Like-Kind Property
Property that qualifies for
exchange under Section 1031 must be "like-kind", which is
defined in the Regulations as follows:
1. Property held for productive
use in a trade or business, such as income property, or
2. Property held for investment.
Therefore, not only is rental or
other income property qualified, so is unimproved property which has been
held as an investment. That unimproved property can be exchanged for
improved property of any type, or vice versa. Also, one property may be
exchanged for several, or vice versa. This means that almost any property
that is not a personal residence or second home is eligible for exchange
under Section 1031. Even the vacation home that is used for that purpose
part of the year, and is rented part of the year, is considered
"mixed use" property and may be exchanged under 1031 for other
mixed use property.
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Time Requirements
The
Exchangor has a maximum of 180 days from the closing of the relinquished
property or the due date of that year's tax return, whichever occurs
first, to acquire the replacement property. This is called the Acquisition
Period. The first 45 days of that period is called the Identification
Period. During this 45 days, the Exchangor must identify the candidate or
target property which will be used for replacement. The identification
must:
This must all occur within
the 45-day period. Failure to accomplish this identification will cause
the exchange to fail.
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Three rules exist for the
correct identification of replacement properties.
-
The Three Property Rule
dictates that the Exchangor may identify three properties of any
value, one or more of which must be acquired within the 180-Day
Acquisition Period.
-
The Two Hundred Percent Rule
dictates that if four or more properties are identified, the aggregate
market value of all properties may not exceed 200% of the value of the
relinquished property.
-
The Ninety-five Percent
Exception dictates that in the event the other rules do not apply, if
the replacement properties acquired represent at least 95% of the
aggregate value of properties identified, the exchange will still
qualify.
These identification rules are
absolutely critical to any exchange. No deviation is possible and the
Internal Revenue Service will grant no extensions.
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Mechanics of a Delayed Exchange
It is important that any exchange
be carefully planned with the help of an experienced, competent and
creative exchange professional. Preferably one who is completely familiar
with the tax code in general, not just Section 1031, and who has extensive
experience in doing many different kinds of exchanges. Thorough planning
can help avoid many subtle exchanging pitfalls and also ensure that the
Exchangor will accomplish the goals which the transaction is intended to
facilitate.
Once the planning is complete, the
exchange structure and timing are decided, and the relinquished property
is sold and the transaction is closed, the facilitator becomes the
repository for the proceeds of the sale. The money is kept in the
facilitator's secured account until the replacement property is located
and instructions are received to fund the replacement property purchase.
The funds are wired or sent to the
closing entity in the most appropriate and expeditious manner, and the
replacement property is purchased and deeded directly to the Exchangor.
All the necessary documentation to clearly memorialize the transaction as
an exchange is provided by the facilitator, such as exchange agreement,
assignment agreement and appropriate closing instructions.
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Partnership Exchanges and IRC §1.761-2(a)
Elections
The Tax Reform Act of 1984 made it
very clear that partnership interests cannot be exchanged and qualify for
deferred gain treatment under IRC Section1031. The regulations also
interpret no difference between general partnership interests or limited
partnership interests. Although actual partnerships can exchange with
other partnerships under Section1031, the exchange of an individual
interest is prohibited. However, the Omnibus Budget Reconciliation Act of
1990 did amend IRC Section1031 to incorporate the use of IRC
Section1.761-2(a), Election of Partnerships to not be treated under
Subchapter K of Chapter 1 of the Code, for the purposes of taxation. This
means that Section1.761-2(a) can potentially provide an avenue to utilize
Section1031 to those investors currently owning partnership interests.
In every case involving an
election under Section1.761-2(a), it is critical to evaluate the status of
your election and exchange with the advice of a qualified tax
professional. They will relate your situation to specific Internal Revenue
Letter Rulings and other interpretations, which could assist in the
strategic structuring of your transaction.
