1031 Exchange FAQ
What the heck is the 1031 exchange "napkin test?"
Old time 1031 Exchange gurus use the term "napkin test" to describe the basic rule that all cash proceeds from the sale of the Relinquished Property must be “reinvested” in the Replacement Property to avoid recognized taxable gain from the exchange. If you trade up, and all the cash is “reinvested”, no taxable boot. But if you trade down, and all the cash is not “reinvested”, the net cash back to you is treated as cash boot received and recognized as taxable gain.
However, there is an adjustment to cash boot received not realized by many 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. This means you can trade down by the amount of your selling expenses paid and still have no recognized gain. Here is an example of this vital tax-planning tool.
You sell your Relinquished Property and the cash proceeds total $135,000. Your selling expenses total $32,000 of which you paid $10,000 outside of escrow. The balance of the selling expenses or $22,000 was paid through escrow and the net proceeds of $113,000 are paid into your QI’s trust account. At this point, your net cash boot received is $103,000 and this is the amount you need to “reinvest” to avoid net boot received and taxable income.
Selling Expenses are all expenses directly related to the sale of the Relinquished Property and is the amount used by IRS to deduct from the Selling Price to figure the Adjusted Sales Price. Selling expenses do not include interest, points, taxes, fixing up expenses, repairs, insurance, operating expenses of the property, personal bills or impound account adjustments. Occasionally selling expenses are paid outside of escrow. For example, a consulting fee paid in connection with the transaction may qualify as a selling expense. Be sure to check with your tax professional if you have any questions regarding your particular selling expenses. See Chapter Four for more discussion of this important topic.
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Can you do a sec 1031 exchange with your second residence?
Your second residence is considered just like your first residence. It is classified as Real Estate held for personal use, which is NOT considered a like-kind property and thereby does NOT quality for 1031 Exchange treatment. If you treat your second residence as a vacation rental there is potential for getting 1031 Exchange treatment, though as usual, there are additional rules to follow. The best thing to do is read more about it. For additional information regarding 1031 Exchange and your personal residence, click here. If you want information about 1031 Exchange and a Vacation Rental, click here.
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Why does the Qualified Intermediary have to hold the proceeds from my 1031 Exchange? Why can't my Title Escrow Company?
The biggest issue here is to avoid "constructive receipt" of your proceeds, which is why you should NOT keep money or other property during the transaction. If you receive the entire cash proceeds from your 1031 Exchange or are in control of those funds in any way, you will not qualify for §1031 treatment. You must overcome the doctrine of " constructive" receipt. The general rules concerning actual and constructive receipt apply to determine if you are in actual or constructive receipt of money or other property before you actually receive like-kind Replacement Property.
You are in actual receipt of money or property at the time you actually receive the money or property. You are also treated as being in receipt if you receive the economic benefit of the money or property. You are in constructive receipt of money or property at the time the money or property is credited to your account, set apart for you, or otherwise made available to you so you may draw upon it at any time. Or if you can draw upon it if notice of intention to withdraw is given. In addition, actual or constructive receipt of money or property by your agent is actual or constructive receipt by you.
The 1031 exchange Regulation provides a "safe harbor" that permits you to sell your Relinquished Property and acquire Replacement Property and avoid constructive receipt. This safe harbor is your written contractual agreement with a Qualified Intermediary.
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The guy building my 1031 Exchange property wants to include his paving services as part of the exchange. Will that work?
Be very careful not to get caught in a 1031 exchange for services trap. The transfer of Relinquished Property won't qualify for §1031 treatment if it's transferred in exchange for services. This includes all production services. You will need to write up and itemize his services in a separate contract. Be sure to discuss the tax rate for those services with you CPA or tax advisor as there may be actionable tax items here.
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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.
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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 want to 1031 Exchange land for a "park" model in an RV park for use as a vacation rental. Can I do this?
