1031 EXCHANGE | RULES & REQUIREMENTS
The identification requirements for a 1031 exchange relative the identification of “like-kind” replacement properties are very specific and must meet certain criteria. We will be outlining those requirements in detail in an effort to assist you in understanding what you can and cannot do in a 1031 transaction. One issue of importance is that any properties that you identify in relation to your 1031 exchange do not need to be in escrow or under contract when you identify them. This is important because you will want to be looking at potential replacement properties well before your official identification timeline begins. Let’s take a look at the 1031 Exchange Rules below:
USE AS REAL PROPERTY: The property that you are currently selling (or have sold) and the new replacement property will each need to be qualified as investment or business use properties. As long as each, or all, of these properties meet this standard – you will be positioned to exchange nearly any type of real estate that you wish to.
THE FORTY-FIVE (45) DAY IDENTIFICATION PERIOD: Once you have closed on your investment/business property, you will have 45 days from the date of that closing to identify a replacement property in your exchange. This is a non-negotiable issue. This 45 days are firm and weekends and/or holidays are inconsequential in the eyes of the IRS. This is why it is vitally important to begin this process as early as possible when the property you are selling has gone under contract. Once you have sold your old property, you must also ensure that all proceeds from the sale of that property are being held by a “Qualified Intermediary”.
180 DAY EXCHANGE PERIOD: Once you sell your property, you will have 180 days from the sale date to take possession of thee replacement property.
THE TOTAL EXCHANGE PERIOD: The period of time of time from when you (or a legal entity) has completed the sale of a property to when you, or your legal entity, have to acquire and take possession of the new replacement property is considered the “Exchange Period” based upon IRS 1031 rules. Many people are under the impression that this is strictly 180 days after the date that the person/entity legally transfers ownership of the relinquished property. However, this is not necessarily the case…and it can be an issue if you do not carefully plan your exchange. IRS 1031 rules state that you have 180 days from when you relinquish ownership of the old property OR the due date for the person’s/entity’s tax return for the taxable year that the transfer occurred – whichever is EARLIER. This is extraordinarily important, as it can work either way. If you sell your property in June and your taxes are due in April of the following year…you have 180 days to get the new 1031 exchange transaction closed, not until April of the following year. On the flip side, if you file in September and you sell your property in June, you may have significantly less time than 180 days to get the transaction closed. Always consult with your tax adviser and Qualified Intermediary when conducting a 1031 Exchange. The 1031 Exchange is a significant option for tax savings, but should be monitored by a qualified tax expert.
IDENTIFICATION RULES AND EXCEPTIONS
1031 EXCHANGE ID RULES
You must comply with at least one of the following identification rules or exceptions when completing the identification of your like-kind replacement properties:
It is advised that you get a purchase agreement set up and a replacement property in mind before starting the 1031 process. This is because “The three-property rule” (under 1031 tax exchange regulations) declares that the exchangor of a relinquished or replacement property may identify up to 3 replacement properties, regardless of their value.
THREE (3) PROPERTY IDENTIFICATION RULE
As a general rule, most investors will use the Three Property ID Rule when seeking like-kind replacement properties. In short, the Three Property ID Rule limits the number of replacement properties that you can identify during your 45 day identification period to three.
Although it is possible for you to purchase all three properties is you would like, most investors simply have three properties as a back-up in case their first choice offer falls through for one reason or another. This is important because you do not want to find yourself outside of the 45 day identification period with only one property lined up for purchase and then the deal falls apart. If that happens…you will be facing a major tax consequence.
Now, let’s consider the 200% of Fair Market Value ID Rule. In this scenario, you are going to be looking to identify more than three properties because you may be trying to add some diversification to your existing portfolio.
THE 200% OF FAIR MARKET VALUE ID RULE
This sound more complicated than it is, so we will keep this short and simple. So here it is…you can replace your sold property with as many properties as you like as long as the total aggregate fair market value of the replacement properties does not exceed 200% of the sales value of the property that you sold. Let’s take a look at it this way:
You sell a property for $3,000,000 and you want to diversify your holdings a bit and spread your gains across different market sectors and rates of return. In this case, you would could pick up to $6,000,000 of replacement properties (200% of $3M). Again, you can pick as many replacement properties as you would like, as long as their total aggregate market value does not exceed 200% of the sales value of your relinquished property. In this case, that would be $6,000,000.
