1031 Exchange FAQ
If my replacement property is a rental how long does it have to remain a rental before it can be converted into my primary residence without losing my §1031 exchange benefits?
There are no hard rules here. Just show IRS your intent to use your replacement property as a rental. Most of tax attorneys we talk to feel that if the property shows up as a rental on two or more consecutive tax returns you will have shown intent.
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Can I do an exchange out of an LLC and purchase the replacement property of which I am also a member of another LLC?
Chain of title requirements state that a property must pass from one entity to the same entity on the 1031 exchange property.
If ABC Company, LLC owns a piece of land and sells it for 1031 Exchange, ABC Company LLC must purchase the replacement property as ABC Company LLC. No exceptions. What this means for the shareholders of ABC is that individual partners cannot split out their shares and purchase something else...unless the individual partner names are listed in the title of the property being sold.
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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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I heard I can take back cash from my 1031 Exchange proceeds. Is that true?
There are two opportunities during your 1031 Exchange where you can take back cash without disrupting the flow of the exchange. The first opportunity is at the closing of your relinquished property. During this time you may take back cash before the proceeds are transferred to your QI's trust account. The other opportunity when you have closed sale on all of your Identified Replacement Properties.
HOWEVER. Please note! The liquid cash that you receive from your 1031 Exchange is called "Boot Received" and may be subject to the capital gains tax. Careful planning of "boot received" should be discussed at length with your CPA or tax attorney.
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I want to do a 1031 Exchange but don't understand why I cannot hold the funds in my bank?
The secret of a successful 1031 exchange is to avoid holding the money or other property during the transaction. If you receive cash proceeds during your 1031 exchange, you will not qualify for the capital gains deferment. While this sounds easy to avoid, it's not. 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 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 deferred 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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If I sell my 1031 Exchange relinquished property in 2010 and purchase my replacement property in 2011, what year do I send the IRS 8824 form?
That is a very common 1031 Exchange question for this time of year. Luckily, the IRS is very specific about this. You need to be sure to file your IRS Form 8824 for the same tax year that you sold your relinquished property. Also, be sure to discuss this at length with your CPA or Tax Attorney.
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Should I use 1031 Exchange to "flip" a property
Never. There are some 1031 Exchange "expert" bloggers out there who claim that there is precedence that shows people have purchased property with an intent for investment but turned around and "flipped" the property instead for profit. As a 20 year Qualified Intermediary, we have seen these types of schemes come and go.
It is commonly known that any property held "primarily for sale" or dealer property is not qualified for 1031 Exchange. Any attempts to create "wiggle" room on this statue is not serving your clients. What if you fail? Too much to risk, here.
While some may get away with it, we feel that claiming that it is possible to "flip" a 1031 property is confusing to most people. 1031 Exchanges are meant to be simple, easy and clear.
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Can a building with more than one shared interest qualify for 1031 exchange if part of the shared interest is already sold?
We are prevented from providing direct tax or legal advice. The answer to your question is probably yes, the un-sold portion of the partnership may qualify for 1031 Exchange. Make sure the property is deeded as un-divided interest for the remaining shareholders. Just make sure to discuss this in detail with your Tax Advisor or Attorney.
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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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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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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.
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I'm a Realtor and have clients who want to do a 1031 Exchange, what do I do?
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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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 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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My 1031 Exchange period ends tomorrow, how soon can I get my money back?
In a 1031 exchange you can receive unused proceeds anytime after you have acquired all of the properties identified in your 45-day identification time period. If you do not acquire all of the properties identified in the 45-day identification, then the unused proceeds cannot be released until the earlier of the due date of your tax return including extensions, or 180 days after the closing of the sale of the Relinquished Property. This is meant to protect you from Constructive Receipt of the money, which will cause your 1031 Exchange to collapse and prevent your from deferment of your capital gains tax.
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Can I 1031 Exchange for a replacement property with construction that isn't finished?