You need to check with your specific state and and find out if the "park" model is classified and treated as real property (not personal property) in the state where it is located. Many states treat it this way, some do not. If you can get the real property classification from the state, a 1031 Exchange should be permitted by the IRS as you would be exchanging like-kind property.
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I did a 1031 Exchange back in 2003 and am selling the property soon. Will I have to pay capital gain on the sale if I don't buy another property?
1031 Exchange, tax-deferred exchange, real estate exchange, like-kind exchange, IRS section 1031 Exchange....these all mean the same thing and are a vehicle for deferring the capital gains on an investment property or business property until your next sale. A common mistake that people make is with a 1031, they think they will NEVER have to pay their capital gains tax. Some tax pros and Qualified Intermediaries advertise this. This is far from true. Yes, you can continue to defer your capital gain if you continue to purchase real estate that is of a qualifying like-kind. But if you "cash-out" a property, those proceeds are subject to capital gains. Discuss this with your CPA to determine how much your capital gains would be and see if there are other strategies available.
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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.
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Do you have any examples of a 3-cornered 1031 exchange?
Earlene T. Barker, 1980 74 TC 555 is a good example and road map to follow in structuring a three-cornered 1031 exchange through a fourth-party escrow holder. Under a series of interrelated contracts, fourth party (the accommodator) took title and received payments for all properties, then transferred title and cash among parties to carry out the exchange.
Under escrow agreements, successful closing of each transaction depended on successful closing of all others. This integrated agreement, and the fact that Barker had no option or right to take cash, guaranteed nonrecognition of gain under §1031.
In Joyce M. Allen, the taxpayers' attempted three-corner exchange did not qualify for nonrecognition of gain under §1031. The transaction was held to be a sale and a purchase. The two transactions were only related by the fact that proceeds from sale of one property were used to buy the other property. The court held the transfers of property were not steps in an integrated transaction and nothing in the records indicated the successful completion of either transaction was a condition of the other. If Allen's purchase escrow had failed, she would have ended up with the proceeds from the sale of her property.
Tax Case: In computing “boot” on three-cornered realty exchange, transferor's receipt of cash to satisfy mortgage on property she transferred was offset by larger mortgage on property she received in exchange. Fact that cash was paid into escrow and mortgage was paid off before transfer was completed didn't bar “netting” of liability discharged against liability assumed. In effect, transferor was merely conduit for funds.Comm. v. North Shore Bus Co., Inc., 32 AFTR 931, 143 F.sd 114 (sd. Cir., 1944) followed.
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What if I die before I complete a 1031 Exchange?
Though tragic, this does happen. Death and taxes are two facts of life that we all want to avoid. If you die during your 1031 Exchange Period, which is time after your sell your property and before you purchase your last replacement property, there are provisions. Your estate and heirs are giving certain Title Considerations which allow them to complete your 1031 Exchange in the event of your death.
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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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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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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.
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In a 1031 Exchange, why isn't Book Value considered over Fair Market Value?
1031 Exchange is always based on Fair Market Value as this is how the rule was written by the IRS. There is not mention of Book Value in the statute. Also, who's book are we talking about? There could be several books published with their own value. Book value has either little or no meaning to some people, OR is lots of meaning to some people. Problem is, Book Value is determined by factors other that what is commonly accepted as Fair Market Value.
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If I close sale close before the 45 day deadline, do I still have to identify?
No. Because you closed sale on your Replacement Property before the 45 day Identification period is over, any Replacement Property received by you before the end of the identification period is treated as being properly identified under the Identification Rules. Some tax payers find this advantageous making the whole process quick and easy.
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Can I 1031 Exchange vacant land that I intend to sell later on?
Vacant land can qualify as real estate held for investment at the time of the 1031 exchange even though you might sell it two years later. Of course, you might not. That's why land held for investment but with the possibility of developing it or selling it years later is treated as land held for investment until when and if something happens to change its classification. However, one taxpayer acquired real estate and immediately sold a two-year option to sell it to a prospective buyer. IRS said no exchange because the land was held for sale right at the start. You need to be very careful with any property that you intend to sell right away. Intent to sell a property quickly can get that property classified as Dealer property which does not qualify for IRS 1031 exchange.
