1031 EXCHANGES
Section 1031 of the U.S. Internal Revenue Code allows investors to defer capital gains taxes on the exchange of like-kind properties. Known as a 1031 Exchange or Starker Exchange, these are complex transactions by which an investment property is sold and then replaced with another like kind investment property following the many rules involved in a 1031 exchange. One should consult with an attorney, CPA, or other investment professional to ensure the transaction is properly performed. Failure to follow the rules can result in the IRS disallowing the exchange, which could possibly cause devastating tax consequences.
1031 EXCHANGE BASICS:
The exchange can only be used for investment properties or properties owned for use in a business. A 1031 Exchange can only be used for residences or for second homes if the property is solely used for rental to third parties.
Exchanges have to be made between like-kind properties. Both of the like kind properties must be used for investment or business purposes although they don’t have to have the exact same use. For example a warehouse can be exchanged for a shopping center.
You must identify the replacement property for the one you exchange within 45 days of the initial property transfer date to meet the 1031 exchange IRS guidelines. All exchanged properties must be located in the United States.
You can identify up to three properties of like value or as many properties as necessary to total the fair market value of the property you are exchanging. You can also exchange properties fortenant-in-common interest shares in a larger institutional grade property. If the property you receive in exchange is from a person related to you and you then sell the property within two years the original exchange won’t qualify to defer capital gains.
You must close on the replacement property within 180 days from the initial transfer date of your property to the other party. If the property exchange isn’t simultaneous, you must use a qualified intermediary to hold the money until the other part of the exchange is complete. If you end up with cash (also referred to as boot) to even out the value of the two exchanged properties that cash is taxable at the current capital-gains rates.
REVERSE 1031 EXCHANGE
As an investor, if you find a property you would like to acquire before you sell your current property, a Reverse 1031 Exchange will allow you to save on capital gains taxes. The IRS issued the Revenue Procedure 2000-37 to give taxpayers guidance on reverse 1031 exchanges. Although a reverse exchange shares similar requirements with the more common deferred exchange, there are many differences and the reverse exchanger must have liquid financial resources to make the exchange viable. Reverse 1031 exchanges are complicated and one should consult with an attorney, CPA, or other investment professional to ensure the transaction is performed properly.
REVERSE 1031 EXCHANGE BASICS:
The property to be exchanged has to be identified in 45 days and the whole transaction completed within 180 days.
Investors must use an accommodation titleholder (a second intermediary) to purchase and warehouse either the relinquished or the replacement property for up to 180 days.
The accommodation titleholder must be named on the title of either the replacement or the relinquished property. The accommodation titleholder can’t be the exchanger undertaking the exchange or anyone who has acted as the exchanger’s agent within the preceding two year period. (this includes an attorney, investment banker, real estate broker, or accountant etc.)
Depending on the exchanger’s resources and available finance there are two ways to structure the reverse exchange:
If the exchanger has sufficient funds to purchase the replacement property for cash, or if the Seller will take back financing, the exchanger lends the accommodation titleholder the money to purchase the replacement property. The once a buyer purchases the relinquished property, the intermediary uses the proceeds from the sale to obtain the replacement property from the accommodation titleholder and deed it back to the exchanger.
If the exchanger does not have the funds to purchase the replacement property in cash then the exchanger must secure a line of credit or other source and then lend those funds to the accommodation titleholder so that the accommodation titleholder can purchase the relinquished property. The sale to the accommodation titleholder means that there are funds the intermediary can use to purchase the replacement property. The intermediary then deeds the replacement property to the exchanger, who can now use the property as collateral for the new mortgage loan. The sale of the relinquished property by the accommodation titleholder provides proceeds to pay back the exchanger’s loan to the accommodation titleholder.
There has to be a written qualification exchange accommodation agreement between the exchanger and the accommodation titleholder defining the intent and obligations of the parties and the restrictions on the proceeds by the exchanger. The exchanger agreement must state that the accommodation titleholder will be treated as the beneficial owner of the warehouse property for federal tax purposes, including reporting interest and depreciation.