THE 95% ID EXCEPTION
If you have chosen to utilize the 200% rule and the fair market value of the identified properties exceeds 200% of the sales value of the sold property, you may still be able to legally conduct the exchange and be within IR guidelines. In this scenario, you would be need to purchase 95% of the replacement properties. Most investors should not find themselves in this situation, but if you do…there is some degree of protection. That said, using our previous $6,000,000 amount, you would not be looking at a $5,700,000 purchase as opposed to a $3,000,000 purchase. This can work out if there is additional cash to work with, or there is always the option of leveraging your purchases through financing.
“LIKE-KIND” – WHAT IS IT?
Like-Kind real estate generally means that any real property held for investment purposes can be exchanged for other real property held for investment purposes. It does not matter if you have an office building that you have sold and now want to buy an apartment complex, or vice versa. Other personal property can also be exchanged and can be quite useful if someone is looking to sell and replace aircraft, machinery, or other tangible property. Personal property exchanges are based upon depreciation schedules and would usually require a segmented depreciation analysis by a qualified expert. At Optimus Commercial Real Estate Investment Advisors, we specialize in 1031 Exchanges of real estate assets.
A FULLY DEFERRED 1031 EXCHANGE
In its simplest form, you basically have to trade up when it comes to the equity achieved in your investment and also any debt you hold in the relinquished property. There are some misconceptions in this regard, as many exchangers feel that as long as they are not receiving cash from the sale, they can exchange all of their equity into a new investment. This is true, however it you held debt on the relinquished property – that must be replaced as well. When you sell that property and pay off your mortgage, you are going to have to replace that mortgage with an equal or greater mortgage as well…AND put all of your equity into the new investment(s). If you receive ANY cash from the sale of your property, or cash received from the purchase of the new property WILL be considered “boot” or cash boot” and you will pay the related tax on that gain. Of course, if you own a property with no mortgage, there will be no new mortgage requirement.
FAIR MARKET VALUE OF THE RELINQUISHED PROPERTY
You can determine the FMV of the relinquished property in a 1031 Exchange by deducting the customary and ordinary transaction costs from the sales price. These costs usually involve broker fees, closing fees, intermediary exchange costs, and state/county recording fees.
A PARTIALLY DEFERRED 1031 EXCHANGE
This generally occurs when the exchange is traded down in debt or equity. Most investors are not seeking to conduct a partially deferred exchange, but if you do then just realize that any gains are going to be taxes at their respective rates.
Boot can be bests summarized as ANYTHING of value that you receive from the exchange that is not like kind to the property being sold. Keep in mind that “boot” can be anything of value, not just cash, so tread carefully here.
CASH BOOT – We have already discussed this a bit previously, but essentially cash boot is just that…cash boot. If you receive any amount of cash from your exchange – you will pay the relative tax on that cash.
MORTGAGE BOOT – We are not trying to beat a dead horse here, but “boot” is a fairly important part of an exchange. In the event that you fail to replace your sold property with another like-kind property of equal or greater value…you will most likely be looking at having either received cash boot (in a cash transaction) or mortgage boot in a mortgaged transaction. Consider it this way:
ABC LLC sells their Walgreens for $2,000,000. They hold a $1,500,000 note on it and replace this property with a CVS that is valued at $1,900,000. ABC LLC puts all of their $500,000 cash down and takes on another mortgage for $1,400,000. In this case, the ABC LLC will have a tax consequence on the $100,000 of “mortgage boot”.
If you receive anything of value that is consider not like-kind property from an exchange – you are paying tax on it. Items that can sometimes be transferred include vehicles, pieces of art, vessels, etc.
As stated, you must identify your replacement property in 45 days or less. There is rarely any deviation allowed from this requirement. If your 45th day falls on a weekend or holiday…the IRS does not care. You must ensure that your Qualified Intermediary receives, in writing (dated and signed), you’re identified replacement property no later than that 45th day.
TIME TO PURCHASE
Generally you will need to purchase your replacement property within 180 days after the sale of your previous asset. However, IRS rules also state “or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier”.
MULTIPLE LEG EXTENSIONS
You may be selling multiple properties and looking to exchange into one property, or perhaps sell one property and exchange into multiple properties. This is not an issue, but the 45 day ID period and 180 day total replacement rules will still apply. In fact, your time periods will start upon the sale of your first relinquished property and end upon the close of your last purchased property. This can create issues and quite a bit of stress of it is not carefully planned out. For this reason, many times it is much better to simply conduct several separate exchanges.