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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%.
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Can I take Earnest Money from my sales proceeds?
No. Your sales proceeds may ONLY be used to purchase 1031 Exchange replacement properties. The best option is to use your own funds for Earnest Money deposits and then get these back at the time of closing.
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Are the selling expenses I paid for my 1031 exchange considered boot?
Many real estate agents and investors when working out the numbers for their real estate exchange often overlook selling expenses as an 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.
If you receive no cash or property boot in the exchange, but you have net mortgage relief, you may offset sales expenses paid against your net mortgage relief. If the offset creates a “loss”, the Code bars any deduction.
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My father is selling his farm and purchasing another one out of state. He wants to add my name to the new purchase when he does the 1031 exchange. My name was never on the current property. Can he do this at the time of the exchange or does he has to wait a certain amount of time?
You cannot change the title names during a 1031 Exchange. Better to Quit Claim Deed AFTER the exchange is completed. Please contact us for 1031 Exchange Qualified Intermediary services. We charge $295 to sell your property and $200 to purchase another.
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Can I 1031 Exchange a property that I've owned for less than a year?
This question usually comes from people who have bought a rental house and want to know how soon before they can 1031 Exchange it again, or someone has purchased some land and wants to know the same thing. First of all, when you want to sell a like-kind property, the only protection you have from it being considered a Dealer Property (property primarily for sale to customers) is time. The longer you hold a property the better chance you have of selling it as a 1031 Exchange. So that rental house you purchased can be considered a Dealer Property if you try to sell it as a 1031 Exchange for less than a year. As a rule of thumb, to prevent being classified a dealer property, it is best to hold your rental house for at least 2 tax periods and collects during that time.
The other like-kind classification pertains to land, or real estate held for investment purposes. It is much easier to 1031 Exchange land that you have held for less than a year because land is always purchased with the intent that it will appreciate in value. So, you could 1031 Exchange your land for a like-kind property after holding it for less than a year.
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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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1031 exchange, can money in escrow be transferred to another escrow account for property deposit?
We've had this question before where a customer is wondering if the 1031 Exchange Proceeds can be held in an escrow account with their title company rather than be transferred to Qualified Intermediary. This is an issue of Constructive Receipt. Constructive Receipt is where you have direct control over your 1031 Exchange funds. This is something you want to avoid at all costs because if the IRS discovers that you had Constructive Receipt of your 1031 Exchange proceeds, they will rule that your Exchange was actually a sale and you could be subject to capital gains tax. So, in order to defer your capital gains tax, should use the Safe Habor rule recommended by the IRS. Safe Harbor is a dis-interested 3rd party, while acting on your behalf and under your direction, has complete control over the proceeds. Safe Harbor is your Qualified Intermediary.
Having your 1031 Exchange proceeds held in an escrow account under the direction of your closing company is not using the Safe Harbor rule, which puts you in direct control over the money and puts you in Constructive Receipt of the funds. If you ever have Constructive Receipt, you have no 1031 Exchange.
If your funds are held in a Safe Harbor, then you cannot transfer them to another escrow account as an earnest money deposit. They can only be used for the direct purchase. Better to use your own funds for this purpose and get them back from the closing company after the sale closes.
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How easy is it to sell my commercial building and 1031 exchange into smaller office complex?
You could structure your transaction to qualify for 1031 exchange treatment depending on the cost of the Replacement Property (Office Complex).
You have 3 options when it comes to purchasing your replacement properties;
The 3-Property Rule
The maximum number of replacement properties you may identify is three properties without regard to fair market values of the properties.
The 200 Percent Rule
You may 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 Replacement Property as of the end of the identification period. You figure fair market value of Relinquished Properties as of the date you transfer them.
If, as of the end of the identification period, you have identified more properties as replacement properties than permitted, you are treated as if no Replacement Property has been identified.
