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Real Estate Exchanges under Irc §1031
Considering a 1031 Exchange?
The Law Office of Andrew R. McKinney offers a wide range of Qualified Intermediary services. We can handle any type of 1031 tax exchange transaction nationwide.
The sale of real estate can create a large tax liability, but if the real estate is being held for productive use and investment, a properly structured tax deferred exchange under Internal Revenue Code §1031 allows businesses and individuals to defer the recognition of capital gains and other taxes associated with the sale, as long as the relinquished property is replaced with qualifying real estate.
By utilizing a 1031 Exchange, businesses and individuals are able to maximize their capital by deferring taxes that would otherwise be incurred on an outright sale of their property and use the entire amount of the equity from the 1031 Exchange to acquire substantially more replacement property. Properly structured, a 1031 Exchange becomes an invaluable tax savings and wealth preservation tool. For more information regarding a 1031 Exchange and how to property structure your next transaction, please contact our office.
The Basics
Exchange Cooperation Clauses
Delayed 1031 Exchange – Timelines, Deadlines and Identification
Tax Deferred Exchange Terminology
Adding language to your real estate contract is important to reserve your ability to complete the exchange without interference.
Tax Deferred Exchange Terminology
Delayed 1031 Exchange – Timelines, Deadlines and Identification
Tax Deferred Exchange Terminology
As with any other specific area of law, tax deferred exchanges under IRC §1031 have their own language, which may be confusing to those who are unfamiliar with these transactions.
Delayed 1031 Exchange – Timelines, Deadlines and Identification
Delayed 1031 Exchange – Timelines, Deadlines and Identification
Delayed 1031 Exchange – Timelines, Deadlines and Identification
The most common type of exchange is referred to as a delayed exchange, although both transactions can be processed on the same day.
Exchange Cooperation Clauses
Relinquished Property Sale Contract
"Buyer hereby acknowledges that it is the intent of Seller to effect an IRC §1031 tax deferred exchange, which will not delay the closing or cause additional expense to Buyer. Seller’s rights under this agreement may be assigned to The Law Office of Andrew R. McKinney, P.C., a Qualified Intermediary, for the purpose of completing such an exchange. Buyer agrees to cooperate with Seller and Qualified Intermediary in a manner necessary to complete the exchange.”
Replacement Property Purchase Contract
"Seller hereby acknowledges that it is the intent of Buyer to effect an IRC §1031 tax deferred exchange, which will not delay the closing or cause additional expense to Seller. Buyer’s rights under this agreement may be assigned to The Law Office of Andrew R. McKinney, P.C., as Qualified Intermediary, for the purpose of completing such an exchange. Seller agrees to cooperate with Buyer and Qualified Intermediary in a manner necessary to complete the exchange.”
Tax Deferred Exchange Terminology
As with any other specific area of law, tax deferred exchanges under IRC §1031 have their own language, which may be confusing to those who are unfamiliar with these transactions. The following are some of the exchange terms and phrases that are often used with their “plain-English” interpretations.
Basis (Adjusted Basis): The amount paid for a property taking into consideration added value for capital improvements and decreased by the amount of depreciation taken (or allowable); it is the value of a property for tax purposes.
Boot: The fair market value of any non-qualified property received in an exchange. While receipt of boot will not necessarily disqualify the exchange, an Exchanger who receives boot in an exchange transaction generally recognizes gain to the extent of the value of the boot received. Some common examples of boot are: cash, debt relief that is not offset with new debt, property intended for personal use, and property which is not like-kind to the Relinquished Property.
Constructive Receipt: A term referring to the control or ability to receive proceeds by an Exchanger even though funds may not be directly in the Exchanger’s possession.
Exchange Accommodation Titleholder: The person or entity used to facilitate a “reverse” or “improvement” exchange The Exchange Accommodation Titleholder (EAT) will hold (park) title to either the Relinquished or the Replacement Property during the exchange.
