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A delayed or forward exchange is a tax-deferred strategy that allows property owners to sell one investment property and purchase another investment property while deferring capital gains taxes. The process involves the following steps:
A "qualified intermediary" (QI) in a 1031 exchange is a third-party entity that facilitates a tax-deferred exchange of "like-kind" real estate by holding the proceeds from the sale of the old property (relinquished property) and then using those funds to purchase the new replacement property, ensuring the taxpayer complies with IRS regulations to defer capital gains taxes on the transaction; essentially acting as a neutral middleman to manage the exchange process. Key points about a qualified intermediary:
To qualify for a forward exchange, the sale property needs a one-to-two-year tax history showing it was used as an investment property AND the replacement property needs to be retained and claimed on tax returns as an investment property for one to two years. The replacement property is substantially the same as the original investment property, it must be: (1) real property, (2) used as for rental, investment, or income-producing purposes, and (3) be the combined purchase price equal to or more than the sale price of the original property.
Exchange rules anticipate that the entity beginning the exchange will be the entity concluding the exchange. The QI will prepare exchange documentation reflecting the vesting information as shown on the relinquished property title commitment or title report. It is important to note that the vesting and tax ID number used at the time of sale needs to remain the same taxpayer ID number for the vesting of the purchase property. Do not dissolve partnerships or change the manner of holding title just before or during the exchange. A change in the exchanger's legal relationship with the property may jeopardize the exchange. It is highly recommended that the exchanger confirms that on the advice of the tax advisor, the exchanger is indeed the same entity/taxpayer under the new title for the purchase property; this would be considered a disregarded entity for tax purposes.
The following changes in vesting usually do not destroy the integrity of the exchange:
Exchangers must anticipate this issue as part of their advanced planning for the exchange. Business considerations, liability issues and lender requirements may make it difficult to meet this rule under the following circumstances:
The first 45 days on the 180-day timeline is known as the identification time period. This is the window of time that the exchanger has to search for the next investment property(ies) for purchase. No later than the 45th day of the exchange, the exchanger needs to provide the qualified intermediary with a list of the potential properties for purchase. If the exchanger cannot identify an investment property for purchase within the 45-day window, the exchange is canceled, and funds will be rescinded. If the exchanger has multiple investment sale properties that will co-mingle funds towards an investment property purchase, the deadlines begin on the transfer date of the first relinquished property.
The methods of identifying replacement property(s) are:
Identified replacement property(s) must be unambiguously described. Under the exchange rules real property generally is unambiguously described if it is described by (i) a legal description, (ii) complete street address, or (iii) distinguishable name. To identify Delaware Statutory Trust (DST) interests or less than a whole property interest, please identify the specific percentage interest to be acquired. Any such property acquired within the 45-day Designation Period is also considered identified property for Section 1031 purposes.
The property owner may go from one type of investment property to another type of investment property in a 1031 exchange. Real estate investment properties that qualify for the 1031 exchange are as follows:
Properties bought and sold as fix and flips, meaning properties purchased, renovated, and then immediately sold for a profit, would not qualify for a 1031 exchange. The property must be used as a rental or income-producing property and must show the proper intent and a longer holding period.
If the purchase property is a vacation home, you are allowed to vacation in the investment property for 14 days a year if you rent the property out at fair market value for 14 days or 10% of the amount of time that you rent it out during the year, whichever is greater.
Please note that a primary residence does not qualify for the 103 exchanges. If the exchanger lives in a portion of the investment property as a primary residence, the exchanger should seek tax advice to determine what percentage of the property is investment related. Typically, it is based on a ratio of square footage between the investment related portion and the primary residence portion. Your tax returns should accurately reflect the ratio of this property. Only the investment percentage of the sale proceeds can be entered into the 1031 exchange and then used on the investment portion of the purchase property.
The timeline for the 1031 exchange begins the day that the sale property closes escrow. In total, the exchanger has up to 180 days to complete the purchase of any and all investment properties identified. The first 45 days on the 180-day timeline is the identification time period. This is the window of time that the exchanger has to search for the next investment property(ies) for purchase.
No later than the 45th day of the exchange, the exchanger needs to provide the qualified intermediary with a list of the potential properties for purchase. If the exchanger cannot identify an investment property for purchase within the 45-day window, the exchange is canceled, and funds will be rescinded. If the exchanger has multiple investment sale properties that will co-mingle funds towards an investment property purchase, the deadlines begin on the transfer date of the first relinquished property.
