1031 Exchange FAQ

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Common 1031 Exchange Questions

How much of 1031 exchange recognized gain is recapture?

What assets qualify for 1031 Exchange?

Should I 1031 Exchange some condos that I just converted from an apartment building that I just bought?

Can I 1031 Exchange Property I purchased from a 1031 Exchange 4 years ago?

How do we 1031 Exchange our vacation home?

Why is a 1031 Exchange called boot?

A 1031 Exchange is the continuation of your property investment when you exchange like-kind properties for the purpose of deferring your Capital Gains Tax to a future sale. Boot is the cash or non like-kind property portion in a 1031 Exchange. 1031 Exchange is not called boot, though there are portions of a 1031 Exchange that are considered boot. Remember, that receiving boot in a 1031 Exchange is a taxable event, subject to Capital Gains or ordinary income.

Related Info: boot, gains, like-kind, capital, portions, portion

How do we separate a house from our 1031 Exchange Replacement Property?

If you are purchasing land through 1031 exchange for as your replacement property and the property includes a personal residence, you need to make an allocation of the substituted basis between the residence and the nominal land to be used as part of the residence and the remaining acreage to be held for investment .

Related Info: replacement, house, residence, land, remaining, nominal, acreage, investment

How do I handle the earnest money deposit for the purchase of my 1031 Exchange Replacement Property?

We recommend using your own personal funds for earnest money deposits. Any unused funds brought into the 1031 Exchange replacement property transaction, other than the exchange proceeds being held by your QI can be reimbursed at the time of closing. Exchange proceeds can only be used for earnest money if the purchase and sale agreement has been assigned in writing to your QI And even then they are not true earnest money as the funds can only be released to the seller at the time of closing. If the transaction fails to close the funds will be returned to your QI.

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Can I take a note on the sale of my Relinquished Property and still qualify for a 1031 exchange?

Yes! Realty Exchangers, Inc., regularly manages these types of transactions and knows the correct procedure that must be followed to assure §1031 Exchange treatment. The installment note and related documents are made out in the name of the QI (Qualified Intermediary). There are four choices on how to use it to buy replacement property:

You can use it to acquire Replacement Property by trading it to the "Seller " for part of the consideration for purchase of new property. This does not trigger the unrecognized gain in the installment note.
You can instruct the QI to sell the note on the open market (you can negotiate this sale or have the QI do it as your agent) and add the amount realized to the exchange proceeds. This will give you all cash to negotiate your replacement purchase. It's less desirable because of the discount you might have to give on the sale of the note. This does not trigger the unrecognized gain in the installment note.
A party related to you, the exchanger, such as a closely held corporation or relative can either purchase the installment note from your QI or provide financing so that your QI receives all cash at closing. You should consult with your tax advisor regarding structuring this type of transaction. This does not trigger the unrecognized gain in the installment note.
You can wait until the end of the exchange and receive the installment note back from the QI. This will result in the note becoming "boot" and it will be taxable. However, at this point the installment sale rules under §453 kick in and you are permitted by election to use the installment method of tax accounting and only recognize capital gain as you collect principal payments each year. Interest on the installment note is always taxable at ordinary income rates. Your installment sale percentage for figuring gain will be 100%.

Related Info: qualify, relinquished, sale, installment, gain, purchase, unrecognized, replacement

Can I 1031 Exchange a rental property for a motor home?

Motor homes are consider personal property, which do not qualify as a replacement property in a Section 1031 exchange. Only real estate for real estate qualifies. Also both the relinquished property and the replacement property must be property used as either investment property (such as land) or as a business (such as a rental property) or held for investment. A motor home will not qualify in this case.

Related Info: home, motor, rental, real, investment, replacement, estate, qualify

Before I 1031 Exchange a property, can I borrow against it?

An interesting concept, this is called anticipatory mortgaging and has some benefits for a 1031 Exchange. What if you were to refinance your Relinquished Property prior to the exchange to get cash and then raise the mortgage to be assumed or paid off by the buyer? Remember these things:

Borrowing money on your property is not a taxable event so it won't affect your 1031 Exchange.
The higher mortgage increases the amount of mortgage boot received that qualifies for offsetting against mortgage boot paid.

