1031 Exchange FAQ
How do I identify a 1031 Exchange Property?
A Replacement Property is considered identified before the end of the 1031 Exchange 45-day identification period only if the following requirements are satisfied. However, any Replacement Property you receive before the end of the identification period will in all events be treated as identified before the end of the identification period.
A Replacement Property is identified only if it is designated as Replacement Property in a written document signed by you. This document must be hand delivered, mailed, telecopied or otherwise sent before the end of the identification period to a person (other than yourself or a related party) involved in the exchange.
A Replacement Property is identified only if it is unambiguously described in the written document or agreement. Real estate is unambiguously described if it is described by its legal description or street address. Be sure to be VERY clear in the description of the property. Reviewing the title deed of the property is a great place to start.
Property incidental to a larger item of property is not treated as property that is separate from the larger item of property. Property is incidental to a larger item of property if in standard commercial transactions, the property is typically transferred together with the larger item of property, and the aggregate fair market value of all "incidental" property is not more than 15% of the aggregate fair market value of the larger item of property.
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I heard I could take boot from a 1031 Exchange and defer the tax. How does that work?
Yes. There is an ingenious tax strategy which will permit you to take back boot in a 1031 exchange without paying tax on it now. The Gain from the boot can be deferred into future tax years. It's done by taking back a purchase money installment note from the “buyer” of the Relinquished Property to balance all or part of the equities. When structured correctly, the taxable gain in the note may be reported using the installment method of tax accounting.
If you are an exchange specialist, be sure to tell your clients about this marvelous tax saving strategy. They will love you for it—all the way to the bank.
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How do I use 1031 Exchange to split up a partnership?
1031 exchange is an excellent vehicle for “splitting-up” two (or more) co-owners.
Let's say you and I both own a rental property as co-owners that we will call the Skyline Apartments. From some reason you want out but I am not willing to give up my interest. If I buy you out, you have a big taxable gain. You don't want this.
So, you find another rental you want to buy. I buy the property and swap it for your 50% tenant in common interest in Skyline. The result is you get your entire equity out of Skyline with no recognized gain and I end up with 100% ownership interest in Skyline.
This can also work to take out a 25% owner, 10% owner and so on.
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Do the 1031 Exchange rules apply to foreclosure transactions?
To the person losing the property, a foreclosure is treated by the IRS as a sale of the property. If the "sale" could be structured according the rules of Section 1031, the sale could be recognized as a 1031 exchange. But it sounds like a legal nightmare if the property is already in foreclosure. Also, you might have a forgiveness of debt problem. You should talk to your CPA or attorney regarding this before you take any steps.
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What qualifies as Real Estate held for investment?
Real Estate held for investment is one of the 4 classifications of Real Estate that the IRS has said qualifies for 1031 Exchange. Typically, this almost always land. Investment real estate is a capital asset (IRC Section 1221). It's property held primarily for appreciation of value due to location, passage of time and other factors outside the activities of the owner. It is treated as a portfolio investment asset. Even if purchased with the idea you might someday develop the property, if you don't develop it (for any reason), the property will not lose its classification as investment property.
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Some 1031 companies say “defer”, some say “don’t pay” capital gains tax with a 1031 Exchange. Which is correct?
Answer: When you sell your property and purchase another property with a like-kind property you are conducting an IRS 1031 Exchange. "Defer" or "Don't Pay" is simply marketing language intended to get your to consider a 1031 Exchange if you have property to sell. With a 1031 Exchange the reality is that "some day" you will be paying the capital gains on your property but with a 1031 Exchange you are really "deferring" it to some other time. We have had customers defer their capital gains several times by buying and selling the same piece of land. Since land almost always qualifies, under the 1031 Exchange rules you can do this. The question is with a 1031 Exchange are you saying that you will "never" pay your capital gains tax. In our 20 plus year experience with the US Internal Revenue Service we learned to "never say never".
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What are the restrictions of using a 1031 Exchange?
First of all the property you are trying to sell and convert into a 1031 Exchange must qualify as like-kind under the IRS's 4 classifications of Real Estate. Of the 4, there are 2 classifications of real estate that qualify for IRS 1031 Exchange. These are:
Property that is held for Investment: This is almost always some form of land. Zoning of the land does not matter. You can sell Farm Land for a land lot in a city, Land is land and is almost always considered like-kind.
Property held for a Business or Trade: This type of real estate is property that is earning an income as a business, such as an apartment or business complex or a rental home. Sometimes vacation homes can qualify IF they are rented out for a significant portion of the year and are never considered as you primary residence.