1031 exchange extensions to deadlines are generally only when the exchanger, the relinquished property or the replacement property is located in an area involving a Presidentially Declared Disaster. A deadline that falls on a weekend or holiday needs to close beforehand. Identified replacement property that is destroyed by fire, flood, hurricane, etc. after expiration of the 45-day Identification Period generally does not entitle the exchanger to identify a new property, except in the case of Presidentially Declared Disasters as described above. Mistakenly identifying condominium, A, when condominium B was intended does not permit a change in identification after the 45-day Identification Period expires. Failure to comply with these deadlines may result in a failed exchange.
If you go down in value, you can still do an exchange to defer a portion of your capital gain; however, you will pay taxes on any “boot” you receive upon completion of the exchange. You will generally be taxed on either the difference in sales price or the amount of the exchange funds that are taken by the exchanger as boot, whichever is greater. The required cost of the replacement property may be reduced by the cost of real estate commissions, escrow and title fees for all transactions involved in the 1031 exchange.
Customary expenses paid or incurred at a closing of the sale are considered “exchange expenses” and using exchange funds to pay those expenses will not result in any tax liability to an investor doing a 1031 exchange. Most tax advisors agree that the following expenses are exchange expenses and may be paid at the closing of the relinquished or replacement properties without any tax consequence:
In a 1031 exchange, "boot" refers to any non-like-kind property received as part of the transaction, essentially meaning any cash or other asset that is not reinvested in a replacement property, making that portion of the exchange taxable as a capital gain instead of being fully tax-deferred; it can include excess cash, debt relief, or personal property received during the exchange. Key points about boot in a 1031 exchange:
In order to qualify for an exchange, the Qualified Intermediary must restrict the exchanger’s access to the funds. IRS Code §1031 clearly states that the exchanger may receive the exchange funds on the 46th day, if they fail to identify replacement property within 45 days, or they may receive funds on the 181st day, if they fail to acquire the identified replacement property(ies).
Funds can be disbursed to the escrow/closing agent for the good faith/earnest money deposit (in addition to sending funds for closing). If the exchanger advances any of these funds they can be reimbursed to him at the close of the escrow without triggering any taxes.
If you sell a property that you own solely, and your spouse does not have an interest in the old property but does want to acquire the new property with you, the IRS could give you credit for only one-half of the purchase! Depending on the values of the properties involved and whether or not you live in a community property state, this could result in a significant tax bill. It may be advisable to add your spouse on title to the relinquished property prior to opening escrow, or to wait until the replacement property has closed and the exchange is completed before adding your spouse on title; consult your CPA/Tax Counsel.
Any property that is part of a 1031 Exchange either sold to or acquired from a related party may not be transferred for a period of two years. For example, if you sell your relinquished property to one of your children, they may not sell it for a period of two years after the exchange, or your exchange could be disallowed. If your replacement property was acquired from a related party, then you must hold title to it for a period of two years, or your exchange could be disallowed. Further, the IRS seems to take a very dim view of replacement property acquired from a related party in an exchange. Consult your CPA/Tax Counsel if you plan to acquire replacement property from a related party.
A key issue when addressing exchanges involving partnerships is to first determine whether the entire partnership wants to do an exchange or whether one or more of the partners elect to defer capital gain taxes under IRC §1031. As long as the partnership meets the requirements that apply to any exchange transaction (i.e. both the relinquished and replacement properties will be held for investment or income purposes) then the entire partnership can do a valid tax deferred exchange.
The more commonly asked question is can one or more partners drop out of the partnership and exchange their interest for a like-kind replacement property? If some of the partners simply want cash and do not intend to exchange, they can be cashed out before or after the sale closes and the partnership can remain intact. However, if various partners want to go their separate ways but still want to exchange, then the only real option is for the partnership to deed the appropriate percentages to the various partners, before the sale closes.
There is a risk in this, however, in that §1031 property must be held for productive use in business, trade or for investment purposes. If the partnership deeds to the individual partners right before the exchange, has the property been "held for investment purposes" by the individuals? The IRS has determined in some instances that the individuals who “suddenly” came onto title at the end can be considered as only holding it “primarily for sale” and are ineligible for an exchange. Transactions of this type can be very complicated and should be carefully reviewed by qualified tax and legal counsel to determine whether the facts and circumstances are strong enough to support a defensible tax deferred exchange.
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