Does my property qualify?
Any property held for productive use in a trade or business or for investment can be exchanged for like-kind property. Like-kind refers to the nature of the investment rather than the form. Any type of investment property can be exchanged for another type of investment property. A single-family residence can be exchanged for a duplex, raw land for a shopping center, or an office for apartments. Any combination will work. The exchanger has the flexibility to change investment strategies to fulfill their needs.
You cannot trade partnership shares, notes, stocks, bonds, certificates of trust or other such items. You cannot trade investment property for a personal residence, property in a foreign country or “stock in trade.” Houses built by a developer and offered for sale are stock in trade. If an investor buys “fixer-uppers” and sells them as soon as they are improved, the properties may be considered as stock in trade and cannot be exchanged.
If an investor attempts to exchange too quickly after a property is acquired or trades many properties during a year, the investor may be considered a “dealer” and the properties may be considered stock in trade. Persons dealing with stock in trade are called dealers and are not allowed to exchange their real estate unless they can prove that it was acquired and held strictly for investment. There are no clear guidelines as to what constitutes being a dealer. The purpose and motivation behind the acquisition and use of real estate, how long the property is held and the principal business of the owner may be considered when determining if a real estate is dealer property.
If we find the asset being relinquished does qualify for a 1031 Exchange, the next question is what the replacement property will be. As discussed previously, section 1031 applies to both “real property” and “personal property.” The primary difference between a personal property exchange and a real property exchange is the definition of like-kind.
What does not qualify for a 1031 Exchange?
Property held for productive use in a trade or business or for investment qualifies for a 1031 Exchange.
The tax code specifically excludes some property even if the property is used in trade or business or for investment. These excluded properties generally involve stocks, bonds, notes, securities and interests in partnerships.
Property held “primarily for sale” is also excluded. This excluded property would include business inventory. For real estate, it means property purchased with the intent to sell it, such as a fixer-upper or vacant land to be developed into a house. An investor who “turns” residential properties, or a private developer, may be classified as dealer.
A primary residence usually does not qualify for an exchange because it is not used in trade or business or investment. That said, that portion of the primary residence that is used in a trade or business or for investment may qualify for a 1031 Exchange.
How do I get started in a 1031 Exchange?
Getting started with an exchange is as simple as calling your Exchange Facilitator. Before making the call, it will be helpful for you to have information regarding the parties to the transaction at had (for example, names, addresses, phone numbers, file numbers, and so on). During the phone call, the exchange coordinator will ask questions about the property being relinquished and any proposed replacement property.
The initial discussion will vary dramatically from company to company with respect to the amount of detail requested. There is very little actual information required to structure a basic delayed exchange. We at Equity Advantage take a more in-depth approach to the process; we like a proactive rather than reactive position. The more we understand our client’s objectives, the better equipped we are to help them achieve them. For this reason, we encourage our prospective clients to both ask questions and answer ours.
How do I choose a facilitator?
In preparation for your exchange, contact an exchange facilitation company. You can obtain the names of facilitators from the internet, attorneys, CPAs, escrow companies or real estate agents. Facilitators should not be acting as “agents” as well as facilitators. Escrow companies, attorneys, real estate agents, etc. are agents and should not be used as facilitators. Ask questions about the procedures employed and the assistance they can provide if problems arise. Price, though important, should not be the qualifier. Exchange fees typically range from $400 to $750, the difference in price often reflecting a difference in service. You may wish to obtain copies of the documents the facilitator will use for review by your attorney.
What are the time requirements in an exchange?
From the time of closing on the relinquished property, the investor has 45 days to nominate potential replacement properties and a total of 180 days from closing to acquire the replacement property.
Identification requirements: The investor must identify the replacement property prior to midnight on the 45th day. The investor normally nominates three potential properties of any value, and then acquires one or more of the three within 180 days. Typically, a common address or an unambiguous description will suffice. If the investor needs to identify more than three properties, it is advisable to consult with your 1031 facilitator.
What restraints do I face when identifying my replacement property(ies)?
As an Exchangor, you are required to provide an “unambiguous description” of the potential replacement property on or before the 45th day after closing on the relinquished property. (A legal description or property address will suffice). If you wish to identify or purchase multiple properties, you must follow one of the following guidelines:
- Identify up to three properties of any value with the intent of purchasing at least one.