The 95 Percent Rule
You may identify any number of Replacement Properties if during the Exchange Period you actually received identified Replacement Properties
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How do I value property for a 1031 Exchange?
When choosing your 1031 Exchange Replacement Property we use Fair Market value to determine which of the 3 replacement property rules to follow.
Fair Market value is determined by checking similar properties on the market in the same area. This is really when an experience Realtor earns their keep. Realtors have access market information that isn't as readily available to everyone and can give you a good estimate as to the Fair Market Value of your property.
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How much does a 1031 Exchange cost?
Qualified Intermediaries charge anywhere from $300 to $3000 per 1031 exchange. Like most industries the prices are market driven, when demand is high prices go up, and the reverse when demand goes down. Realty Exchangers is a 20-year Qualified Intermediary for IRS 1031 Exchange. Our prices have always been in balance with current market conditions. Our company charges fees for each closing on a 1031 Exchange. When you sell your Relinquished Property (the property you intend to sell), we charge $295 for the documents required to close this sale. Then, when you are ready to close on your 1031 Exchange Replacement Properties, Realty Exchangers charges $200 for the documents necessary to each closing.
So a complete 1031 Exchange, with one property sold and one property bought is $495.
The prices given in this posting are subject to change. Please visit our Fees page for current pricing on our 1031 Exchanges.
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When my qualified Intermediary holds my funds, how safe are they?
Given todays economic climate, we can think of no better question to ask. You should know that as your 1031 Exchange Qualified Intermediary, Realty Exchangers takes the safety and security of your funds very seriously.
For over 20 years now the safety of client proceeds has been of prime importance to us and here's what we've done about it.
The two most important areas of concern are:
1. The Bank where client funds are deposited.
2. The Qualified Intermediary.
1.) The Bank: Although our bank is considered strong and very well capitalized the only real safety for bank accounts today is "FDIC" (Federal Deposit Insurance Corporation) insurance. Our bank, Riverview Community Bank of Vancouver Washington, has qualified for the FDIC's Transaction Account Guarantee Program and ALL OF REALTY EXCHANGERS ACCOUNTS ARE "FDIC" INSURED. Unlike previous "FDIC" insurance there is no upper limit on the amount.
2.) The Qualified Intermediary: Our company is Licensed, Insured, and Bonded but the only real protection is a QUALIFIED ESCROW AGREEMENT. This is a separate signed agreement between you, us, and the bank, which requires you to approve in writing any withdrawal of your 1031 funds. At the same time it keeps control of the 1031 funds with Realty Exchangers, Inc. thereby meeting the IRS's §1031 requirements (see note below). Unless otherwise requested ALL EXCHANGE ACCOUNTS WILL NOW INCLUDE A QUALIFIED ESCROW AGREEMENT.
Note: The Qualified Escrow Agreement is signed by all parties at the time of closing of the relinquished property. When the 1031 funds are wired into Realty Exchangers account the bank places a hold on the account. Then when the exchanger is ready to close on the replacement property a form is signed by the exchanger (you) that authorizes the bank to release the specified amount to that escrow as requested by Realty Exchangers wiring instructions. Quite simply, the exchanger will have to authorize any use of their 1031 funds.
We want you to feel secure and able to devote your full attention to the structure and completion of your 1031 exchange knowing that your funds will be there when you need them.
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In a 1031 Exchange, what is the difference between land held for sale and land held for investment?
When you purchase land, it is difficult to prove that you purchased it with the intent to sell it, as the nature of a land purchase is to hold it for investment because most all land will continue to go up in value. In a 1031 Exchange, the two types of Real Estate that qualify for tax deferment is Real Estate held for investment or Real Estate held for a business or trade, as these types of property are considered like-kind, according to the IRS. Perhaps you have heard of the term, property held for sale. Don't confuse this term for land. Typically, property held for sale (or dealer property), refers to property purchased with the intent to "flip" for a quick buck. The IRS has taken steps to prevent these type of property from 1031 Exchange and they shouldn't be confused with land.
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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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