1031 Exchange

When you sell your home or a piece of property you will be taxes on the gain that you get on the sale. That is unless you use Section 1031 Exchanges. These Section 1031 Exchanges will allow you to defer the tax that you have to pay for what could be years.

A Section 1031 Exchange is a tax deferred exchange that will allow you to not pay tax if it is on property that is exchanged for investment purposes or business purposes. This means that you can take part in Section 1031 Exchanges by switching your property with another property of similar description, these properties are known as like-kind properties. Once you have switched these properties you will then be able to defer payment of the taxes.

The reason that Section 1031 Exchanges exist is that the gain is not considered realized yet because all you have done is exchanged properties, you have not actually sold anything for straight profit yet. This tax deferral does not mean that you will never have to pay any taxes on your new property, you will just not have to pay them until you sell it once and for all.

Section 1031 and its time restrictions

Section 1031 exchanges do not come without a time limit, there are definite limits to this type of exchange. For instance the tax payer has only 45 days in order to find themselves a new property once they have relinquished theirs. At the 45 day limit he or she will have to identify the property that they are wanting to acquire.

Another deadline that there is, is the 180 days in which the parties have to complete the entire exchange transaction. This deadline starts when the first property is relinquished or when the tax payer federal tax return is due. It comes down to whichever date comes first that particular year.

How a reverse exchange will work for you

A reverse exchange is a simple transaction. In it the Exchange Accommodation Titleholder will take possession of the title and then hold onto it until the time when the tax payer finally sells their relinquished property. At this time the Exchange Accommodation Titleholder and the tax payer switch the relinquished property and the new property. Then the Exchange Accommodation Titleholder will own the other property. This holding of title by the Exchange Accommodation Titleholder cannot continue for over 180 days.

And if your exchange cannot be completed in the allotted 180 days…
If your Section 1031 exchange cannot be completed in the allow 180 days it will not be protected by safe harbor. If you do need your reverse exchange to last longer than the 180 this can be done if you plan accordingly. If you do choose to structure the reverse exchange to go beyond 180 days you will lose the presumptions that go along with safe harbor.

It is possible to identify more than one property
It is possible for you to identify more than one property within the 45 day limit but how many can you identify? There are some regulations that need to be met.  For instance there is what is known as a 3 property rule.  This is the rule that allows for the tax payer to identify up to three properties. When making use of the 3 property rule you will not have to worry about the value of the properties.

Another rule that exists is the 200% rule this rule allows you to identify as many properties as you want to but you will have to take into consideration their value. Their combined value cannot exceed twice the value of your relinquished property. The last rule is the 95% rule and with this rule you will also be able to identify however many properties that you wish to but the aggregate value at the end of the final replacement properties must be equal to or at least 95% of all the identified properties.

You need not meet all of these rules obviously you must meet only one.

After 45 days
It can be difficult to find and identify your replacement property in the 45 day time limit that is set out just as it can be hard to complete the exchange transaction in the 180 days that you have. No matter how hard these deadlines are to deal with they are something that you will have to deal with. There are no extensions available to anyone, no matter the circumstances.

If you cannot find your replacement property within 45 days or close the exchange within 180 your exchange will not be completed, it will fail. If this happens to your property you will not be able to take advantage of tax deferral, you will have to pay all of the taxes right away on the sale of your relinquished property.

What do I need to take part in a valid exchange?
There are several factors that must be present if you want to take part in a valid exchange. For instance you will have to have qualifying property. Not all property can be exchanged according to Section 1031. These properties are properties that are held only for sale, your home residence, stocks, inventories, bonds, notes and other securities among others.  If your property is not excluded from Section 1031 then you can take part in tax deferred exchanges.

You will also need to have proper purpose. This means that the property that you are exchanging must be of like kind and they need to be used for productive reasons, like business and/or investment. You cannot exchange the property and then sell immediately, if this is your intent then your property will not qualify for an exchange. Like kind is a simple concept and it means that the property that you are trading must be similar. It cannot vary too much in size and it cannot be in different countries. There is also an exchange requirement. You cannot exchange property for money, it must be fore another like kind of property

About the Qualified Intermediary
The Qualified Intermediary that you work with will most likely not actually take title of either one of the properties. The properties will be deeded straight to the main parties involved in the exchange transaction just as if you were buying and selling the properties in the normal way.