- Identify more than three properties with an aggregate value that does not exceed 200% of the market value of the relinquished property.
- Identify more than three properties with an aggregate value exceeding 200% of the relinquished property, knowing that 95% of the market value of all properties identified must be acquired.
What closing costs can be paid with exchange funds and what cannot?
The IRS stipulates that in order for closing costs to be paid out of exchange funds, the costs must be considered a Normal Transactional Cost. Normal Transactional Costs, or Exchange Expenses, are classified as a reduction of boot and increase in basis, where as a Non Exchange Expense is considered taxable boot. The following table indicates what is and is not considered a Normal Transactional Cost.
YES (Exchange Expense)
NO (Non-Exchange Expense)
|Sales Commission||Rent Proration||Appraisal Fees|
|Legal Fees||Utilities||Inspection/Testing Fees|
|Escrow Fees||Mortgage Insurance|
|Inspection/Testing Fees||Property Liability Insurance|
|Transfer Taxes||Application Fees|
|Title Insurance Fees||Lender’s Title Insurance|
|Recording Fees||Assumption Fees|
|Property Taxes||Home Owners Dues|
|Exchange Fees||Repairs/Termite Work|
|Messenger Fees||Security Deposits|
|Document Fees||Replacement Property Loan Acquisition Fees|
If an Exchangor wants to take money out of the exchange to pay a Non Exchange Expense, they must do so at closing and taxes will be owed on the amount paid. Taking money out for a Non Exchange Expense while the money is sitting with the Exchange Facilitator may jeopardize the exchange.
Is it ok to go down in value and reduce the amount of debt I have in the property?
An exchange is not an “all or nothing” proposition. You may proceed forward with an exchange even if you take some money out to use any way you like. You will, however, be liable for paying the capital gains tax on the difference (“boot”).
Does a vacation home qualify for exchange?
The answer is “yes” if the dwelling meets the qualifications set forth in Revenue Procedure 2008-16. Effective March 10, 2008. This revenue procedure clarified what was once considered a muddled area of 1031 exchanges. The qualifications are the following:
- The holding period for the vacation home is at least 24 months immediately before the exchange*;
- For each of the two-12-month periods, the vacation home is rented to another person at a fair rental for 14 days or more; and
- The homeowner limits his use of the vacation home to not more than 14 days or 10% of the number of days during the 12-month period that the vacation home is rented at a fair rental value.
* For this purpose, the first 12-month period immediately preceding the exchange ends on the day before the exchange takes place (and begins 12 months prior to that day) and the second 12-month period ends on the day before the first 12-month period begins (and begins 12 months prior to that day).
- The holding period following the exchange is at least 24 months*;
- For each of the two-12-month periods, the vacation home is rented to another person at a fair rental for 14 days or more; and
- The homeowner limits his use of the vacation home to not more than 14 days or 10% of the number of days during the 12-month period that the vacation home is rented at a fair rental value.
* For this purpose, the first 12-month period immediately after the exchange begins on the day after the exchange takes place and the second 12-month period begins on the day after the first 12-month period ends.
Here’s an example to analyze this revenue procedure. Let’s assume that taxpayer has owned a beach home since July 4, 2002. The taxpayer and his family use the beach home every year from July 4, until August 3 (30 days a year.) The remainder of the year the taxpayer has the house available for rent. Now, the taxpayer has negotiated the sale of his beach home so that ownership of the house transfers on May 5, 2008. Under the Revenue Procedure, the IRS will examine two 12-month periods: (1) May 5,2006 through May 4, 2007 and (2) May 5, 2007 through May 4, 2008. To qualify for the 1031 exchange, the taxpayer was required to limit his use of the beach house to either 14 days (which he did not) or 10% of the rented days. So, the IRS will need to find that the taxpayer actually rented the house at a fair market value for 300 days each during the two 12 month periods for the vacation home to qualify for a 1031 exchange.
As always, your CPA and/or attorney can advise you on this tax issue.
What information is needed to structure an exchange?
Typically the only information we require in order to structure your exchange is the following:
- The Exchangor’s name, address and phone number
- The escrow officer’s name, address, phone number and escrow number
With this said, the following is a list of information we would like to have in order to thoroughly review your intended exchange:
- What is being relinquished?