Exchange Period: The period during which the Exchanger must acquire Replacement Property in the exchange. The Exchange Period starts on the date the Exchanger transfers the first Relinquished Property and ends on the earlier of the 180th day thereafter or the due date (including extensions) for filing the Exchanger’s tax return for the year of the Relinquished Property transfer.
Exchanger or Taxpayer: The property owner seeking to defer capital gain, recapture or other income tax by utilizing a IRC §1031 exchange.
Forward Exchange: The most common form of exchange transaction in which the exchange begins with the sale of the Relinquished Property to a buyer and concludes with purchase of Replacement Property from a seller (typically a third party).
Identification Period: The period during which the Exchanger must identify Replacement Property in the exchange. The Identification Period starts on the day the Exchanger transfers the first Relinquished Property and ends at midnight on the 45th day thereafter.
Improvement Exchange: An exchange in which improvements are made to the Replacement Property prior to acquisition by the Exchanger, either using exchange funds or funds lent by the Exchanger (or lender) to the Exchange Accommodation Titleholder.
Like-Kind Property: Properties having the same or similar nature or character, regardless of differences in grade or quality. Generally, all real property located within the United States is considered to be “like-kind” to all other U.S. real property as long as the Exchanger’s intent is to hold the properties as an investment or for productive use in a trade or business.
Qualified Intermediary: The person or entity that facilitates the exchange for the Exchanger. Although the Treasury Regulations use the term “Qualified Intermediary,” other common terms are “exchange facilitator” or “exchange accommodator”. To be a Qualified Intermediary, the exchange facilitator must meet certain criteria spelled out in Treas. Reg. 1.1031(k)-1(g)(4).
Realized Gain: The amount realized from the sale of property which is potentially subject to tax; it equals the gross sales price minus the closing costs minus the adjusted basis.
Recognized Gain: The amount of the realized gain that is subject to tax. In a taxable sale (no 1031 exchange) the realized gain is all recognized. In a fully deferred 1031 exchange, no gain is recognized; the realized gain is deferred.
Relinquished Property: The “old” property divested (sold) by the Exchanger.
Replacement Property: The “new” property acquired (purchased) by the Exchanger.
Reverse Exchange: An exchange involving an Exchange Accommodation Titleholder (EAT) when it is necessary for the Replacement Property to be acquired before the Relinquished Property can be sold to a Buyer, or when improvements must be made to the Replacement Property before it can be acquired by the Exchanger.
Delayed 1031 Exchange – Timelines, Deadlines and Identificat
The most common exchange structure is the delayed “forward” exchange in which the Relinquished Property is sold, the proceeds (Exchange Funds) are delivered to the Qualified Intermediary and are subsequently used to acquire Replacement Property from a third-party seller. Two critical requirements in a delayed exchange are that the Replacement Property must be properly identified within the Identification Period and acquired before the end of the Exchange Period. IRC §1031(a)(3); Treas. Regs. §1.1031(k)-1(b)-(e). Following these regulations and time frames for exchange identification and deadlines is imperative for investors.
There are two key deadlines that the Exchanger must meet to have a valid exchange:
- Identification Period: Within 45 calendar days of the transfer of the first Relinquished Property, the Exchanger must identify the Replacement Property to be acquired.
- Exchange Period: The Exchanger must receive the Replacement Property within the earlier of 180 calendar days after the date on which the Exchanger transferred the first Relinquished Property, or the due date (including extensions) for the Exchanger’s tax return for the tax year in which the transfer of the first Relinquished Property occurs.
- The time periods for the 45-day Identification Period and the 180-day Exchange Period are very strict and cannot be extended even if the 45th day or 180th day falls on a Saturday, Sunday or legal holiday. They may, however, be extended by up to 120 days if the Exchanger qualifies for a disaster extension under Rev. Proc. 2007-56.