If at the end of your 180 day 1031 Exchange period, the replacement property is not completed, the builder can deed over the property "as is" (before the 180-days) and the cost of the property at that time will count as qualified property of like-kind. Any costs added after that date will count as boot received. If you are "trading up", then it is possible the cost at the time of transfer will be more than enough to qualify you for a full 1031 benefit. It's a matter of crunching the numbers and it's always a good practice to consult your CPA.
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Why is depreciation important to a 1031 exchange?
Depreciation is important in a 1031 Exchange because it is the amount of money you have taken off of your yearly taxes since you purchased the property. It is part of the formula for determining your basis when figuring out whether you will have capital gains on the sale or purchase of a property.
The depreciation recapture provisions of §1250 (real property) and §1245 (personal property) apply to 1031 Exchange as well as sales. These provisions require certain depreciation to be recaptured as ordinary income (instead of long-term capital gain) when the property is sold or exchanged and a gain is recognized.
If you exchange property subject to recapture, and no gain is recognized, the “recapture potential” of the Relinquished Property carries over to the Replacement Property.
If you exchange property subject to recapture, and gain is recognized because of boot taken, the ordinary income portion of the recognized gain is limited to the depreciation that would be recaptured as ordinary income if the property had been sold.
If you exchange property subject to depreciation recapture, and gain recognized because boot taken is less than depreciation that would be recaptured as ordinary income if the property had been sold, all the recognized gain will be taxed as ordinary income. The balance “recapture potential” carries over to the property acquired in the exchange.
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How much of 1031 exchange recognized gain is recapture?
In a 1031 Exchange your Realized Taxable Gain is always the Adjusted Basis of your property subtracted from the Adjusted Basis of your property. We determine adjusted basis by adding Capital Improvements and closing costs to your Original Sales Price, then subtracting the Depreciation you took from your property over time. The amount of Depreciation Recapture is always 25% of the total amount of Depreciation.
So if you took $10k in Depreciation, your Depreciation Recapture would be $2,500.
When add your Depreciation Recapture Amount to your Net Realized Gain you get your Total Capital Gains Tax due.
You can check your Capital Gains Tax due yourself! Just visit our Capital Gains Tax Estimator at http://www.realtyexchangers.com/estimatecapitalgains.php
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Are 1031 Exchange Qualified Intermediary Escrow Accounts safe?
The Safe Harbors required to conduct a 1031 Exchange insist that your 1031 Exchange proceeds are stored in an escrow account held by your Qualified Intermediary. It should be understood that not all QI accounts are created equal. Insist that your Qualified Intermediary pay to have every penny of your 1031 Exchange proceeds FDIC insured. Many banks only offer FDIC insurance for funds up to $250,000. Few banks over this coverage on amounts higher than $250k. Another safety measure is to request that your QI establish a Qualified Escrow Account with your money, which mean that no funds are accessed without your knowledge and consent signature. As your Qualified Intermediary Realty Exchangers takes the safety of your money seriously. Review our safety protocols by clicking here.
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Can I be my own Title/Closing/Escrow/Attorney/CPA in a 1031 Exchange?
It's true. In a 1031 Exchange situation, people often consider this option. Think about it. You could save so much money on the closing of your property if you didn't have to pay those annoying fees like Title insurance, Broker's fees, etc. You can write your own closing statements and report your sale to your county. The savings potential is tremendous!
One problem. RISK!
How do you know if you are buying property from the person who actually owns that property? I could write an offer to sell you my interest in the Empire state building for $100k on a paper napkin. How do you know if I own any part of the Empire State Building? And if you are dumb enough to take my offer, please let me know when you want to meet and be sure to bring the $100k in cash, small spendable bills, please.
Without a Title Search how are you going to know whether they own the property or not. Without Title insurance, how do you know if the property has any liens or mortgages against it. What if 10 years of property taxes are owed? What if you buy the property without this knowledge, without Title insurance, YOU would be liable for the liens. That's a risk we don't like very much.