When was the property acquired?
What was the cost?
How is it vested?
How was the property used during the time of ownership?
Is there a sale pending? If so, what is the closing date?
Who is closing the sale?
What are the value, equity and mortgage of the property?
- What would you like to acquire?
What would the purchase price, equity and mortgage be?
If a purchase is pending, who is handling the escrow?
How is the property to be vested?
Is it possible to exchange out of one property and into multiple properties?
It does not matter how many properties you are exchanging in or out of (1 property into 5, or 3 properties into 2) as long as you go across or up in value, equity and mortgage. The only concern with exchanging into more than three properties is working within the time and identification restraints of section 1031.
After buying a rental home, how long do I have to hold it before I can move into it?
There is no designated amount of time that you must hold a property before converting its use, but the IRS will look at your intent. You must have had the intention to hold the property for investment purposes. This could include, but does not require, renting the property out at a fair market value. Since the government has twice proposed a required hold period of one year, we would recommend seasoning the property as investment for at least one year prior to moving into it. A final consideration on hold periods is the break between short- and long-term capital gains tax rates at the year mark.
Can I make an offer on a property and sign a contract before my relinquished property is sold?
If you are in a situation where you locate a property you would like to acquire before you have a buyer for the property you own, it is okay to make an offer prior to the closing of your relinquished property. Many Exchangors in this situation make the purchase contingent on whether the property they currently own sells. As long as the closing on the replacement property is after the closing of the relinquished property (which could be as little as a few minutes), the exchange works and is considered a delayed exchange.
If, however, you find a property that you must have and need to close on prior to having a buyer in place for your relinquished property, you can acquire it using a Reverse Exchange. While the Reverse Exchange approach is much more costly, many Exchangors prefer it because they know they will get exactly the property they want today while selling their relinquished property in the future.
Can I take advantage of a 1031 Exchange if I want to acquire a replacement property in a different state than the relinquished property is located?
Exchanging property across state borders is a very common thing for investors to do. In fact, a great number of our clients do exactly that. It is important to recognize that the tax treatment of interstate exchanges vary with each state and it is important to review the tax policy for the states in question as part of the decision-making process.
How long does a property need to be held prior to doing an exchange?
The tax code does not provide a specific time period for holding investment property. Time is less important than the investor’s intent at the time of acquiring the property (that is, did the investor intend to hold the property as an investment).
Often times, people have the general understanding that there is a one-year hold period for an exchange. The reason for this general consensus is that the government has proposed a one-year hold period several times. An additional indication that the IRS may like to see the one-year time period is that the tax code differentiates a long-term capital gain from a short-term capital gain at one year.
Again, there is not a tax code mandate of one year, but it may be that the IRS would like to see at least a one-year hold. The only minimum required hold period in section 1031 is a “related party” exchange where the required hold is a minimum of two years.
What does a 1031 Exchange cost?
At Equity Advantage, we take pride in our ability to make the most of a client’s exchange. We consider the exchange the tool to move a client from one investment to another. The course taken will vary from client-to-client depending on the client’s needs and circumstances. Often it’s not a question of doing an exchange, it’s a question of what kind of exchange to do.
The cost of an exchange varies depending on the circumstance and the type of exchange. A True Swap of properties can be as little as $500. A Delayed Exchange of two properties starts at about $750. More complex transactions such as Reverse or Improvement Exchanges start at $3,500.
When choosing an Accommodator, ask about procedures and the assistance they can provide if problems arise. Exchange fees should range from $400 to $1,000 for a basic Delayed Exchange. The difference in price is often the difference in service.
Price should be a factor of the decision process, not the decision process. Please contact Equity Advantage today for exchange consultation and a price quote.
Are you secured/insured?
While the exchange industry as a whole is not regulated, we take great pride in making sure each one of our clients feels comfortable and safe during their exchange. We are backed by a fidelity bond, which insures up to $5,000,000 for each occurrence. Additionally, Equity Advantage maintains an Errors and Omissions policy to insure our work; this policy covers up to $1,000,000 per claim. Copies of these policies are available upon request.
When your exchange funds are sent to us, they are placed in a money market savings account. We do not commingle our operating account with your exchange funds. The money does not move from this account until authorized by the Exchangor to do so for the purpose of closing.