Let's say Davis wants to exchange Cloverleaf Apartments for Sunshine Apartments owned by Roberts. The terms of his exchange include:

Davis assumes a mortgage of $274,000 on the property he acquires in the exchange.
Davis has a mortgage on Cloverleaf of  $100,000 that will be assumed by Roberts.
Based on the market values of the properties, Davis receives cash boot in the amount $200,000 to balance the equities.
When the exchange is closed, Davis receives taxable boot in the amount of $200,000 making him very unhappy.
Here’s how his taxable boot is figured following the offset rules of 1031:
Mortgage on Cloverleaf Property relinquished was $100,000 (mortgage boot received)
Deduct mortgage on Brentwood assumed by Jones - $274,000 (mortgage boot paid)
This results in a negative offset - $174,000
However, under the rules, mortgage offset cannot be less than zero. Davis gets no boot offset from the difference of $174,000 to offset his cash boot received of $200,000. The result is Davis gets hammered for a $200,000 taxable gain.

Experienced 1031 exchangers are quick to recognize transactions where negative boot relief can result in more gain being recognized from net boot received. In our example, Davis should consider borrowing on his Relinquished Property (Cloverleaf) prior to and outside the exchange transaction. If he refinanced and took out $175,000 cash (non-taxable), his boot would be figured like this:

Davis assumes a mortgage of $274,000 on the property he acquires in the exchange.
Davis has a mortgage on Cloverleaf of  $275,000 that will be assumed by Roberts.
To balance the equities, Davis receives cash boot in the amount $25,000.
When the exchange is closed, Davis receives taxable boot in the amount of only $26,000 making him very happy. Here’s how the taxable boot for this exchange is figured following the offset rules of 1031:
Mortgage on Cloverleaf Property relinquished was $275,000
Deduct mortgage on Sunshine assumed by Davis - $274,000
Difference – Mortgage relief boot received by Davis is $1,000
Add Cash boot received of $25,000
Total boot received by Davis is $26,000
By refinancing outside the exchange, Davis reduces his gain $200,000 to only $26,000.

Exchangers should seriously consider some financing moves outside the exchange to reduce the negative boot relief to zero if possible. Even though equities would not change, the amount of taxable boot could be substantially reduced. This can be accomplished but only with very careful and knowledgeable planning. You don’t want any financing moves treated by the IRS as part of the exchange transaction.

If the refinancing can be demonstrated to be unrelated to the exchange of the Relinquished Property, the proceeds of the refinancing will not be characterized as boot.

The IRS issued a Proposed Regulation making such mortgage proceeds taxable but it was not adopted.

Replacement Property may be refinanced after the exchange is closed and the proceeds used by the owner for any purpose. This is a non-taxable event. However, to qualify, the refinancing must not be connected to the exchange transaction such as a contingency for the exchange to close. The exchange agreement and closing statements should be silent regarding the refinancing.

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In a 1031 Exchange, when is boot not taxable?

Nearly all boot is taxable. Many taxpayers forget that all of the costs that went in to selling your 1031 Exchange property are offset against any of the boot that you have received. If you have $10k in boot but it cost $11k to sell your property, you would have boot but none of it would be taxable because the $11k to sell your property would be written off. More reading about Boot can be found here!

Related Info: taxable, boot, $11k, found, cost, reading

What is the difference between capital gain and equity in a 1031 Exchange?

Do not confuse capital gain with equity in your 1031 Exchange. There is no comparison between the two.

Equity is the amount of money you have in your pocket after you have sold the property and paid off all related liabilities and mortgages. As an example lets say you bought a property $30,000 ten years ago, it's free-and-clear and has basis of $20,000.