Both of these types of real estate are inter-changeable, meaning both are considered as like-kind. This means you can 1031 Exchange a piece of land for a rental home. You can 1031 Exchange an apartment complex for a parcel of land. Land that has a primary residence or an apartment complex that has a primary residence as considered Mixed Classifications and have a different set rules.
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Can I use my 1031 Exchange Proceeds to make improvements on my replacement property?
The rules about 1031 exchange are such that the proceeds from the sale of your property must be applied to purchase of your replacement properties. Let's run out this scenario and see where it goes. Just so you know this has actually happen but we'll remove the names to protect the not-so innocent from their foolish selves.
Let's say you sell your rental property as a 1031 Exchange. A month later you find another rental property that you want, so you identify that property as your replacement and begin working out a deal with the owner to purchase it. Upon inspection of the property you determine that you want to "gut" the house, removing the lathe and plaster and replace it with sheet rock. You also decide you want to replace the aging roof. So you make a deal with the property owner who wants to sell it in "as-is" condition that you will make improvements to the home as a 'partial payment" for the property. The owner agrees that the amount you spend will be deducted from the total purchase price of the property. So you take a "withdrawal" of $20,000 from your 1031 Exchange proceeds to purchase the materials you need to fix walls and roof of the home yourself and begin your work. After you've torn the house apart, you discover extensive water damage with has lead to rot and mold on all of the walls of the house. No you've decided not to purchase the house after all and you're stuck with a purchase of materials for a house that you don't even want. Plus you've already torn it apart and the property owner is going to sue unless you fix it! Yikes!
First off, it is important to understand that many of the aspects of this scenario should never have happened in the first place. If you Qualified Intermediary allowed you to withdraw funds from your 1031 Exchange proceeds "like a bank" you would be in extreme danger of allowing your Exchange to collapse. This becomes a constructive receipt issue as you should never have control over the money during the exchange period. The constructive receipt rules were put in place to prevent this type of scenario.
Also, 1031 Exchange proceeds are intended ONLY as the funds to outright PURCHASE your replacement properties, you cannot use them as some sort of down payment, that they can be a partial payment (which you'll kick in some more of your own money) at the time of closing.
Further, common sense is often mis-placed when we spot a "good deal" on a property we think we must have. In the above scenario, a proper home inspection should have happened before any deal was struck and an attorney should have been consulted to prevent this episode. People make mistakes, luckily there are rules to save them from themselves.
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Do I need a broker for a 1031 exchange?
What type of broker are we talking about here? A Real Estate Broker employs the Realtor who will help you to sell your qualified like-kind 1031 Exchange property and buy a replacement. Going it alone is risky, unless you work in the Real Estate industry and have access to the same marketing and research materials that a Realtor has. It's a common fact that people who sell or buy real estate without professional help tend to get less money for their home and pay more for properties than people who do. If you are in the market for a local 1031 Exchange Real Estate Professional, we recommend our directory located here.
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Can I 1031 Exchange a property that I already sold and purchased?
1031 Exchange only works with real estate properties for which you have not closed sale. This is why timing is so important. If you have already written your purchase and sale agreement on some business or investment property that you own and are now beginning to work toward a closing with a Title/Closing Company or an attorney, NOW is the time to start your 1031 Exchange, waiting until after you close sale is TOO LATE!
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Can a partner in a limited Partnership participate in a 1031 Exchange as a separate person?
No. Because of the Chain of Title requirement, a Partnership can complete a 1031 Exchange as a single entity...the partners don't get to split out their shares an buy separate properties.
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I read that I can do a 1031 Exchange without a Qualified Intermediary. Is that possible?
Well, good luck. There are many articles on-line from self-professed 1031 Exchange GURUs who proclaim that you can 1031 Exchange properties without the help of a 1031 Exchange Qualified Intermediary. We ask with so much that can go wrong, is it really worth the risk? If you 1031 Exchange fails, you will be subject to the capital gains tax. The purpose of the Safe Harbor is to prevent Constructive Receipt of your 1031 Exchange proceeds. Your 1031 Exchange Qualified Intermediary IS the preferred method of Safe Harbor.
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I sold a property on November 30, 2010 and entered into a 1031 exchange via an accomodator. My tax preparer filed my return on April 15, 2011 prior to my closing, but also filed for an extension. Now that my exchange has completed, can I file an amended return, or is my exchange invalidated? should he not have filed the return, and just the extension?
