the nature or character of the property,
not its grade or quality. Generally, real property is "like-kind"
as to all other real property as long as the Exchanger's intent
is to hold the properties as investment for productive use
in a trade or business. With regards to personal property,
the definition of "like-kind" is much more restrictive.
Qualified
Intermediary The entity that
facilitates the exchange for the Exchanger. Although the Treasury
Regulations use the term "Qualified Intermediary,"
some companies use the term "Facilitator" or "Accommodator."
Relinquished
Property The property "sold" by the Exchanger.
This is also sometimes referred to as the "exchange"
property or the "downleg" property.
Replacement Property
The property acquired by the Exchanger. This is sometimes
referred to as the 'acquisition" or "upleg"
property.
Identification
Period The period during which the Exchanger must identify
Replacement Property in the exchange. The Identification Period
starts on the day the Exchanger transfers the first Relinquished
Property and ends at midnight on the 45th day thereafter.
Exchange
Period The period during which the Exchanger must acquire
Replacement Property in the exchange. The Exchange Period
starts on the date the Exchanger transfers the first Relinquished
Property and ends on the earlier of the 180th day thereafter
or the due date (including extensions) of the Exchanger's
tax return for the year of the transfer of the Relinquished
Property.
Like-Kind
Property
To qualify
for a tax deferred exchange treatment under the 1031 tax code,
the relinquished property must be exchanged for replacement
property that is of "like- kind". The term "like-kind"
refers to the nature or character of the property and not
to its grade or quality. It does not matter whether the real
property involved is improved or unimproved since that fact
only relates to the grade or quality of the property and not
to its kind or class. In essence, all real property is "like-kind"
with all other real property. To qualify for an exchange the
Exchanger must have held the relinquished property for investment,
or for "productive use in their trade or business,"
and must intend to do the same with the replacement property.
The following
are examples of "like-kind" properties:
Residential for commercial
Bare land for rental property
Fee simple interest for 30-year leasehold
Single family rental for multi-family rental
Non-income producing raw land for income producing rental
property
Rental mountain cabin for a rental office in which the
Exchanger intends to practice
Corporate twin-engine aircraft for a corporate jet
Mitigation credits for restoring wetlands for other mitigation
credits
Buses for buses
Garbage routes for garbage routes
Livestock of the same sex
1031 Do's
and Don't
DO advanced planning
for the exchange. Talk to your accountant, attorney, broker,
lender and Qualified Intermediary.
DO keep in mind
these three basic rules to qualify for complete tax deferral:
Use all proceeds from the relinquished property for purchasing
the replacement property.
Make sure the debt on the replacement property is equal
to or greater than the debt on the relinquished property.
(Exception: A reduction in debt can be offset with additional
cash; however, a reduction in equity cannot be offset by
increasing debt.)
Receive only "like-kind" replacement
property.
DO attempt
to sell before you purchase. Occasionally Exchanges 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. Exchangers
should be aware that "reverse" exchanges are considered
a more aggressive exchange variation because no clear IRS
guidelines exist.
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.
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 NOT dissolve
partnerships or change the manner of holding title during
the exchange. A change in the Exchanger's legal relationship
with the property may jeopardize the exchange.
For professional
advice on Tax Deferred Exchanges in Las Vegas, Nevada, contact
one of the following:
IPX 1031 Investment
Property Exchange Services, Inc.
Robert Noggle,
Esq.
500 N. Rainbow Road # 100
Las Vegas, Nevada 89107
Email: rnoggle@fnf.com
W- 702-822-8132
F- 702-870-7117
C- 702-592-1938
Web site: http://www.ipx1031.com