If you sold that property today for $115,000, and paid out $15,000 in closing costs and commissions, you have equity of $100,000. That's the amount of cash you would get out of the closing. However your capital gain on this property would be the difference between your basis of $20,000 and your adjusted sales price of $100,000, or $80,000.

Result: If you sell instead of doing a §1031 Exchange, you would be obligated to pay a capital gains tax on the entire $80,000.

Example with Mortgage: If you had mortgage of $90,000 on this property, you will need to repay this loan at the time of closing. This results in net cash to you at the closing of only $10,000 ($100,000 less the loan payoff of $90,000). But your capital gain tax would still be $16,000.

It is in this area you must be extremely careful not to trap yourself with a regular sale. You are almost bound to exchange in a case like this unless you have the additional funds to pay the taxes. In larger transactions with larger dollars and leveraging, the situation only gets worse.

Related Info: equity, gain, capital, difference, closing, $100, example

Can I include jewelry as part the Replacement property purchase in a 1031 Exchange?

Sometimes you may find it necessary to pay for a 1031 Exchange Replacement Property in a form other than cash.  Be very careful here: KNOW WHAT YOU ARE SELLING. The name for what you use to purchase a Replacement Property is called boot. If you use anything other than the proceeds from your Relinquished property, it can be taxable.

Any boot you give (payment in part consideration of the Replacement Property) is treated as a straight sale of the boot. The tax-free provisions of §1031 do not apply to boot you transfer in the exchange. If you give money, no gain or loss to you is recognized on the money you give. However, if you give boot in property other than money, a gain or loss will be recognized. The transaction is treated as a sale of the unlike property and the regular gain and loss tax rules apply.

The gain or loss is the difference between your adjusted basis in the property and your amount realized. The fair market value is considered to be your amount realized. For example, as part of an exchange you give unlike property with a cost of $1,000. The fair market value of the property at the time of the exchange is $1,500. You will recognize a $500 gain.

If the personal property was business property (§1245), the gain would be treated as ordinary income to the extent of depreciation taken, and might be taxed as ordinary income.

If the sale of the personal property had resulted in a loss, the loss would be deductible as an ordinary loss since the nonrecognition of gain or loss provision of §1031 does not apply to unlike property.

Related Info: purchase, replacement, jewelry, include, loss, gain, boot, give, treated, sale

Is there a penalty if I switch my 1031 Exchange identified properties after the 45 day period?

The penalty is that your 1031 Exchange would collapse.  The IRS has said that you have 45 days to identify your replacement properties. Soon as that 45 day deadline is reached, your replacements are "locked-in", which means you cannot change them. The good news is that you do have the option of NOT closing sale on all your identified properties without penalty. But you do have to close on at least one of your identified properties. And remember, any remaining proceeds from your 1031 Exchange are subject to the capital gains tax.

Related Info: period, properties, identified, switch, penalty, sale, option, closing

I just sold my rental property. Is it too late to turn it into a 1031 Exchange?

Chances are, YES, it is too late to 1031 Exchange a property once that property has already sold, title has changed and you have access to the funds. Careful planning with your tax advisor is paramount. Next time you are planning to sell a business or investment property be sure to discuss it immediately with your tax advisor or contact your friendly 1031 Exchange Qualified Intermediary at 800-570-1031.  The 1031 Exchange rules were written by the IRS and designed to be easy to follow.

It should be noted that if you sell your property and have not yet taken title and haven't had access to the money, it is possible to contact your closing company and reverse your sale before the title changes. Your attorney can be off help in this situation as well.

Related Info: rental, title, access, advisor, planning, closing, money

Do you have to have a Qualified Intermediary for a 1031 Exchange?

One of the rules of 1031 Exchange is the necessity of Safe Harbor. Safe Harbor is the storing of your 1031 Exchange proceeds with protections from Constructive Receipt. If you are in direct control of your proceeds at any time during your 1031 Exchange period, you are in danger collapsing your 1031 Exchange and having to pay the capital gains tax on your sale in the same year, rather than defer the gains to some future date.  More information about Safe Harbors and why you need them for your 1031 Exchange can be found in our 1031 Exchange Knowledge base.