1031 Exchanges expire 180 days after you sell your property. The exception is when you taxes are due. Tax Time Trumps your 180 expiration ... unless you file for the extension. Since you filed for the extension, you should be able to get the full 180 days of your 1031 Exchange period, regardless of whether your taxes have been filed or not. The best best is to check with your CPA or Attorney as we obviously don't know your specific situation and there may be issues that we couldn't know.
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Why is depreciation important in a 1031 Exchange?
Depreciation is a deduction you will take when you figure out the basis of the property you buying.
Before you enter into any 1031 exchange of your real estate, you must figure the basis of the Replacement Property you are acquiring and see how it fits in with your financial and tax plans.
Much depends on this basis. For example, if the Replacement Property is an apartment complex (§1231 property), an allocation must be made of your 'new' basis to figure the amount qualifying for depreciation. You need this to figure the amount of your depreciation deduction. If your unrecognized gain on the Relinquished Property is large, the basis of your Replacement Property will be very low compared to market values. This can have unexpected results if not anticipated.
Your operations statement for the apartment complex will reflect rental income based on today's market values. But your depreciation deduction will be based on "yesterday's cost". You need to recognize this difference and accept it as part of your planning before going ahead with the exchange.
Basis is used as the base point for the calculation of capital gain on a transaction. Capital gain is described as the difference between the basis and the adjusted sales price of a property.
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I just closed on my last 1031 Exchange Replacement Property and have money left over. What can I do with the money?
Your 1031 Exchange ends after you close sale on your last identified Replacement Property. All of the funds that were not spent will be returned to you by your QI. What you do with the money is up to you but you need to realize that these funds are considered Boot and subject to capital gains, even if it's pennies or thousands of dollars. Discuss this with your tax advisor. There are opportunities here if the left-overs are significant. Your tax advisor will give you ideas such as charity or re-investment.
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It's my understanding that a 1031 exchange must be "In-Kind". Is that true?
The term is "like-kind" and in for there to be a 1031 Exchange, the IRS is looking for a transaction where both relinquished property and the replacement property are be held for use in a trade or business and/or held for investment. Also, these properties must be held in the United States or US Virgin Islands. There are several examples of these types of properties but the easiest way to determine qualification is to ask yourself, "Is this a personal property or am I holding this property with the intention of quick resale?"
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How do I 1031 Exchange a rental home for a business?
1031 Exchange involves the exchange of like-kind business property for the purpose of deferring capital gains tax. Emphasis must be placed in that statement regarding physical property or real estate. Since a business is neither property nor real estate, is would be very difficult to convince the IRS that this is a valid 1031 Exchange. If you were going to use the proceeds from your rental home to purchase the real estate assets of a business your chances of conducting a 1031 Exchange would be more successful.
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In a 1031 Exchange what is the adjusted basis on the property you are selling?
The adjusted basis of the property you are selling in a 1031 Exchange is:
Your Original Purchase Price of the property
Closing Costs to purchase the Property
Any Capital Improvements you made to the property
(such as adding a garage)
Any depreciation you have taken since you bought the property
YOUR ADJUSTED BASIS
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Can I 1031 Exchange my interest in a business for interest in another business?
Partnership interests are specifically excluded from 1031 exchange treatment. A partner's exchange of an interest in one partnership for another partner's interest in a different partnership does not qualify for 1031 exchange. However, please note that this IRS rule does not apply to exchanges of interests in the same partnership.
You should also know that a partnership as a business entity can qualify to exchange real estate it owns for other real estate.
For example: A limited partnership owned land and an office building leased under a long-term lease. The limited partnership wanted to dispose of the land and building and acquire several parcels of real estate. It located someone interested in buying the land and building. The limited partnership proposed to transfer title directly to a Qualified Intermediary and then form separate entities to take title from the QI for each of the replacement properties. The limited partnership would be the sole owner of each "replacement entity.” These entities would then either elect to be disregarded as an entity or would rely on the default classification for single-owner entities.
For discussion of strategy using §1031 to Split Up Partners and Investors in Real Estate see Topic 11.
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What is a 1031 Exchange Starker Exchange?
A Starker Exchange IS a 1031 Exchange. The term Starker comes from a lawsuit case in 1979, Starker vs. U.S. (602 F.2d 1341), that a contract to exchange a property in the future is the same as a simultaneous exchange. It is this case where the delayed 1031 Exchange originated. In order to get 1031 Exchange treatment from the IRS, you need to identify the property as a 1031 Exchange before closing, identify the replacement property with 45 days of closing and acquire your replacement properties with 180 days of closing and you MUST use a Qualified Intermediary to facilitate your transaction.