Ultimately, your greatest security is the comfort of knowing that Equity Advantage has been under the same ownership since 1991. We have handled tens of thousands of transactions during that time, and we have never suffered a loss or claim. Before bonding was available, a company’s reputation, policies and procedures were all the guarantee an investor had. We at Equity Advantage take great pride in our firm’s well-earned reputation in the exchange business.
When exchanging, do I need to re-invest the net proceeds or the sales price?
There is a common misconception amongst Exchangors on how much money needs to be re-invested when participating in an exchange. In order to be fully tax deferred, you must re-invest in a property that is equal to or greater than the sales price of the property you are relinquishing. If you are selling a rental house for $500,000 with $200,000 in equity, you must purchase a new property with a price of at least $500,000 and equity of at least $200,000. If you choose to go down in value or choose to pull some equity out, an exchange is still possible but you will have tax exposure on the reduction. The value and equity numbers are net after paying “normal transactional costs.” Please call Equity Advantage for a thorough explanation of costs and their effect on your exchange.
Can I recoup my initial down payment on the property I am selling?
No, the IRS takes the position that the first money out is theirs. In other words, you cannot be reimbursed your initial investment without incurring tax exposure. It is possible to receive money; however, any funds received will be taxed.
Is it ok to buy the property that my business occupies as a tenant?
Depending on the behavior of your business as the tenant, it is possible for your business to be a tenant of your own property. It will be important that your business pays rent for the space at current market value and that the business does not get treatment that other tenants do not receive.
Is it possible to convert an investment property into a primary residence and eventually sell the property applying Section 121?
The IRS realizes that a person’s circumstances may change; therefore, a property may change in character over time. For this reason, it is possible for an investment property to eventually become a primary residence. If a property has been acquired through a 1031 Exchange and is later converted into a primary residence, it is necessary to hold the property for no less than five years or the sale will be fully taxable.
The Universal Exclusion (Section 121) allows an individual to sell his residence and receive a tax exemption on $250,000 of the gain as an individual or $500,000 as a married couple. In order to gain this benefit, the investor will need to live in the property for an aggregate of 2 of the preceding 5 years.
After the property has been converted to a primary residence and all of the criteria are met, the property that was acquired as an investment through an exchange can be sold utilizing the Universal Exclusion. This strategy can virtually eliminate a taxpayor’s tax liability and therefore is a tremendous end game for investors.
If I have a property that I fixed up a year ago, am I able to do an exchange on it now?
There is no clear answer to this question. The answer really has to do with your intent with the property. In order for it to qualify for an exchange, you must have held the property for investment purposes. Flipper properties do not qualify as investment properties. To determine whether your property may qualify, it is important to examine how long you owned the property before fixing it up, what your intention was when you first acquired the property, whether anyone has lived in the property during this time and what your intention is with the property you wish to buy with the proceeds.
Depending upon your answers to those questions, you may or may not qualify for an exchange. If the answers indicate you held the property for resale, the exchange would not be possible. If, on the other hand, you and your tax counsel can show intent to hold as investment, the exchange is a logical next step.
Can I exchange a foreign property for a domestic property or vice-versa?
Property located in the United States is not considered “like-kind” to property located in a foreign country. It is not possible to exchange out of the United States into foreign property, and vice-versa.
There has been case law that passed that supports exchanging from the States and into a US territory. There are fourteen US territories: American Samoa, Baker Island, Guam, Howland Island, Jarvis Island, Johnston Atoll, Kingman Reef, Midway Islands, Navassa Island, Northern Mariana Islands, Palmyra Atoll, Puerto Rico, Virgin Islands and Wake Island. It is important to speak with your legal council when considering this option.
Section 1031 allows domestic for domestic and foreign for foreign. Please call Equity Advantage for a thorough discussion of your situation.
Is it possible to do an exchange using the proceeds from the sale to improve a property that I already own?
While not considered a conservative option, there are several “liberal” letter rulings that recognize this as a viable strategy. If this is an option that interests you, please call us so we can send you additional information.
May a person exchange one form of business, such as a hotel, for another business, such as a restaurant?
To answer this question, let’s keep in mind some general principals of a 1031 Exchange. A person’s business usually consists of three components: real property (real estate), personal property (usually depreciable tangible assets) and good will.
