Category Archives: 7 Keys to Success in 1031 Exchanges

Following these Keys should bring you success in completing a 1031 exchange

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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Key #2 To Success in 1031 Exchanges – Holding Period

In the second of seven parts of the “7 Keys to Success Series”, the HOLDING PERIOD of an investment property is next on tap.

At issue is how long a property must be held to qualify as “held for investment” prior to exchanging it, and how long a replacement property must be held after the exchange. While there is no definitive answer in the Internal Revenue Code or from the IRS, some guidelines have been developed through IRS requests of Congress and through court cases. Following these guidelines will provide a considerable degree of safety.

The General Rule: Investment properties should generally be held for more than 12 months (and preferably 18 to 24 months) before being actively marketed or any action is taken to convert the property to personal use. This guideline can be used for both the relinquished property and the replacement property.

The ‘Under One Year’ Exception:
Last week, Eileen Tefft posted a comment on Rain City Guide wondering whether a 1031 property can be held for under a year. In certain circumstances, property can be held for less than a year, but that is an exception to the rule. Thus, what I am about to say is in the very gray area of the 1031 world and I do not accept any sort of liability for your choice to hold the property for less than a year. I usually tell clients the decision to hold property for under a year and then do a 1031 exchange is between them, their Maker and the IRS. That being said, you will definitely want to hold the property for at least two (2) tax years in order to bring up as few red flags as possible to the IRS. Your Form 8824 will ask when the property was purchased and when it was sold, so they will definitely have the dates before them. However, they may not look too closely if they see two tax returns with your property listed, rents received, and depreciation taken. If you are more risk adverse, HOLD HOLD HOLD for at least 12 months! If you like to push the envelope, make sure you hold for at least two tax years.

The inevitable question now coming is: “What if I buy in December and sell in January? Will that still count because I’m holding for two tax years?” My response to that question invariably is, “I can look in the Yellow Pages and find someone who doesn’t care about their future professional life and they may be willing to help you.”

Related Party Exchanges: Another element to the holding period has to do with dealing with a direct swap with relatives or other related parties. This is permissible and the timing is clear: the properties must
be held for two years. If either property transferred in an exchange involving related parties is disposed of within two years, the entire exchange is disqualified. Related parties include family members — brothers, sisters, parents, and lineal descendants — as well as any corporation, partnership, trustee, or other fiduciary relationship where the exchanger owns or controls more than 50%. Related parties must file Form 8824 for two years following an exchange. Specific language should be included to prevent any prohibited action by either party, as failure to follow these guidelines by either related person disqualifies the exchange benefits of both.

General Example: John and Jane Doe own Blackacre as an investment property (let’s say a single-family residence rental). They own the property together as Husband and Wife in fee simple with no encumbrances. The Doe’s have owned and rented out Blackacre for 5 years. They decide that they want to get another rental, but one that is closer to their primary residence let’s say. So, they sell Blackacre doing a 1031 exchange and buy Whiteacre. Two years down the line they move to Ohio and want another rental – but this time So, they sell Whiteacre doing another 1031 exchange and buy Redacre in Ohio.

You tell me, are the Does holding their properties long enough to satisfy the Holding Period requirement of a 1031 exchange?

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7 Keys to Success in 1031 Exchanges Series – Key #1 Property Type

In facilitating 1031 like-kind exchanges we have found there to be 7 Keys to Success for investors who most successfully and profitably exchange properties.

The First Key to Success in 1031 Exchanges…Property Type

The first key to a successful 1031 exchange is recognizing the difference between investment property and property held for personal use. Property type is determined by your usage of the property. Section 1031 deals with deferring the taxes on an exchange of property “held for productive use in a trade or business or for investment” and is not applicable for property generally held for personal use.

Section 1031 allows for the exchange of non-owner occupied real property such as a rental home, duplex, apartment building, farm, raw land, or a tenant-in-common interest in an office building. I’ll talk more later about what properties are Like-Kind. Any property that is owner occupied as a primary residence will not qualify for tax deferral under Section 1031 unless there is mixed use in the same dwelling unit. E-mail me if you have questions about mixed use as it can be very complicated. Section 121 deals with primary residences, which have better tax breaks than those for investment properties. Second homes, vacation condos, and recreational lots are part of a special group and are usually considered personal use property and are not eligible for tax-deferred exchange unless personal use of the property amounts to 1) less than 10% of the time the property is rented or 2) no more than 14 days in a year.

So, think money making property and not your primary residence as the type of property that you can do in a 1031 exchange. Discuss amongst yourselves and let me know how I can help flesh out how property types are key in 1031 exchanges.

– Chad

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