1031 Exchange FAQ - REPLACEMENT PROPERTY

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Common 1031 Exchange Questions

Does my condo qualify for 1031 Exchange?

It's my understanding that a 1031 exchange must be "In-Kind". Is that true?

What is a 1031 Exchange Bank Escrow Agreement?

Can I do a 1031 Exchange in Guam?

Can I 1031 Exchange a business?

What if I can't find a replacement property during the 1031 exchange 45 day identification period?

Yes. This is a risk. The IRS gives you 45 days after you close sale on your Relinquished Property to officially Identify the properties that you intend to purchase or replace your relinquished property with. Some people already have a replacement property in mind before they close BUT this is not a necessity. You DO NOT have to have a replacement property in mind before you close on your relinquished property. Many clients use the entire 45 days to identify their replacements and as your IRS 1031 Exchange Qualified Intermediary, Realty Exchangers will provide you with the necessary Identification Form that you use to show the IRS that you property Identified your Replacement Properties.

We also have a number of resources on our web site that can help you find your Replacement Property, be sure to check out the Exchanger's Clearinghouse and our 1031 Exchange Professionals Directory that will help you find a local 1031 pro.

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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.

Related Info: rental, losing, benefits, residence, converted, remain, intent, consecutive, returns, shown, shows


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.

Related Info: replacement, purchase, deposit, money, earnest, funds, transaction, time, closing


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


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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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 we separate a house, which we plan to live in, 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, live, plan, house, residence, land, remaining, nominal, acreage, investment


What if my 1031 Exchange Replacement Property has a mortgage?

A 1031 Exchange for a mortgaged property is common, though there are some issues you should consider:

We all know that mortgages are paid at the time of closing.  Any xcess is treated as "boot paid" which is subject to this rule:

Mortgage boot paid offsets mortgage boot received but does not offset cash or unlike property boot received.

Negative mortgage relief counts as boot paid and adds to the basis of Replacement Property. Knowing how this treatment could affect your exchange is essential in your tax planning.

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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.

Related Info: money, over, replacement, closed, advisor, funds, opportunities, discuss, dollars, left-overs


The seller of my 1031 Exchange Replacement Property wants an Earnest Money Deposit. What do I do?

Treat the purchase of your 1031 Exchange Replacement Property as a regular sale and if the seller requires an Earnest Money Deposit, use funds from your own bank account. DO NOT use any of your protected 1031 Exchange Proceeds for an Earnest Money Deposit.  The reason for this is because what if the deal falls through? You would be in constructive receipt of your funds, which would negate your 1031 Exchange. Better to use your own money, then have the Closing company refund you your deposit after the sale closes.

Related Info: money, deposit, earnest, wants, replacement, seller, sale, funds, receipt


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.

Related Info: member, replacement, purchase, company, title, individual, entity, split


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


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.

Related Info: replacement, ratio, equity, debt, properties, numbers, ratios, multiple, figuring


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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Soon as I buy my 1031 Exchange Replacement Property, how long do I have to hold it before I can 1031 exchange it again?

The IRS code and 1031 exchange regulations are silent on the issue of time held. You must be able to show and take the position that the decision to exchange after your acquisition was not related to or a contingent part of the original acquisition. In other words, if there is any written evidence what-so-ever such as agreements, deposits or any other record showing intent to exchange the property once acquired, the proposed exchange of the property is dead - there is no way to qualify property acquired for resale.

To help, here is an excerpt from our 1031 exchange book. Notice in the example, the taxpayer attempted to qualify the property by holding it for a period of time as rental income property. The option was fatal to the exchange since it recorded the taxpayer's mind and intent at the time of the exchange. Even though the circumstances are somewhat different, the same rules still apply.

The step transaction doctrine embodies a general requirement that all steps, which are an integral part of the exchange, will be considered in determining the proper tax treatment for the exchange. The step doctrine may be applied by the IRS if

there was a pre-existing binding commitment to take each of the steps at the time the transaction was commenced, and
the steps were functionally interdependent in the sense the earlier step would have been unproductive without the later steps.

The step transaction doctrine may also apply if all the steps, although functionally independent, were contemplated at the outset of the 1031 exchange.

Example: You find a choice apartment house property for sale. You know of a buyer who would be willing to pay top dollar for the property. You decide to acquire the property and sell the buyer a two-year option to buy the property. In the meantime you will operate it as a rental income property. You currently own a commercial property you want to sell now but your accountant advises you need another capital gain this year like you need a hole in your head.

You enter into an exchange agreement to sell your commercial property and acquire the choice apartment house with the plan of selling the option, operating the property until the option is exercised, and taking your total gain in that taxable year.

The exchange will be disallowed and treated as a sale. Not only does the step transaction doctrine apply and collapse the exchange but also the act of selling the option at time of acquisition reclassifies the rental property as real estate held for sale in the ordinary course of business.

Related Info: replacement, time, option, steps, doctrine, transaction, sale


I was told I have to claim my 1031 replacement property the same day I sell my property. Is that right?

If by claim you mean identify your 1031 exchange replacements when you sell your relinquished property, no this is not true. When you sell your property you have 45 days to identify your replacements. You do not have identify your replacements on the same day you sell your property, though some people have done it that way, this is not a necessity.

If by claim you mean purchase your replacements when you sell your property, you don't have to do that either, though some customers have found it advantageous to do so.

Related Info: replacement, claim, replacements, identify, found, advantageous, customers


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.

Related Info: replacement, improvements, proceeds, purchase, house, owner, payment, home


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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I have a 1031 Exchange property that I want to sell and I want to purchase one in the same day. Is this possible?n

Answer: Very good question. What you are talking about is a "simultaneous exchange". In order for a 1031 Exchange to happen, the exchanger needs to prove to the IRS that the proceeds from their sale were out of their immediate control. This is very difficult to do in the same day. The process is that when your sale closes, the proceeds get wired to our FDIC insured Client Trust account. You may access your proceeds immediately to fund purchase of a replacement but due to the nature of our federal wire system, we can make no guarantee that you funds will be available on the same day. We have had many Replacement Property closings happen in the same week, or the next day, but rarely have we seen them happen on the same day. These are possible but discouraged as you never want to complicate something that should be simple.

Related Info: possiblen, purchase, proceeds, sale, replacement, wire, system, nature


Frequently Asked 1031 Exchange Question

Question: I have a 1031 Exchange property that I want to sell and I want to purchase one in the same day. Is this possible?

Answer: Very good question. What you are talking about is a "simultaneous exchange". In order for a 1031 Exchange to happen, the exchanger needs to prove to the IRS that the proceeds from their sale were out of their immediate control. This is very difficult to do in the same day. The process is that when your sale closes, the proceeds get wired to our FDIC insured Client Trust account. You may access your proceeds immediately to fund purchase of a replacement but do to the nature of our federal wire system, we can make no guarantee that you funds will be available on the same day. We have had many Replacement Property closings happen in the same week, or the next day, but rarely have we seen them happen on the same day. it

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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






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