Real Estate Market

In a 1031 exchange property agreement between the exchanger and the intermediary there is a document where the exchanger gives the intermediary the right to acquire the relinquished property from the exchanger and then pass it on it to the buyer. The other documents that are required are 1031 exchange escrow agreement, 1031 exchange amendment and assignment to roll over the surrendered property and the 1031 exchange amendment and assignment for the purchase of the identified substitute property. There are four types of 1031 exchange properties and there are the simultaneous exchange, the delayed exchange, the reverse exchange and the improvement exchange. These types have been briefly described below:

1. The Simultaneous exchange – is the 1031 lease where the exchange property and the replacement property are switched over on the same day.

2. The Delayed Exchange – This is also known as the Starker Exchange and takes place after the closing of the exchange property. In this exchange there are strict time frames on that must be adhered to.

3. The Reverse Exchange – is a 1031 exchange where the replacement property is purchased before the exchange property has been sold.

4. The Improvement Exchange – is an exchange where the purchaser arranges for some improvements on a property before receiving it as a replacement property. The legal regulations do not allow for any kind of improvements after exchange that is to be included in a 1031 exchange.

The above exchanges are very popular and they are highly beneficial in the long run too. There are many people who are going in for these 1031 properties exchanges because of the legal benefits that are attached to acquiring them. They are solid and lucrative property deals that serve the utility of both the parties to the contract. It is mandatory that both parties have a consensus on all the terms and conditions that have been laid down in the above.

As mentioned above there are many advantages in the 1031 exchange property and the main one is that the Exchanger gets more buying power because the federal taxes are deferred. He gets easy finance and thus becomes a solid buyer. He also gets the gain of getting more flexibility in the selling price. Investors can also exchange after exchange to create a pyramiding effect. The tax liability is forgiven upon the death of the investor and the heirs are directly eligible to get the inherited property. The exchanger also gets more selling power and he does not have to inflate the selling price to cover the capital gains that would otherwise be due upon the selling of investment property. He gets a replacement property with greater income potential and he also has the right to acquire income producing property as well.

Such an 1031 exchange property can also help an investor acquire a less management intense property. The Exchanger gets the opportunity to consolidate properties to a single managed property or can diversify several small properties into one large property. It also provides him or her an excellent opportunity to relocate or expand any current business or investment that he is operating.

While many real estate investors across the United States are aware of the powerful strategy of the 1031 tax-deferred exchange, there are others who are just discovering it – and some who have never heard of it.

What is the 1031 tax-deferred exchange, sometimes also known as the Starker exchange, Delayed exchange, Like-kind exchange, or simply “a 1031″? It is the sale or disposition of property and the acquisition of “like-kind” property following the rules and structure of Section 1031 of the Internal Revenue Code in order to defer federal tax, capital gain, and depreciation recapture taxes. “Like-kind” as applied to real estate is essentially any type of investment real estate, with a few exceptions such as a personal residence. You can sell an office building and buy a retail center or land in a 1031 exchange; you can sell an apartment building and buy an industrial building or hotel.

Defer Capital Gains Tax
Educated investors know they never need pay the tax on their capital gains in the sale of investment real estate IF they intend to reinvest sale proceeds into more investment property. They also know they can DEFER the tax due by reinvesting the proceeds into another investment property. This is not a tax-free transaction – it is a tax-deferral – which can go on indefinitely and for any number of exchanges, until the day an investor or his heirs decide they will cash out and pay the tax. The IRS specifically states in its code:

“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”

Section 1031 does not apply to exchanges of such items as inventory, stocks, bonds, notes, other securities or evidence of indebtedness, or most other types of assets. However, it does apply to some business and personal property, such as planes, boats, or trucks. For purposes of this article, real estate to real estate is being discussed.

Very detailed I.R.S. rules must be followed in a 1031, with no exceptions. If you break one of the rules, the exchange is disallowed, and you will pay the capital gains.

The day you decide you are going to sell an investment property, you should determine if there will be sufficient capital gain with that “relinquished property” and whether it makes sense to do a 1031 in the first place – if you were planning to reinvest in more investment property or a “replacement property”. Your accountant or attorney can help you determine your capital gains if you cannot.

