Category Archives: 1031 exchange basics

Does Hanan make you feel less secure about the future?

From all the comments to Hanan’s recent post about weathering the RE downturn over at grow-a-brain, it got me thinking about how secure people feel when facilitating a 1031 exchange. 1031 Exchange Coordinators (our firm) has put out a list of questions you should ask your potential future Qualified Interemediary before you start working with them.

They are: 

  1. Do you have a current Fidelity Bond?
  2. What is you investment policy?
  3. Where do you keep trust funds?

I’ll let you look at our answers for the sake of brevity in this post.

With the Qualified Intermediaries (QI) holding your client’s money for up to 6 months in their trust account, you have to make sure you can trust your QI. In the last year or two there have been a spate of QIs that have skipped town with their clients’ monies and now the clients can’t get it back because they never checked for the QI’s E&O Policy or Fidelity Bond. You gotta check them people or you may be liable!!!

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Key #7 to Success in 1031 Exchanges – Intent

Nothing will be more frustrating than not having the proper paperwork when the Tax Man comes a’ knockin’

The Rule

The seventh and final key to a successful 1031 exchange is to recognize that both form and intent are critical to show that an exchange transaction qualifies for tax deferral under the Internal Revenue Code. Intent is measured on the date of the exchange by all the events that occur before and after the exchange. Facts and circumstances surrounding the exchange must demonstrate compliance with the requirements of a valid exchange, and must also show a good faith effort to act within the intent of the Code.

Documentation

This is simple, but very important key as many investors can follow all of the other 6 Keys and do everything correct to the letter of the law, but cannot prove objectively that they are trying to hold a property for 12 months or more as an investment. The key to all of this is documentation. Document all of the work you do on a house from repairs to rental listings to rent checks and receipts. Keep a “house journal”, if you will, so that when (not if) the IRS ever decides that you are that day’s lucky audit winner, you will be prepared to show your proper intent.

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Key #6 – 45 day Identification and 180 day Completion Time Frames

The sixth key to success in a 1031 exchange is adherence to the very specific time-frames involved in a 1031 tax-deferred exchange. You may remember me talking about time frames when I wrote about the Identification Period not too long ago(here and here). The identification period plays a part in Time Frames of a 1031 exchange. This is one area in which the Treasury Department has given very clear directions in its regulations published in 1991. Exchangers must be keenly aware of the 45-day identification period and the 180-day exchange period.

The Internal Revenue Service requires that replacement property be “unambiguously identified” by the 45th day after closing of the relinquished property. Unambiguous means specific identification such as a street address, plat and lot, metes and bounds, or tax lot number. A loose identification such as, “A lot on the north end of Bainbridge Island” would not qualify. This identification must be made in writing and be in the hands of a Qualified Intermediary by midnight of the 45th day after selling your first relinquished property.

45 Day Identification Period

There are three ways to identify potential replacement properties. The method most applicable to each situation may be used. They are:

  1. 3 Property Rule: Up to three properties may be identified without restriction as to value or any requirement to acquire more than one of those properties identified. One, two, or all three of the properties may be acquired in the exchange. This is known as the Three Property Rule, and is the method most commonly used in the industry.

  2. 200% Rule: Any number of properties may be identified as long as the aggregate fair market value of properties identified does not exceed twice the value of the property sold. Any number of these properties may be acquired in the exchange. The 200% Rule is used some, but not often.

  3. 95% Rule: Any number of properties of any value may be identified so long as 95% of the value of all properties identified is acquired. The 95% Rule is rarely used.

Property with a mutually signed purchase and sale agreement by the end of the 45 day period or property that is acquired within the 45 day period is considered to be properly identified.

180 Day Completion Period

One, several, or all of the identified properties must be acquired and the transaction completed by the 180th day after closing of the relinquished property. Essentially, if the property must be purchased in order for you to comply with the identification rule you choose way back on the 45th day, you must close on that property by the 180th day. The transaction must be closed and recorded by that date. These dates are not negotiable and are not altered or extended by weekends or holidays.

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Key #5 in 1031 Exchanges – Target Replacement Values

When in doubt, think equal or greater value

if you want to defer all of your taxes


Within the 7 Keys to Success in 1031 Exchanges Series, the fifth key involves meeting targeted replacement values.