REPLACEMENT PROPERTY TITLE
When you exchange properties, you must take title to your new property in the same name that you relinquished your old property. Keep this in mind BEFORE you choose to sell your property, as this rule applies where husbands and wives are concerned, partnerships, etc. We recommend that you ensure that your selling entity is exactly what you want it to be PRIOR to closing on that property.
RELATED PARTIES AND EXCHANGES
In summary, if you are exchanging properties between related entities or persons, then all of the properties involved in the exchange must be held by the person conducting the exchange and the related party or parties for a minimum of two (2) years from the last transfer date. If this does not occur, then the exchange will not qualify for a deferral.
Related parties are defined as:
- Members of a family, including only brothers, sisters, half-brothers, half-sisters, spouse, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.);
- An individual and a corporation when the individual owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation;
- Two corporations that are members of the same controlled group as defined in Â§1563(a), except that “more than 50%” is substituted for “at least 80%” in that definition;
- A trust fiduciary and a corporation when the trust or the grantor of the trust owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation;
- A grantor and fiduciary, and the fiduciary and beneficiary, of any trust;
- Fiduciaries of two different trusts, and the fiduciary and beneficiary of two different trusts, if the same person is the grantor of both trusts;
- A tax-exempt educational or charitable organization and a person who, directly or indirectly, controls such an organization, or a member of that person’s family;
- A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital interest, or profits interest, in the partnership;
- Two S corporations if the same persons own more than 50% in value of the outstanding stock of each corporation;
- Two corporations, one of which is an S corporation, if the same persons own more than 50% in value of the outstanding stock of each corporation; or
- An executor of an estate and a beneficiary of such estate, except in the case of a sale or exchange in satisfaction of a pecuniary bequest.
- Two partnerships if the same persons own directly, or indirectly, more than 50% of the capital interests or profits in both partnerships, or
- A person and a partnership when the person owns, directly or indirectly, more than 50% of the capital interest or profits interest in the partnership.
TAX BASIS ON REPLACEMENT PROPERTY
This is an aspect of 1031 Exchanges that is frequently misunderstood by many principle investors and brokers. Your tax basis from the property you have sold is carried forward into the property that you are exchanging into. If you invest additional cash or you have an increase in the mortgage on your replacement property, you will increase the tax basis of the replacement property. If you have taken depreciation on the property that you have sold, that depreciation cannot be taken again on the property you are replacing the relinquished property with. For many, this is considered to be a negative aspect of the 1031 tax-deferred exchange.
LLC’s, Trusts, Corporations, and partnerships can exchange assets. As stated previously, title must remain the same between the property being sold and the replacement property. Again, make sure all is well on the ownership front prior to selling. However, you cannot exchange stock or interest in one corporation or partnership for stock/interest in another corporation/partnership.
RECEIPT OF TITLE
Many investors ask if they can receive title to the new property before relinquishing title to the property that they are selling. You cannot hold title to both properties at the same time, but you may conduct a Reverse 1031 Exchange. In this scenario, you will utilize an Exchange Accommodation Titleholder to hold the title to one of the properties. Having a good Qualified Intermediary in this process is of absolute importance.
EXCHANGE FUNDS AND MORTGAGES
We have been asked by several investors if it is possible to use funds received from an exchange to pay down the mortgage on a property that they already own. This is not considered like-kind by the IRS and as such, you cannot do this.
USE OF EXCHANGE FUNDS FOR REPAIRS/REPLACEMENTS
Utilizing exchange funds to conduct repairs and/or replacements on the property that is being exchanged into is generally a bad idea. If possible, you should make arrangement through the sale price, etc. with the seller to make all required repairs or replacements prior to closing on the property. You could also use other available capital once you acquire the property. However, to answer this question – yes, you can use exchange funds to make repairs/replacements, but you must accomplish this prior to taking title to the property. As you can see, this could prove to be quite difficult in most situations and is best to be avoided.
USE OF EXCHANGE FUNDS FOR BUILDING IMPROVEMENTS/CONSTRUCTION
If you must do this, then you should use an accomplished Qualified Intermediary to set this up properly for you. You will need to have a Special Purpose Entity acquire title to the property being purchased and have that SPE build the required improvements. You will then acquire the property from the SPE under exchange regulations.