Now that we are throwing a 1031 Exchange into the mix, we have a problem of something called constructive receipt. One of the first rules of 1031 Exchange is to avoid constructive receipt. Constructive Receipt, as it refers to 1031 Exchange, means that at some time during your 1031 Exchange period, you had active access to the 1031 exchange proceeds. If you are acting as your own Title Company, this means you have had control over the the proceeds which makes you in Constructive Receipt of the funds. Plus, you Closing company is supposed to be a third party, this is an IRS rule!
No. Acting your own Title Company is not a good idea. We recommend you follow the IRS rules, use your brain and hire a Title company to help you with your 1031 Exchange.
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What are the legal fees associated with a 1031 Exchange?
As with any sale of real estate, often tax payers will consult an attorney to facilitate the creation of a Purchase and Sale Agreement for their 1031 Exchange. The fees associated with paying at attorney varies, though most have standard rates. A simple phone call to your attorney can help with this question. There should be no other legal fees associated with your exchange unless you are having an attorney facilitate the closing of sale on the property. Again, this is a question for your attorney and a simple phone call should suffice.
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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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In a 1031 Exchange, if I take back cash as boot, is this considered income?
In a 1031 Exchange, any cash taken back from your sales proceeds is considered boot. The IRS wants you to re-invest these proceeds in your replacement property but since you are taking control over these proceeds, you are expected to pay taxes on them as capital gains and/or regular income. So the answer to this questions, is YES, cash as boot IS considered taxable income.
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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 bought a house in June 2010 and told the bank that it is for a primary residence. However, I have not lived in the house yet. Does it qualify for a 1031 exchange?
Hi there. Remember that a 1031 Exchange property must be an investment property, such as land or an income producing property such as a rental home. In order for you home to match the 1031 Criteria, you must show you collected rents from it for 2 tax periods. Some QI's tell customer that it is 2 years but this is not exactly correct. 2 tax periods are 2 tax periods, which means if you bought in June of 2009 by January of 2011, you can show you collected rents for 2 tax periods. The first tax period being part of 2009 and the second tax period being all of 2010. In general, please review our 1031 Exchange Knowledge Base for general information AND consult your CPA or Tax attorney for specifics pertaining to your local area. You can find local CPA's and Tax Attorneys on our web site at http://www.realtyexchangers.com/1031_Exchange/index.html
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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.
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In a 1031 Exchange, how many Replacement Properties can I have?
In a 1031 Exchange, you have 3 choices for determining how many Replacement Properties to Identify. These are the 3 Identification rules set down by the IRS for 1031 Exchange. You may choose which of these rules to follow at any time during the 45 day Identification period. One you have chosen which rule to follow, you may not change your mind after the 45 day deadline.
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 having a fair market value equal to or more than 95 percent of the total fair market value of all identified Replacement Properties.
Any Replacement Property received by you before the end of the identification period is treated as being properly identified under the Identification Rules.
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If I 1031 exchange into a rental, how long before I can live there?
It’s a matter of facts and circumstances. For example, at the time of the 1031 exchange, you have no intention of converting it to your primary residence. But an unforeseen event, not related to the exchange, takes place. Perhaps the death of a spouse. Or the rental turns out to be an unbearable negative cash flow situation. In such cases, you should have no problem supporting the like-kind exchange.
We recommend that you hold the Replacement Property for at least two years.
If you have any doubts or questions about the classification of either your Relinquished Property or Replacement Property, be sure to discuss it with both your tax professional and your real estate agent.
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I own my mom's house, never lived in it and want to 1031 Exchange it into something else, now that she is gone. Can I do this?
Answer: This is a very tricky scenario. Be sure to discuss this at length with your CPA and/or Tax Attorney. Be sure to put your situation to this test. Did you collect rents from your mother while she lived in the house? If not, the IRS could view your mother's place as a second home for you, though you never lived there. Be advised that only income producing property or investment property qualifies for 1031 Exchange Treatment. If you mom's home wasn't producing an income from rents (and these rents must be on par with average rents for the area, not say $1 dollar per month) then you would have a difficult time demonstrating that your mother's house was a 1031 Exchange property.
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