The Rule

For the capital gain and depreciation recapture taxes to be totally deferred, the newly acquired replacement property must meet three targets:

1) The property acquired must be of equal or greater fair market value than the property sold.

2) At least as much debt liability as is on the relinquished property must be carried onto the replacement property. Lower debt is considered debt relief, which is considered a benefit to the taxpayer and is taxed. Additional cash added by the taxpayer to the purchase of the replacement property can be used to offset differences in debt amounts.

3) All net cash from the relinquished property sale (after selling expenses and debt payoff) must be applied to the purchase of the replacement property. These monies must go to the Qualified Intermediary so that the taxpayer doesn’t have constructive receipt of the monies, which would vitiate the exchange.
If the replacement property value, debt, or cash is less than the relinquished property’s property value, debt, or cash a partial exchange will take place. The greatest shortfall in meeting any of the three targets will be taxed, not to exceed the total amount of the gain.

Cash or other property received in an exchange when the replacement property is of lesser value than the relinquished property is called “boot.” Back in 1921 when section 1031 came into existence someone might have said “For your property I’ll give you my five acres and a horse to boot.” In this example, the horse would not be considered like-kind property and its value would be taxable. In the terms of IRC § 1031, boot is property not used “for productive use in a trade or business or for an investment” or property received that is unlike the property given up. Any cash or non-like kind property taken out of the transaction by the taxpayer is considered boot and is taxable.

Example

Regardless of all the other tax rules that apply, here’s a quick and easy example to think about in regards to the three targets.

You sell a property for $500k paying off $300k in mortgage and receiving $200k in cash equity at closing after selling expenses. Thus, for full deferment of taxes, the replacement property value must be greater than or equal to $500k. Then, $300k or more must be put forward as debt replacement in either the form of a new mortgage or excess cash brought to the table. Finally, the $200k cash equity must be put toward the exchange. And remember, of the three replacement targets that is not greater than or equal to the relinquished values, the one target that is furthest from its target value will be taxed. This is called a partial exchange and may fit within your needs.

Partial Exchange

A partial exchange, as seen above, may be within your financial goals. It might be worth it to you to take out $50k cash equity of the $200k from the relinquished property in order to make other use of that $50k. Just know that you will be paying taxes on that amount. Otherwise, if the other targets are met, that is the only tax you will pay and you can go forward with the exchange. For many people this is a great form of getting a little cash and still deferring most of their taxes.

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Key #4 to Success in 1031 Exchanges – Valid Exchange


The fourth key to success in 1031 exchanges is to make sure an actual exchange takes place. Tax-deferred exchanges differ from a sale and a purchase in several important ways. Listed below are the distinguishing characteristics of an exchange and how they differ from separate purchase and sale transactions.

  1. The first difference is the way in which the property value is transferred. If the property is temporarily converted to cash that is available to the taxpayer, the IRS considers the transaction indistinguishable from a sale and disqualifies the transaction from being an exchange. The funds must be held by a third party (such as a Qualified Intermediary) under strict conditions. The taxpayer cannot have constructive use of or access to the funds at any time during the exchange.
  2. The sale and purchase transactions must be interrelated. Merely having two transactions occur simultaneously or at nearly the same time is not sufficient. The Purchase and Sale Agreement, escrow instructions, and other documentation must be specific in stating that one property is to be exchanged for another like-kind property. When using a third party Qualified Intermediary (QI), the documentation on both the sale side and purchase side of the exchange should reference a common QI. In a direct swap with another party, the exchange must be reflected in the title transfer.
  3. The taxpayer must sell property that is owned for property that is not owned. While this sounds simple enough, situations can occur where a taxpayer might want to exchange property for other property held through a business or entity in which the taxpayer has an interest or other disqualifying relationship. Proceeds from a sale usually cannot be used to improve a separate property (i.e. a piece of raw land) also owned by the exchanger. Simply put, a taxpayer may not trade with him/herself.