Your interests may be signed over to the Qualified Intermediary but nothing is in their name. The Qualified Intermediary will simply tell the other party to deed the property to you.

Does one need to have a Qualified Intermediary?
If you are taking part in any property exchanges like those in Section 1031 you will need to have a Qualified Intermediary. It is the Qualified Intermediary that facilities these types of tax deferred exchanges according to the rules set out in Section 1031. These Qualified Intermediaries are independent parties who cannot be the tax payer.

There are several jobs that the Qualified Intermediary will have to carry out when conducting one of these exchanges. First of all the Qualified Intermediary will have to have a written agreement with the tax payer. This written agreement will state that it is the Qualified Intermediary that will acquire the property from the tax payer in order to then transfer it over to the new buyer.

It is also the Qualified Intermediary that will hold the proceeds from the sales. This is done in order to protect the funds from the tax payer and it keeps this tax payer from having any form of constructive receipt of said funds. And last but not least it is also the Qualified Intermediary that will acquire the replacement property for the tax payer. The Qualified Intermediary will then hand it over to the tax payer and the exchange transaction can then be completed.

It is essential that you have a Qualified Intermediary. A Qualified Intermediary is the person that is keeping everything safe for all parties involved in the exchange transaction. It is the Qualified Intermediary that acts as the safe harbor for the tax payer.

The Section 1031 exchange is not considered completed until the tax payer finally has control of the money from the sale of his or her relinquished property. This control is also called constructive receipt.

It is only when the tax payer has met the requirements set up by the IRS that they will be able to get control of this money. The money is first handed over to the Qualified Intermediary and then the Qualified Intermediary will then use it to acquire the new property. It is at this time that the Qualified Intermediary will give the money to the closing agent, directly. This is the safest way for the transaction to take place.

Converting the replacement property
Many people involved in property exchanges wonder if they are ever allowed to convert it into their home property. You can turn this replacement property into your primary residence or even into a vacations home for you and your family but in order to do this you will have to meet the holding requirements found in Section 1031. While Section 1031 does not state specific time periods of holding most experts will agree that you should wait at least one year before even attempting to convert it into a primary residence. When it comes to the tax man it is far better to be safe than sorry.

What you need in order to identify your replacement property the right way

When it comes to your replacement property there are some requirements that must be met. The first thing that you need to do when you have chosen your replacement property is to identify it is writing. You will have to sign this written identification and deliver it to another party of the exchange transaction, one who is not a disqualified person or one who has any relationship to you, the tax payer. This means that this person cannot be a blood relative, your lawyer, your banker or real estate agent. If these people have not been acting for you in that capacity for over 2 years then they may be eligible to be this third party.

Realized gain vs. recognized gain
The difference between realized gain and recognized gain is simple. With realized gain you are looking at the increase in ones financial position due to this exchange whereas the recognized gain is the amount of taxable gain. The realized gain is what the tax will be paid on in a regular sale. You will find that recognized gain is lesser than the amount of realized or net boot that has been received.

How to defer taxable gain
If you are wanting to defer your taxable gain there are some rules that you will have to follow when it comes to Section 1031. These are simple and easy to understand and they must be adhered to in order to have a valid exchange.

First of all the property that you are acquiring, the replacement property needs to be at least equal to or even greater than the property that you are giving in exchange and the equity that is in the new property must also be at least equal to that in the old property.

The debt on the new property must be equal to or greater than that on the old as well and the entire net proceeds from the sale of the relinquished property must be used in order for you to get the new property.

These are important points that you need to know in order to make sure that you have exchanged your property properly. That is the only way for you to defer your taxable gain.

Taking money out of the exchange account
There are some regulations that concern when and how you can money out of the exchange account and it is best for you to familiarize yourself with these regulations before you try to take the money.  You must follow the regulations if you want to successfully withdraw money from the exchange account once it has been deposited.