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Can I 1031 Exchange an investment property and use the proceeds to reduce the principal of another investment property?
You must have an exchange of qualifying 1031 Exchange properties in order to make this work. The question you describe doesn't sound like you are purchasing a like-kind property. So, in this case the answer is no. However, if you intend to purchase the other investment property, then Yes, perhaps you can have a 1031 Exchange. Better to call us at 800-570-1031 and explain your exact situation.
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Do the 1031 Exchange rules apply to off-shore companies?
1031 Exchange rules apply to all US taxpayers. If the offshore company you are asking about is a US Taxpayer and both the of the 1031 Exchange properties are located within in the fifty states or the US Virgin Islands, and the properties are either investment real estate or business real estate, then the answer is Yes
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Do I have to use the same debt and equity ratio on each Replacement property?
Remember that the tax accounting math for the 1031 exchange requires you to add the Replacement Properties together and treat as "one property" when figuring the exchange numbers. There are no "ratios" to worry about. Just be sure your Qualified Intermediary knows how to deal with multiple Replacement Properties.
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How do I figure the basis in my 1031 Exchange Replacement Property?
The rules for figuring basis for property acquired in a 1031 exchange take into account the gain is not forgiven, but “postponed” This is accomplished by providing a “substituted basis” for the property received. The basis of your Relinquished Property exchanged without recognition of gain becomes the basis of your new property. Your old basis is “substituted” into the new property. Someday, if you dispose of the new property, the previously unrecognized gain (or loss) might be subject to tax.
More reading and information can be found here!
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Can a farmer take 1031 Exchange money from an agricultural easement and buy another farm?
The sale of an easement gets special treatment under federal tax rules. It works like this: The sales price of an easement is not treated as income. Instead, it reduces the basis of the underlying land. If the sale price of the easement is more than the cost basis of the entire parcel of land, the difference is treated as long-term capital gain and the farmer has a zero-basis in his farmland.
Example: You are a farmer and your farmland has a federal tax basis of $50,000. You sell an easement to the power company (or anyone) for $3,000. You pocket the $3,000 tax-free and the cost basis of your farmland is reduced to $47,000.
This is a mandatory rule so farmers can do anything they want with money.
This is a great tax benefit that all farmers should know about.
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I sold a property last month, is it too late to 1031 Exchange it now?
Hi, I am interested in determining if I can qualify for a 1031. I sold a property on Sept 22, 2011. I did deposit the cash into my bank account. I am now bidding on another property and could close before the end of the month. The properties are both investment properties. Can I still qualify? Can you assist me in the transaction? Thank you.
1031 Exchange must happen at the time of closing. Because your property has already closed, you now have access to the funds, this means you cannot 1031 Exchange. However, there are times when you have closed sale on a property but the money is still in escrow and out of your control. If that is the case, there may still be time to setup a 1031 Exchange. Check out http://www.realtyexchangers.com
for more information.
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Do I need to find a local 1031 Exchange Qualified Intermediary?
Some people who are getting ready to close on their 1031 Exchange property think they need to work with a local Qualified Intermediary in their city or state. This is not true. The IRS Section 1031 Exchange is a federal action. This means you should be able to work with the Qualified Intermediary of your choice from any location in the US. You recommend you choose a QI that you can trust. Realty Exchangers, Inc is a Qualified Intermediary with a 20-year reputation of providing fast and easy 1031 Exchanges to taxpayers in all 50 states and the Virgin Islands. Our credentials are impeccable, the security of our funds is the best available and our 1031 Exchange knowledge is the most comprehensive.
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What assets qualify for 1031 Exchange?
For 1031 Exchange the real estate you own is considered an asset that must be thoroughly vetted in order to determine if it qualifies for 1031 Exchange. Since we are dealing with IRS matters, you should know that there are 4 classifications of real estate of which only 2 qualify for 1031 Exchange. Your personal residence and the property you purchased for a "quick flip" does not qualify for 1031 Exchange. Your vacant land and your rental home does qualify for 1031 Exchange.
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My biggest worry about doing a 1031 Exchange is the 45 day deadline. Help?
Yes, you have 45 days to identify Replacement Properties once you convert your sale into a 1031 Exchange. You are right that doesn't seem like a lot of time. We encourage to you find a local 1031 Exchange Real Estate Professional who can help you find some qualified replacements. Careful planning before you sell your property is not out of the question. Many people already have replacement properties in mind before they sell but if you do not a great place to look in on-line. Try the Exchangers Clearinghouse, our national 1031 Exchange Property Search Engine, it's free! We have new listings being added daily, so check back often.
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