Replacement Property must be identified within the Identification Period by at least one of the following methods:
- Completed the purchase of the Replacement Property within the Identification Period; or
- Identified in a written document (Identification Notice), signed by the Exchanger, and delivered prior to the end of the Identification Period (by midnight of the 45th day), to the Qualified Intermediary or other permissible party to the exchange that is not a “disqualified person” or agent of the Exchanger. Treas. Reg. §1.1031(k)-1(c). Other allowable recipients of the Identification Notice include the seller of the Replacement Property or the settlement agent. Delivery to the Exchanger’s attorney or broker would not qualify as these parties are agents of the Exchanger. Best practice is to send the Identification Notice to the Qualified Intermediary prior to close of business on the last business day prior to the end of the Identification Period, so that the Exchanger can confirm timely delivery and receipt.
Requirements for a Proper Identification Notice:
- Must include a specific and unambiguous description of the Replacement Property
- Must be signed by the Exchanger
- For real property, the Identification Notice must include
a) the legal description,
b) a street address, or
c) a distinguishable name (i.e. “Empire State Building”) - For property to be produced, such as raw land to be acquired after improvements have been constructed, the Identification Notice should include a description of the underlying real estate and as much detail regarding the improvements as is practical, for example, 100 S. Main St., Gotham City, IL, improved with a 6 unit apartment building.
- When identifying Replacement Property, it is not necessary to separately identify any incidental property included in the purchase that has a value of less than 15% of the total value of the Replacement Property and that is typically transferred with the larger asset. This does not change the rule that only like kind properties qualify for exchange treatment. The value of the non like-kind property may not be attributed to the identified Replacement Property for purposes of deferring gain. For example, Relinquished Property is a rental house valued at $200,000, with $195,000 allocated to real estate and $5,000 allocated to appliances. If the sole Replacement Property is a rental condominium unit valued at $200,000, with $190,000 allocated to real estate and $10,000 allocated to appliances, the Exchanger would recognize $5,000 of boot, notwithstanding that only the condominium unit needs to be identified, and it is not necessary to separately identify the appliances. For purposes of the Three Property Rule, the condominium unit and appliances are treated together as one identified property.
- An identification of Replacement Property may be revoked prior to the end of the Identification Period. The revocation must be in writing, signed by the Exchanger and delivered to the same person to whom the original Identification Notice was sent. No changes or revocations may be made to the Identification Notice after the end of the Identification Period.
Exchangers have flexibility to identify multiple and alternate Replacement Properties.
A taxpayer may identify new properties utilizing one of two rules. There is also an exception to the two rules. But for ease of discussion, let’s say there are three identification rules. They are mutually exclusive, so a taxpayer may only use one rule at a time.
- Three Property Rule: The Exchanger may identify as potential Replacement Property any three properties, without regard to their fair market value.
- 200% Rule: The Exchanger may identify as potential Replacement Property any number of properties, provided the aggregate fair market value (as of the end of the Identification Period) of all of the identified properties does not exceed 200% of the aggregate fair market value of all of the Relinquished Properties.
- 95% Exception: If the Exchanger identifies more potential Replacement Properties than allowed under either the Three Property or the 200% Rules, the Exchanger will be treated as if no Replacement Property was identified. However, this does not apply with respect to any Replacement Property received before the end of the Identification Period and any properly identified Replacement Property received by the end of the Exchange Period if worth at least 95% of the aggregate fair market value of all of the identified Replacement Properties. Treas. Reg. 1.1031(k)-1(c)(4)(ii). For this purpose, fair market value of the aggregate Replacement Property is determined as of the earlier of the date the property is received by the Exchanger or the last day of the Exchange Period.
Disaster Relief Deadline Extensions
Revenue Procedure 2018-58 permits extensions of the IRC §1031 45-day Identification Period and 180-day Exchange Period deadlines to certain taxpayers affected by Federally (formerly called “Presidentially”) declared disasters and terroristic and military actions.
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