The Qualified Intermediary
In a 1031, your sale proceeds MUST be held by an independent third party. A “qualified intermediary” (QI) or exchange accommodator is the professional third party who will hold the escrowed funds. If you take possession of the sale proceeds yourself, you will pay the tax. The QI handles the specific necessary paperwork before you sell your property, will hold the funds in trust, and then will transfer the funds for acquisition of your new chosen properties, along with other important details.

Only 45 days to “identify” replacement property
From the day you sell your property, the clock starts ticking. You must “identify” replacement property or properties that you may or will acquire in your exchange no later than 45 days from the day you sold your property. This is done officially through your QI. There are no exceptions to the rules for dates and deadlines, even if specific dates fall on a Sunday or holiday. You then have no later than 180 days from the day you sold your property to close on any or all of your identified replacement property, completing the exchange. The time limits imposed by the I.R.S. are absolutes. If you are one day or one hour late, your trade is disqualified, and you will pay the tax. From time to time in recent history, the IRS has granted extensions to exchangers, for example, to those affected by devastating hurricanes or major earthquake. However, this is rare.

HINT: Find your QI well before you sell your property, and make sure to do a background check or verify the structure of the QI operations (there were some fraudulent QI’s in the news last year and investors lost money). Your broker may be able to make some recommendations. There are many QI companies throughout the United States. Their national association, Federation of Exchange Accommodators (FEA), lists all members on its Web site (1031.org).

TO KNOW:
You have several choices for identification, and your QI will supply the instructions:

The Three Property Rule. Identify up to three properties of any value that you may acquire. Acquire one, two, or all three of the properties. Most choose this option as it is the simplest. It is wise to use all three slots, even if you intend to acquire only one property. You will have backup options in case something goes awry with the first choice.

The 200 Percent Rule. Identify four or more properties, whose value cannot exceed twice (200 percent) of the relinquished property value. Exceeding the 200 percent limit will disallow your transaction. A few choose this option.

The 95 Percent Rule. Identify any number of properties with an aggregate fair market value exceeding 200 percent of the relinquished properties. Acquire virtually all (at least 95 percent of them, based on the total fair marker value). Very few choose this option.

What else do I need to know?
In a 1031 tax-deferred exchange, you must take title to the new property in exactly the same way you held title in the relinquished property, whether it is you personally or an entity such as a trust, corporation, partnership, or LLC.

When exchanging into the replacement property, you must replace both equity and debt at the same amount or greater, if you wish to defer the capitals gains in full.

You do not have to place all of your proceeds into a new property, but whatever you take out will be taxed.

Why Do a 1031 Exchange?
Investors can trade up, consolidate, diversify, leverage or relocate their investments and not be penalized by having to pay either capital gains or recapture (the amount deducted while owning the property is taxable if the property is sold). The taxes are deferred until the investor does a non 1031 exchange sale or dies.

1031 exchanges can be both a powerful wealth building tool and a way of adjusting investment portfolios to more accurately reflect life style choices and circumstances. An example would be an apartment owner wanting to trade into net lease properties that do not require management.

What are the general guidelines for a 1031 Exchange?

* The value of the replacement property must be equal to or greater than the value of the relinquished property less any selling expense.

* The equity in the replacement property must be equal to or greater than the equity in the relinquished property.

* All of the net proceeds from the sale of the relinquished property must be used to acquire the replacement property.

* Constructive receipt of sales proceeds is prohibited during the exchange process.

* Deadlines for identifying and closing on the replacement property must be followed.

What is Boot?
Boot is any property received by the taxpayer in the exchange which is not like-kind to the relinquished property. Boot is characterized as either “cash” boot or “mortgage” boot. Realized Gain is recognized to the extent of net boot received.

What is Like Kind?
Real or personal property of the same nature or quality is like kind. Generally, real property is like kind to all other real property as long as it is held for investment or productive use in a trade or business. Foreign real property can be trade for foreign real property while US properties can only be exchanged for US properties. Personal Property must be either the same General Asset Class or Product Class.