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How do I figure my 1031 Exchange Closing Costs?

Your Title/Escrow/Mortgage/Closing company can help you figure out your 1031 Exchange closing costs. Be sure to choose a Qualified Intermediary with competitive rates and secure funding. Check out our 1031 Exchange Fee Schedule for more information.

We also recommend that you remind your closer and real estate agent that  selling expenses can offset against boot received. Factoring in this offset is critical when the exchange is originated and in the planning stages. Selling expenses paid in connection with a §1031 exchange are treated as cash boot paid and offsets any boot received. Selling expenses include brokerage commissions and other closing costs such as title policy fees, escrow fees, and recording fees.

Related Info: costs, closing, figure, boot, fees, selling, expenses, offset

Does improved land for unimproved land qualify as a 1031 exchange?

Land, regardless of how it is zone, or whether it is improved or not, qualifies for like-kind treatment in a 1031 Exchange. 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. An example of investment real estate is raw land held for appreciation. 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. Additional reading can be found here.

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When does a 1031 Exchange become taxable?

1031 Exchange is a Yes/No question according to the IRS. Your 1031 Exchange will become a taxable property sale if you fail to follow the rules that were set down by the IRS over 20 years ago. Not following the following rules can force your 1031 Exchange to become a taxable property sale.

Selling a property that is not considered as Like-Kind.
Not using a 1031 Exchange Safe Harbor.
Withdrawing from your proceeds during 1031 Exchange Period.
Failing to Identify your replacements within the 45 day deadline.
Not closing sale on your replacements before the 180 day deadline.

These are just some of rules to follow, more can be discovered in our FREE 1031 Exchange Procedure Manual, which you can access by clicking here!

Related Info: taxable, rules, sale, replacements, deadline, following

How do I use the personal residence exclusion in my 1031 Exchange taxes?

If you make more than one sale during the 2-year period and claimed the exclusion on your tax return, and sell another primary residence within the 2-year period, you cannot exclude the gain from the second sale. You must include the gain in your income. However, there are exceptions to this rule.

If you sold the residence and did not meet the ownership and use tests, you may exclude a reduced amount if you sold the residence due to:

A change in your place of employment.
Unforeseen circumstances to be determined by the IRS.

The amount of exclusion is the ratio of the number of months you owned and lived in the primary residence multiplied by 24 months. For example, if you owned and lived in the property for 12 months, your ratio would be 12 months/24-months or 50 percent.

Related Info: taxes, exclusion, residence, personal, months, exclude, lived, owned, sale

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.

Related Info: person, participate, partnership, limited, partner, partners, split, shares, properties, entitythe, single

My place of business is also my residence, can I do a 1031 Exchange?

This is what we call a property with two classifications; each classification is subject to a different set of tax rules. The business portion of the property qualifies for 1031 exchange treatment - the personal residence portion does not. However, the personal residence portion of the property qualifies for the Section 121 250K/500K exclusion on the sale of a personal residence.

The allocation of basis values between the business and the residence portions has already been made on the client's tax return when the business property was set up for depreciation and the allocation for interest and real estate tax deductions.

An exchange sounds like your best bet since the entire property would be exchanged - the business portion would qualify for 1031 treatment - and even though the residence portion is a part of the exchange, since it does not qualify for 1031 treatment, it's treated as a sale and qualifies for the Section 121 exclusion. It's like having your cake and eating it too!

Related Info: residence, business, portion, personal, treatment, qualifies

1031 Exchange seems complicated. Is it?

Like a lot of things in life, it's only as complicated as you make it. In fact, the rules for 1031 exchange are actually quite simple. Owners of qualified 1031 Exchange properties, either investment real estate or business real estate, can defer the capital gains tax from a sale by exchanging their property for a like-kind property. The proceeds from the sale must be kept with a Qualified Intermediary.