If a person’s business has a real estate component, the real estate (or real property) qualifies as like-kind property with other real estate (real property). For example, a single-family rental can be exchanged for a duplex, raw land for a shopping center, or an office building for an apartment. Any combination of real property will work.
Personal property, unlike real property, is more restricted in a 1031 Exchange. The IRS is less inclined to state that one type of personal property qualifies as like-kind for other personal property. For example, personal property may be characterized as depreciable tangible property, intangible property and non-depreciable personal property. Personal property within each category is not necessarily like-kind. Any personal property held as inventory does not qualify for exchange treatment.
Good will is the remaining portion of the business that is not characterized as real property or personal property. The good will of the business does not qualify for a section 1031 exchange.
So, with the information above in mind, it is well established that portions of a hotel business may be exchanged for portions of a restaurant. The real estate owned by the hotel may be exchanged for the real estate owned by the restaurant. It may be the hotel and restaurant own common assets that could qualify for a 1031 Exchange. The good will of the hotel could not be exchanged for the good will of the restaurant.
Can I do a cash-out refinance prior to an exchange in order to pay off other loans?
The whole point of the 1031 Exchange is moving investment money forward to invest in more property. Pulling money out tax free prior to the exchange would contradict this point. For this reason, you cannot refinance a property in anticipation of an exchange. If you do, the IRS may choose to challenge it.
If you wish to refinance your property you will want to make sure the refinance and the exchange are not integrated by leaving as much time in between the two events as possible. You can choose to refinance prior to the property going on the market (6 months to a year) or wait until after the exchange is complete and refinance the newly owned property.
Is it possible to do an exchange with a property that is being auctioned off?
While it is a bit more complicated, it is possible to use exchange funds to purchase a property being auctioned off. The IRS requires the Exchangor to provide an unambiguous property description if the property is not acquired prior to the 45th day of the exchange. For this reason, the auctioned property must be purchased prior to the 45thth day unless property descriptions are available prior to the auction.
On the day of the auction, you will need to get a check from us written out to the courthouse or whoever is to receive the money with a specified dollar amount. If you do not win the property, the check must be returned to us. To make sure everything runs smoothly and there is no concern of constructive receipt of the funds, it is important you talk with us throughout this exchange process and it is critical we buffer you from actual or constructive receipt of the exchange funds.
Can a note and trust deed sale be used in an exchange?
A note typically represents equity in the property being relinquished. Since a 1031 Exchange requires all equity be carried forward into the replacement property, the note must be converted somehow prior to receipt of the replacement property in order for the exchange to be totally tax-deferred.
The Exchangor has the following options in converting the note:
- Use the note and cash in acquisition of the replacement property.
- Sell the note and then complete the exchange.
- The Exchangor buys the note from Equity Advantage.
- The note is a short-term note and is to be paid off prior to the acquisition of the replacement property.
- Finally, the Exchangor chooses to pay tax on the note, exchanging only the net equity.
Is it possible to use all of the proceeds from an exchange to pay down a mortgage on a property already owned?
To fully defer all taxes in a 1031 Exchange it is necessary to carry all equity from the relinquished property forward into a new replacement property. If, through the exchange, some or all of the proceeds from the relinquished property sale are used merely to pay down an existing mortgage, the Exchangor would have tax exposure on the funds received. Even if the Exchangor acquires new replacement property meeting the necessary value and debt requirements, the funds pulled out of the exchange to pay off the unassociated debt would have tax exposure.
One possible solution for a taxpayor in this situation would be to complete the exchange using all equity from the relinquished property’s disposition. After completing the exchange, and after a reasonable period of time, it may be possible to do a cash-out re-finance and take the desired proceeds to pay off the other property. The amount of time necessary to wait before the refinance is entirely up to the discretion of the taxpayor and their tax counsel.
Can oil, gas, minerals, water and timber rights be exchanged?
A successful 1031 Exchange requires that property be exchanged. Contractual rights and obligations pertaining to real property may or may not be characterized as a property interest and may or may not be eligible for an exchange.