You, the taxpayer will not be bale to get any of this money until the entire exchange has been completed according to procedure. If it is cash that you want to receive, at least in part, then you will have to get this cash before the funds get deposited into the hands of the Qualified Intermediary. Once the money has been deposited with them you will not be able to get it in cash.

Know when it is too late for a tax deferred exchange
It is important for those considering a tax deferred exchange to know when they are eligible for one. It is not too late for one to take part in a tax deferred exchange until the title or the benefits and burdens of the property have been handed over to another. If you have not done this yet you can take part in a tax deferred exchange even if you have signed a contract in order to sell your current property.

If on the other hand closing has already occurred you will not be able to start the exchange process, Section 1031 is lost to you this time, no mater whether you have cashed the final check or not.

Is there more than one type of exchange?
There is more than one type of exchange that you can use in your investment strategies. These exchanges can be put to work for you with ease, all you need to know are what they are.

A build to Suit exchange is sometimes called an Improvement or Construction exchange and it is a great option if you are planning to build on a piece of property. You will exchange property and then be able to build on the new one using the proceeds from the exchange

A Simultaneous exchange is a common form of exchange and in this type you will be exchanging properties with another at the same time. A delayed exchange on the other hand is the most common type of exchange and it is only slightly more complicated. In this form of exchange the properties will not be switched at the same time, there will be a time difference. One will be acquired by one party and after some time, not long, the other will be acquired. There are some rules and regulations concerning the amount of time that can be in between these transactions and they are found in the Treasury Regulations.

If you are taking part in a reverse exchange then you will be getting the new property before you give over the current one. There are laws that govern these transactions and those involved are safe under the IRS safe harbor laws.

Boot is…
If you have received property in an exchange that is not like kind to the property that you are exchanging then you have received boot. Boot can be cash and or mortgage boot. Realized gain can be recognized in relation to the net boot that has been received.

Boot netting
There are some rule that concern boot netting such as the fact that boot that has been paid can offset the boot that has been received. Also cash boot that has been paid can also offset any of the mortgage boot received, which is great debt relief. And when you have paid mortgage boot this will also offset any mortgage boot received and the mortgage boot paid does not offset any cash boot that you have received during the transaction.

Cash boot is…
If you receive boot as the tax payer you are receiving any boot that is not mortgage boot. Cash boot does not have to be actual cash it can also be other property.

Mortgage boot is…
Any liabilities that are assumed by or given up by the tax payer are considered to be mortgage boot. When and if you put debt onto your new replacement property you will be paying mortgage boot. The same thing happens when you assume debt on the replacement property.

You will be getting mortgage boot when you get relieved of the debt on this property. Any debt relief portion of the property is taxable unless it has been offset when it is netted against all other boot in the transaction.

Limitations of Section 1031
Section 1031 is not strictly limited to real estate. You can use any property that is held for business purposes or trade or investment purposes. It boils down to whether the property is being held for productive use or not, as long as it is then it can be used in the tax deferred exchange. The majority of Section 1031 exchanges are multi asset exchanges. With these types of exchanges you will exchange property as well as personal property.

Should you sell outright or exchange?
Knowing whether it is better for you to sell your property outright or exchange it for a like kind property is a serious decision and one that can have many repercussions. If you make use of Section 1031 Exchanges you will be able to defer your taxes indefinitely. This means that you will not have to pay your taxes until you do sell the property outright. If you exchange properties again you will get these tax deferred as well. You do not have to pay the taxes until you have made a money gain.

Deferring the tax can be an effective investment tool because you will be able to use this saved money for your other investments. It is like getting a loan. You still have great property, one that you may be able to use better than the last one and the money you save in taxes can be used to make even more money. It is important to note that the gain from depreciation recapture is postponed.

Section 1031 also allows you to get rid of the properties that you have no use for while acquiring ones that are much more useful. This new allocation of investments can not only save you money but also make you much more and all without having to pay any taxes.