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The issue of constructive receipt
is one that continues to concern taxpayers, their accountants and tax
advisers alike. Over the years that the public has benefited from tax
deferred exchanges, various elements of control have been reviewed by the
courts in attempting to determine whether the taxpayer has in fact
exercised sufficient control over the proceeds from the disposition of the
relinquished property so as to be considered in receipt of such funds and
thereby taxed.
Clearly if a taxpayer receives the
proceeds from the disposition of his relinquished property, the terms
"exchange" or "relinquished property" have no meaning
since the transaction will be viewed as a sale and the taxpayer taxed
accordingly. Where someone other than the taxpayer receives and controls
the use of the proceeds from the disposition of the relinquished property,
the relationship between that person or entity and the taxpayer is closely
scrutinized to determine whether or not it is so closely related to the
taxpayer that it can be considered that the taxpayer has constructively
received the funds.
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There are virtually no state or
federal regulations governing the function of facilitators, other than the
fiduciary responsibilities that govern the conduct of any entity holding
or handling other people's money. For this reason, care in selecting a
facilitator for you or a client's exchange is an important process of
evaluation. Select the facilitator as you would an attorney for personal
representation or a physician to treat your children. Look for experience
in doing exchanges and reputation in the real estate, legal or tax
communities.
Talk to escrow and closing
professionals that handle exchanges and get their opinion. If possible
choose a facilitator who is thoroughly familiar with the process, since
many times other aspects of the process will bear significantly on your
exchange (for instance, the handling of Promissory Notes, bulk transfers
or other variations). Ask the facilitator if their firm handles reverse
exchanges. If they do not, the company and its personnel may not be
adequately experienced. Ask about the security of your funds, and what
options you as an Exchangor may have to assure that your funds will be
safeguarded. Although the costs and fees for an exchange are relatively
insignificant, ask about them, and get a clear explanation of what you
will be charged. With a few notable exceptions, fees are very similar, one
facilitator to the next. What is of far greater importance is the
competence and ability of the facilitator and its personnel to complete
your exchange promptly, professionally and legally.
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In order to assess the tax
consequences inherent in any exchange transaction, it is first necessary
to understand the definition and exchange related meaning of terms such as
“cost basis”, “adjusted basis”, “capital gain”, “net sales
price”, “net purchase price and boot” “new adjusted basis.” Cost
Basis: This is where all tax related calculations in an exchange begin.
Cost basis essentially refers to your original cost in acquiring a given
property. Therefore, if the original purchase price of the property you
anticipate exchanging was $175,000, your cost basis is $175,000. Adjusted
Basis: At the time of your exchange it is necessary to determine your
current, or adjusted, basis. This is accomplished by subtracting any
depreciation reported previously from the total of the original cost
basis, plus the value of any improvements.
Capital Gain: “Realized
gain” and “recognized gain” are the two types of gain found in
exchange transactions. Realized Gain reflects the difference between the
total consideration or total value received for a given property and the
adjusted basis.
Recognized Gain: reflects
that portion of the Realized Gain, which is ultimately taxable. The
difference between realized and recognized gain exists because not all
realized gain is ultimately determined to be taxable and issues such as
boot can affect how and when gain is recognized.
Net Sales Price: This
figure simply represents the sales price, less costs of sale.
Net Purchase Price: This
figure simply represents the purchase price, less costs of purchase.
Boot: When considering an
exchange of real property, the receipt of any consideration other than
real property is determined to be “boot.” So, essentially, a working
definition of boot is: any property received which is not considered
like-kind. And remember, non-like-kind property in an exchange is taxable.
Therefore, boot is taxable. There are two types of boot, which can occur
in any given exchange. They are mortgage boot and cash
boot. Mortgage boot typically reflects the difference in mortgage
debt which can arise between the exchange or relinquished property and the
replacement property.
Overhanging Dept: As a
general rule, the debt on the replacement property has to be equal to, or
greater than, the debt on the relinquished or exchange property. If it is
less, you'll have what is called "overhanging debt" and the
difference will be taxable.
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