1031 EXCHANGE NOTIFICATION
Both the buyer and seller of a property must acknowledge that they understand that the transaction they are entering into involves the use of a 1031 Exchange. In the commercial investment world, most principles and brokers are well versed in this arena. However, it is required that the Purchase Contract have the correct 1031 verbiage in it or in an addendum to the contract. Most Qualified Intermediaries have their own addenda for this purpose, as do most state Realtor associations in their form databases. As a principle, broker, or closing agent it is important to ensure that the proper 1031 language is included in the sales contract/addenda. If for some reason the original contract included exchange language and then later in the process it is determined that the use of the 1031 Exchange will not be necessary, then that language will need to be removed from all closing documents.
WHEN TO GET A QUALIFIED INTERMEDIARY INVOLVED
As soon as your due diligence and/or other contingencies expires on your contract and escrow goes hard, you will want to contact your QI. It is not a bad idea to be in contact with them prior to that, but this will be the point that hard commitments exist on the deal and the potential for a successful closing becomes much more viable. If you are looking at a very quick close transaction, you should be involved with your QI as soon as you go under contract and not wait for your contingencies to expire.
THE QUALIFIED INTERMEDIARY
Your QI is essentially going to become the new Buyer and Seller for tax purposes. Once they get the PSA and title, they will generally prepare their own Exchange Agreement and Substitution of Buyer/Seller. There should be close contact between your QI and closing agent/attorney and they will be working to ensure that each has all of their required paperwork. Once the Substitution of buyer/Seller has been executed – your QI is your Buyer and/or Seller. As such, any addenda, amendments, etc. that require signatures beyond this point should show your QI in addition to the original signatories for execution. If this does not occur, the exchange is at risk of not being qualified.
It is very important to ensure that your Qualified Intermediary’s name replaces your name as the Exchangor/Seller/Buyer and that you are simply acknowledging receipt of the docs.
QUALIFIED HOLDING PERIOD
There are no clear rules in regard to how long this period it, but most stay in the two year range. You simply must be purchasing the property with the intent to hold it for investment purposes. In reality, as with everything noted within these 1031 pages, you should consult with your tax advisor on this issue and others.
FULL NON-RECOGNITION OF CAPITAL
To receive full non-recognition of capital and the full benefits of a 1031 Exchange, you simply need to spend n equal or greater amount of the exchange capital/debt value.
HANDLING TAX BASIS IN A 1031 EXCHANGE
Many, many investors want to know what occurs to the basis when they sell their property and acquire a new one. First, you need to understand that from the IRS’s perspective with 1031 exchanges, you still “own” your old property – even after you sell it. You can only carry over your remaining basis of your old property. Whether you are trading up or down that basis does not change. So, in order to determine what the basis is for your new property, you need to determine what it is on the old property. Let’s take a look at the following example with ABC LLC again:
PURCHASE PRICE SAME AS SALES PRICE (BUYING EQUAL)
ABC LLC is selling an office building for $500,000. The LLC purchased the office building in 2005 and have since taken $180,000 in depreciation. Their tax basis in the property is now $320,000 ($500,000 – $180,000). ABC LLC is buying a warehouse in 2015 for $500,000. ABC LLC is “buying equal”, which is an important factor that will determine what the new property tax basis will be. Because they bought equal, the tax basis ($320,000) simply rolls forward into the new property. Additionally, all tax schedules in the future will be based off of a purchase date of 2005 – the same date as the purchase of the original office building.
Why you ask? As stated previously, in a 1031 Exchange the IRS makes no differentiation between the office and the warehouse. From their perspective, for tax purposes, you still own the office building only the address and legal description have changed. The depreciation schedule simply carries forward as if you were still depreciating the office building.
PURCHASE PRICE MORE THAN SALES PRICE (BUYING UP)
In the next example, we will consider what happens when ABC LLC buys up:
ABC LLC sells their office building for $500,000, but this time they pay $600,000 for that new warehouse. IN this case, the original basis amount of $320,000 carries over just as it did when they bought equal, but the added $100,000 is combined with the existing tax basis for a total of $420,000. On the depreciation schedule the $320,000 will still show as if they still owned the office building and the $100,000 will show as of the date that they acquired the new warehouse.
PURCHASE PRICE LESS THAN SALES PRICE (BUYING DOWN)
This is fairly simple. As with the buying equal or buying down, the basis still carries over. In this example, ABC LLC buys that warehouse for $450,000. The original basis of $320,000 still carries over and is still based on that 2005 date. However, ABC LLC is going to pay tax on the $50,000 gain.
TAX AND LEGAL ADVICE DISCLAIMER
Optimus Commercial Real Estate Investment Advisors and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.