A working interest is considered a real property interest, whereas a royalty interest is not. What is the difference? It is the Exchangor’s rights and obligations to access the property. A working interest is the exclusive right to enter land and extract oil, gas and minerals. It involves the right and cost obligation to explore, drill and develop the oil, gas and minerals. It also carries the obligation of paying for operating expenses. In contrast, a royalty interest allows for a percentage share of production only. There is not any obligation for development or operating expenses. As such, this interest is not considered a real property interest, but rather payment for services.
Clearly, a working interest in gas, oil and minerals may be exchanged to a different working interest in gas, oil and minerals, but what about other type of exchanges? Just as real estate properties can be exchanged as “like-kind” even though the properties are not exactly the same (for example, an apartment complex for a vacant lot), the same may be true for property rights, such as the rights to oil, gas and minerals. So, depending upon the particulars of the property, a working interest in oil may be exchanged for a rental house. In contrast, a royalty interest cannot be exchanged for a working interest.
Water rights (the right to access and receive water) and timber rights (the right to enter land and cut down timber) are generally characterized in the same manner as oil, gas and mineral rights. It should be noted, however, that these rights are characterized according to state law. For example, the State of Oregon characterizes that the right to cut standing timber is personal property, whereas the State of Georgia characterizes it as real property.
What are the guidelines with a related party transaction?
A related party transaction is allowed by the IRS, but significantly restricted and scrutinized. The purpose for the restrictions is to prevent Basis Shifting among related parties. Using a third party to circumvent the rules is considered to be a Step Transaction and is disallowed. If your transaction is audited, the IRS will look at the chain of ownership for the property.
The definition of a related party for 1031 purposes is defined by IRC 267b. Related Parties include siblings, spouse, ancestors, lineal descendants, a corporation 50% owned either directly or indirectly or two corporations that are members of the same controlled group.
The restrictions vary depending on whether you are buying from or selling to a related party. The following lists guidelines for each.
Investor selling investment property to a related party:
- 2-year holding requirement for both parties.
- Does not apply where related party also has 1031 Exchange; death; involuntary conversion.
- 2 years are tolled during the time there is no risk of loss to one of the parties (put right to sell property/call right to buy property/short sale).
Investor buying investment property from a related party:
- Related party must also have a 1031 Exchange; or
- Taxpayor’s deferment of capital gain is less than or equal to seller’s taxable gain from selling the property.
What are the rules about canceling an exchange?
It is possible to cancel an exchange but the cost and timeframe in which you can terminate a deal varies from facilitator to facilitator. The issue with exchange termination is the constructive receipt concept. Section 1031 requires the taxpayor not have actual or constructive receipt of the exchange proceeds. If a taxpayor can simply ask for and receive the funds at anytime, the exchange procedure may not be defendable.
Therefore, it is possible to terminate an exchange at the following times:
- Anytime prior to the close of the relinquished property sale.
- After the 45th day and only after you have acquired all the property you have the right to acquire under section 1031 rules.
- After the 180th day.
Please contact us directly if you have additional questions in regards to canceling your exchange.
Although IRC 1033 and 1031 both allow for the deferment of capital gain on property, the code sections operate and impact the taxpayer differently. IRC 1031 may provide more flexibility on the type of replacement property that can be acquired. IRC 1033 offers more flexibility on time constraints and receipt of funds.
Here is a quick summary of the differences.
- Pertains to the exchange of property used in “trade or business or investment.”
- Do not report gain if property is exchanged for “like-kind” property (e.g., real estate for real estate).
- A third party intermediary is required.
- May not have actual or constructive receipt of sales proceeds from the relinquished property (all funds must be deposited with the exchange-accommodator).
- 180 days to replace the relinquished exchange property.
- 45 days to identify replacement property.
- Net equity must be reinvested in property of equal or greater value to the relinquished property.
- Pertains to property involuntarily converted or exchanged (destroyed, stolen, condemned or disposed of under the threat of condemnation).
- Do not report gain if property received is “similar or related in service or use” to the converted property. Exception: If converted property is real estate used in trade and business or investment, then do not report gain if exchange is for “like-kind” property (e.g., real estate for real estate).
- An accommodator is not needed; the deferment is reported on Form 4797.
- OK to directly receive payment/proceeds for the involuntary conversion.
3 years to replace real estate; 2 years for other property.
- No time restrictions during which the replacement property must be identified.
- Proceeds must be reinvested in property of equal value to the converted property.