What are the 45 and 180 Day Deadlines?
The clock starts with the close of the property being sold. From the close date there are 45 days to identify the properties to be purchased and 180 days to complete the purchase (or the due date for your tax return-whichever is earlier). Both periods are calendar days. If the 45th or 180th day falls on a weekend or holiday, the deadlines still apply. There are no extensions for legal holidays or Saturday or Sunday.

What Constitutes Proper Identification of Replacement Property?
Property is properly identified only if you clearly describe it in a written document signed by you and hand delivered, mailed, faxed to the person obligated to transfer the replacement property to you (typical a Qualified Intermediary (QI) or to any other person “involved in the exchange” other than you or any one disqualified under Treasury Regulation 1.1031 (k)-1(K). An unambiguous description would be if it described the property using the legal description, street address or distinguishable name. If more properties than are permitted are identified it will be treated as if no replacement property was identified and the exchange will be disallowed.

To Defer Taxes How Much Must be Invested?
The minimum amount to be invested must be equal to or greater than the sales price on the property being sold less any selling expenses. If there is debt on the property being sold that amount needs to be replaced by new debt or cash from the investor’s pocket.

How Many Properties May Be Identified as Replacement Properties?

* Three Property Rule: Any three properties of any value.

* 200% Rule: Any number of properties not to exceed 200% of the sold property.

* 95% Rule: Any number of properties of any value. 95% of identified properties must be closed in 180 days or the exchange will be disallowed.

Can Multiple Owners of a Single Property Exchange into Different Properties?

If the intent of varies owners of a single properties is to go their separate way it is important to first review with legal counsel the manner in which the property title is held before selling. Once any title issues are resolved the property can be sold and exchanged. In such a circumstance one investor can do an exchange while another can receive cash and pays taxes. It is very important that the investors be clear on their intentions before entering into an exchange agreement with a Qualified Intermediary (QI). Once the property being sold is closed and all exchange investors have entered into one exchange agreement the exchangers lose their options to divide the proceeds and buy separate replacement properties.

Does the Investor have Access to the Sale Proceeds During the Exchange?

Part of doing an exchange is that the investor does not take constructive receipt of the sales proceeds. If no property is identified during the 45 day identification period the investor can receive their money on the expiration of the identification period. If the investors identifies properties during the 45 day identification period then does not close on an identified property the investor will have to wait the full 180 day waiting period to receive their money. There are a few limited exceptions to this rule.

Is a Delayed Exchange the Only Way to do a 1031 Exchange?
There are five ways to accomplish a 1031 exchange. They are a Delayed Exchange, Reverse Exchange, Simultaneous Exchange, Improvement Exchange and a Personal Property Exchange.

How Should the Replacement Property Be Vested?
The investor needs to hold title in the replacement property exactly as they held title to the property they sold. What this means is that the person or entity beginning the exchange needs to be the same person or entity ending the exchange. An exception would be a husband and wife (or individual) holding a revocable living trust which is a true pass through can sell then take title to the new property as individual(s). Other exceptions would be a single member LLC sells and the sole member buys as an individual or if an individual dies after selling his or her estate can purchase the replacement property.

Can an Investor Use a Personal Bank Account To Hold Sales Proceeds?

No. The IRS regulations are very clear. The taxpayer may not receive the proceeds or take constructive receipt of the funds in any way, without disqualifying the exchange.

Is it too late to start a tax-deferred exchange after signing
the sales contract before closing?

No, as long as title has not been transferred. Once the sale is closed it is too late to do a 1031 exchange even if the proceeds check has not yet been cashed.

What is a “multi-asset” exchange?
A multi-asset exchange involves both real and personal property. For example the sale of a hotel frequently involves both real estate and furnishings and equipment. In this example an exchange would be done for the land and building and another exchange for the furnishing and equipment in a separate exchange. The definition of like-kind for personal property and equipment is much narrower than for real estate.

What is the difference between “realized” gain and “recognized” gain?

Realized gain is the increase in the taxpayer’s economic position as a result of the exchange. In a sale, tax is paid on the realized gain. Recognized gain is the taxable gain. Recognized gain is the lesser of realized gain or the net boot received.