What makes this difficult is the fact that some individuals try to circumvent the IRS's section 1031 Exchange rules by either trying to 1031 exchange a property that doesn't qualify or trying to tamper with their sale proceeds. The easiest and simplest way to conduct a 1031 Exchange is to understand the rules and keep your 1031 Exchange easy and simple.

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In a 1031 Exchange, can I have a gain even if I don't have any boot?

YES! Believe it or not. Many people don't know or even realize them, some pros may not know it as well.

It is possible, in a 1031 exchange, to recognize gain even if not one cent of boot is received! There’s a little-known rule that can cause you to trigger the entire recapture as ordinary income even if you do not recognize gain figured under the regular exchange rules. Recapture income will be recognized if the fair market value of the depreciable property you receive in the exchange is less than the income subject to recapture. The amount of gain recognized is limited to the difference between the depreciation subject to recapture and the value of the depreciable property.

Related Info: boot, gain, recapture, income, recognized, value, depreciable

After we close on my relinquished property, how soon can I access my proceeds.

Answer: As you qualified intermediary, we are holding your proceeds for one specific purpose, so that you can purchase a replacement property and complete your 1031 Exchange. We can give you proceeds back anytime you wish and for whatever purpose, but if the goal is  1031 Exchange, there are some IRS rules to follow.

1. You can take back proceeds, called "boot receivable" at the time your Relinquished Property closes. These funds are subject to Capital Gains and are deducted from your proceeds BEFORE they are transferred to your Qualified Intermediary.

2. Soon as you Identify your properties (within 45 days of the sale of your relinquished property), you have 180 days to close sale on them. The IRS states that you cannot access any of your proceeds until ALL of your identified properties have closed sale.

Any access to your proceeds during the 180 day period prior to closing on your identified replacement properties could negate your entire 1031 exchange, which means your entire proceeds could be subject to the Capital Gains Tax.

Related Info: proceeds, access, relinquished, sale, properties, identified

How many replacement properties can I have?

There are 3 rules:

The one most people use is the 3-Property Rule because they can identify 3 1031 Exchange Replacement Properties without regard to fair market values of the properties. You figure fair market value of Replacement Property as of the end of the identification period.

The next rule is the 200 percent rule which allows you to identify any number of properties as long as their total fair market value does not exceed 200 percent of the total fair market value of all Relinquished Properties. You figure fair market value of Relinquished Properties as of the date you transfer them.

The final rule is the 95 percent rule which allows you to identify any number of Replacement Properties if during the Exchange Period you actually received identified Replacement Properties having a fair market value equal to or more than 95 percent of the total fair market value of all identified Replacement Properties.
Beware of the 200 percent rule and the 95 percent rule. If you are choosing to follow these rules, we suggest you get help from your CPA or Tax Attorney. If they are not conducted properly as of the end of the identification period and you have identified more properties as replacement properties than permitted, you are treated as if no Replacement Property has been identified. Which means the IRS could decide that no 1031 Exchange occurred and you would end up paying the capital gains tax.
This is why most people follow the 3 property rule, it is easiest to understand with lessor risk.

Related Info: properties, replacement, rule, market, fair, value

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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In a 1031 Exchange, how do you define a personal residence?

Section 1031 Exchange and the related regulations make it very clear that real estate held for personal use cannot qualify for 1031 exchange treatment. But sometimes the residence gets involved in an exchange and it can get complicated.

The term primary residence refers to the place in which you principally reside. If you have more than one home, only your principal home qualifies as your primary residence.

Your primary residence includes the dwelling unit and the land it's located on. The land alone, however, is not a residence. If part of the land is sold, but not the dwelling unit, the land sold is not treated as the sale of a residence.

Related Info: residence, personal, define, land, primary, dwelling, home, includes

What if no depreciation recapture was taken on my 1031 exchange property?

Depreciation recapture is a factor that must be considered when you determine your capital gains tax and if you are considering an IRS 1031 Exchange. You add it the 15% tax on your Net Realized Gain (Adjusted sales price  minus Adjusted Basis). If you have taken NO depreciation during the time you owned your property, your Depreciation Recapture would be ZERO and you would just use the 15% tax on your Net Realized Gain to determine your Capital Gains Tax. Check it out for yourself on our FREE Capital Gain Tax Estimator, by clicking here.