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Key # 3 to Success in 1031 Exchanges – Same Taxpayer Requirement


Suppose you and your spouse own a rental as “Husband and Wife”. For whatever reason, when you are doing a 1031 exchange and sell that property you feel it best to put the new property in the name of your business, which is a partnership and has 11 partners. The partnership is its own taxpayer. The IRS has issues with the husband and wife doing an exchange like this. Likely, they will not consider this type of exchange valid. Do you know why? Not many Realtors know this, so listen up to get an edge on the competition.
 

In layman’s terms, the answer is: The same taxpayer that sold the 1031 exchange property has to buy the new 1031 exchange property. Here’s the more complete answer.

Property can be held in various forms of title including Individual, Joint Tenancy, Community Property, Corporation, Partnership, LLC, Trust, and more. Exchange rules require that the taxpayer selling the relinquished property or properties must be the same taxpayer acquiring the replacement property or properties. A husband and wife are considered a single taxpaying entity. A partnership can exchange property for new property in the name of the partnership; however, individual members are considered to be owners of shares or interests in the partnership itself and not the actual owners of the real property held by the partnership. Partnership interests are specifically excluded from tax-deferred exchanges; therefore, careful consideration must be made on how partners get in and out of partnerships that own exchangeable real estate.

If you or someone you know wants to do a 1031 exchange, but wants to change taxpayers, there are ways to get that done, but methodical planning with a Qualified Intermediary is necessary. So, don’t despair and think all hopes of doing a 1031 exchange are lost. They aren’t; you just need to get in touch with a good QI to educate you.

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Identifying your Replacement 1031 Properties

Over the last week or so I have been having a running dialogue with Michael Lindekugel of Team Reba – RE/MAX Metro Realty, Inc. about general 1031 exchange principles on the Rain City Guide. To continue that conversation about identifying replacement 1031 properties, I decided to post here about how to identify replacement properties. Tomorrow I will talk more about the challenges to identifying 1031 replacement properties and some ways to fix the potential identification problems. Sorry to Eileen Tefft for being a little late on the post.

The Identification Rules

When doing a 1031 exchange one of the greatest challenges we have seen is our clients do not often understand how to properly identify appropriate properties within the 45-day time deadline.

No matter which of the three identification rules is followed, the properties must be identified and submitted to the client’s Qualified Intermediary before midnight on the 45th day after the closing date of the first sold property.

Three Property Rule – The norm

The first identification rule is to identify three (3) properties of any value within the 45-day time period. The bulk of exchangers will follow this first rule.

200% Rule – Used sparingly

Michael stated the second rule well in our earlier conversations:

The exchanger identifies any number of properties as long as the aggregate FMV is less than or equal to 200% of the aggregate fair market value of all disposed properties.”

For example, if I sold $500k worth of properties, I could identify an infinite amount of properties so long as their aggregate FMV did not exceed $1 million (200% of the aggregate relinquished FMV). This rule is used sparingly as most people keep their options to less than three properties as they have a goal in mind of where they want to be and how much they want to spend. This second rule is useful though for especially hot markets where a property you identified has the potential to be sold before you can purchase it.

95% Rule – Used very rarely

The third rule states that an exchanger can identify as many properties as they wish for whatever aggregate value, so long as they close on 95% of the properties they identified. This does not mean that you purchase 95% worth of the aggregate FMV that was identified, it means that you must close on every 19 of 20 houses you identify. It’s a very stringent rule that seems unrealistic, but some people – especially big-time investors – will be exchanging this many properties at once. The more realistic application of this rule exists in the example below.

Suppose you want to identify and purchase 5 properties but their aggregate FMV is over 200% of the sold properties’ FMV. This would vitiate the 3 Property Rule and the 200% Rule. So, if you are certain you will close on all 5 then you will want to follow this rule as closing on all 5 means that you will close on 100% of your identified properties.

But what if you only close on 4 of the properties? That means you have purchased only 80% of your properties, and because you used the 95% Rule for identifying your properties, your whole exchange is null and void. Taxes will be due and the government looks at it as if no exchange took place.

This rule is very cumbersome and generally only used by large investors who have great trust that they will be able to get nearly all of their properties. But, it can be used on a smaller scale too, as evidenced in our example.

Now that we know the rules, tomorrow we’ll discuss the challenges that identification of replacement properties brings and how to fix these challenges before they actually become challenges.

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