Related Info: recapture, depreciation, capital, gain, adjusted, gains, realized

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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How do we 1031 Exchange our vacation home?

Vacation homes or your second home are tricky when it comes to 1031 Exchange. If they are not held as a rental they are classified as real estate held for personal use which does not qualify for 1031 Exchange. However, under the rules of §280, a dwelling unit held for both personal use and rental purposes must take a use test each tax year to determine its tax classification for that tax year:

The property is treated as real estate held primarily for personal use and treated as an asset not held for profit if the owner's personal use is more than 14 days or 10% of the total rental days, and the unit is rented for one day or more during the tax year. Does not qualify for §1031 treatment.

The property is treated as rental property if the owner's personal use is no more than 14 days or 10% of the rental days during the tax year and the property is rented more than 14 days during the tax year. May qualify for §1031 treatment.

Related Info: home, vacation, rental, personal, qualify, treated, estate, real

Can a 1031 Exchange be claimed on an amended return?

If you filed your tax return before the April tax filing deadline, you still have a chance to file your 1031 Exchange. The most important aspect of this issue is to consider the due dates surrounding your 1031 Exchange. You are expected to close sale on your final identified 1031 exchange replacement property on or before 180 days after you sold your relinquished property. However, if you closed on your relinquished property during late November or December, it is very possible that your 180 day deadline falls after the April tax filing deadline. You should know that your closing deadline IS the April tax filing deadline, regardless of when you actual 180 closing date is. If you want to realized all 180 days, you must file an extension with the IRS. So, if you filed your tax return before your April tax filing deadline and before your 180 day deadline, you may still have the option to claim your 1031 Exchange on an amended tax return. The best move is to discuss this with your CPA or tax preparer ASAP! You Tax Advisor is your best ally for this issue.

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Does the 1031 exchange have to be included in the purchase agreement?

Normally, in a 1031 Exchange, we encourage tax payers to use the following clause in their Purchase and Sale Agreements.

"Buyer hereby acknowledges it is the intention of Sellers to complete a deferred exchange and qualify for treatment under Internal Revenue Code Section 1031. This exchange will not delay the closing (of escrow) or cause additional expense to Buyer. Seller's rights and obligations under this agreement may be assigned to a Qualified Intermediary (as defined in IRS Regulation 1.1031(k)-1) of Seller's choice for the purpose of completing the exchange. Buyer agrees to cooperate with Seller and the Qualified Intermediary in a manner necessary to complete this exchange."

However, in situations where time is of the essence a suggested clause that the deal is a 1031 Exchange doesn't necessarily have to be included in the purchase and sale agreement. The Seller providing the Closing company with the documents necessary to convert the sale to an exchange (these are supplied by the Qualified Intermediary) is sufficient.

Related Info: agreement, purchase, included, sale, buyer, complete, seller, closing

My realtor told me that I am not a loud to use any of my proceeds before I purchase a Replacement Property. Is this true?

When you close sale on your Relinquished property the proceeds need to be kept in a safe harbor with a Qualified Intermediary (Realty Exchangers). During your exchange period your proceeds can ONLY be used to purchase qualified 1031 Exchange Replacement Properties. Any withdrawal of your funds could negate your 1031 Exchange when the IRS reviews your file.

You have two opportunities to access your proceeds and not jeopardize your exchange.

The first is when you close sale on your Relinquished property. At that time you make take a portion of the proceeds back for your own use. This called Boot Receivable and is subject to Capital Gains Tax. The remaining funds from your sale should be transferred as your proceeds into your Qualified Intermediary's (Realty Exchangers) client trust account.

The second is after you have closed sale on all of your Identified Replacement Properties before the 180 day deadline. These left-over proceeds are also subject to capital gains tax.

Related Info: replacement, purchase, proceeds, realtor, sale, funds, gains, capital

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