Lawyers Equity Exchange - 1031 Questions and Answers

1. What are the advantages of Exchanging?

   The primary advantage of exchanging over selling is that the owner may dispose of property without incurring any immediate tax. Permitting the owner to retain and reinvest money that would otherwise have been paid in federal and state taxes increases leverage.

   In effect, the owner-exchangor receives an interest-free loan from the government. These “loan proceeds” representing your unpaid taxes are invested in your replacement property.
   Exchangors may continue to avoid taxation (and the corresponding reduction of their estates) as long as they stay invested. At death all tax liability is forgiven and the gains which have been accumulated will escape income taxation entirely. The exchangor's heirs get a new, stepped-up basis on inherited property.

   More than sheltering the exchangor from tax, the tax-deferred exchange opens other avenues and opportunities the small investor may not have fully contemplated previously.
   An exchange can be used to consolidate multiple properties into one property to ease management burdens. A real estate investment can be relocated to a more attractive region. Retirement and estate planning objectives can be combined with exchanging to reach personal goals in a variety of ways.

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2. What exactly is a tax-deferred exchange?

   A tax-deferred exchange is a procedure by which an owner trades one property for another without having to pay any capital gains taxes on the transaction.

   This procedure is provided for in Section 1031 of the Internal Revenue Code and is a safe and inexpensive way to achieve significant tax savings.

   Current practice calls for the owner's sale and reinvestment transaction to be converted into an exchange through the services provided by a Qualified Intermediary, the use of prescribed written documentation and accomplished within set time limits.

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3. What kind of property can be lawfully exchanged?

   Avoidance of tax demands that the owner trade for property that is like-kind.
   Fortunately all interests in real estate are considered to be like in kind to any other whether improved or not.
   For example, the following types of real property are considered to be of like-kind:

A single family house for a duplex
Unimproved land for commercial income property
Ranch or farmland for city condominiums
A lease of 30 years or more for a fee interest
A co-tenancy interest for sole ownership in realty
A conservation easement for a fee interest in an apartment building

But, U.S. realty is not permissibly traded for foreign realty.

In dealing with personal property (equipment, office furniture) the IRS has published detailed guidelines for determining whether these exchanges involve like-kind property. In general, the focus and categories of permitted trades are more narrowly drawn than in real estate.

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4. What or who is a Qualified Intermediary?

   The Intermediary is the party who participates on behalf of the owner by transferring and acquiring the exchange properties and holding the proceeds of sale. Nearly all exchanges today are handled by professional intermediaries.

   The widespread use of independent intermediaries solves the practical difficulty the owner would otherwise face in finding a suitable exchange partner and property in the marketplace by substituting a “straw man” to facilitate the trade.

   More importantly, the risk of disqualification and denial of benefits is substantially reduced when the owner chooses to use a party the IRS defines as a “Qualified Intermediary.” LEX meets the definition of a Qualified Intermediary.

   The owner is cautioned not to use his or her real estate agent, accountant, personal attorney or family member to handle an exchange. These are deemed to be related or controlled parties by the IRS and can cause denial of tax-deferred treatment.

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5. What time requirements must be met?

Unless the exchange of properties is done simultaneously (only a small number of trades are now done this way), the replacement property must be:

Identified no later than 45 calendar days after the date on which the old or relinquished property is transferred (typically the closing date of escrow), and
Acquired on or before 180 calendar days after the old property is transferred.

Should the owner's tax return due date occur during the 180 day period, it is necessary to obtain an extension of time to file in order to obtain the full 180 days. Otherwise, the due date can cut down the acquisition period and cause loss of tax deferral!

The government will not extend these time limits. They must be met to qualify for the benefits afforded under Section 1031.

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6. Can 1031 benefits be obtained if the exchangor lives in one unit of the multi-unit property to be exchanged?

Yes. You may use the tax-deferred exchange provisions for the rental portion of your multi-unit real estate by allocating an appropriate share of the price to such units. Use either a price per unit method or a square foot measurement to calculate the allocation.

You can also apply the personal residence tax exclusion (IRC Section 121) to the unit in which you have lived in for at least two of the past five years. These two tax provisions can be used in combination to achieve remarkable tax savings (See Answer to Question 16).

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7. Do all exchange proceeds have to be reinvested?

    No. But to defer all taxes, the exchangor must reinvest all cash realized in the transaction. To the extent part of the cash realized is taken out of the sale escrow, such proceeds will be subject to taxation.

    Once proceeds are in possession of the Intermediary and replacement property has been identified, 1031 rules limit disbursement of funds to or for the benefit of taxpayer until either (a) all identified property to which taxpayer is entitled has been acquired or (b) the expiration of the 180 day exchange period.

    A superior alternative for the exchangor who wishes to defer tax and also obtain some cash is to borrow following receipt of the replacement property. Borrowing secured by the replacement realty is normally non-taxable.

    Borrowing against the old exchange property just prior to or in anticipation of the exchange poses unnecessary tax risk and is not advised.

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8. Can tax be avoided when trading down to a smaller property?

     Scaling down from a property of greater value to one of lesser value unavoidably results in the exchangor receiving either some cash or a reduction in the mortgage owed after the exchange is completed. Both the receipt of cash and a reduction of debt owed are “unlike” property received and are subject to tax. Tax practitioners call this kind of unlike property “boot.”

    A simple rule to remember and apply when avoidance of all tax is your goal: ALWAYS TRADE ACROSS OR UP IN BOTH EQUITY AND VALUE WHEN EXCHANGING.

    Here's a simple example. The exchangor's old property is "A" and the replacement properties are "B."

	Property A (old)	Property B (replacement )
VALUE:	$650,000	$700,000
EQUITY:	$400,000	$400,000
MORTGAGE:	$250,000	$300,000

In this situation , the exchangor traded across in equity and up in value and avoids receiving "boot." But if the exchangor traded down to a property worth only $600,000 with his $400,000 equity, the mortgage debt would be reduced by $50,000. A tax on the $50,000 debt reduction would be imposed.

There are “boot netting” rules which can be applied to save or avoid tax in certain situations but the applicability of such rules to any individual transaction is beyond the scope of this page. Following the simple rule stated above will preserve your tax benefit but is not a replacement for doing the actual calculation for each individual transaction. Always seek the assistance of your own personal tax advisor before exchanging.

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9. What kind of property is entitled to tax-deferred treatment?

     Both the property given up (the old property) and its replacement must be held or intended for use by the owner-exchangor for productive use in a trade or business or for investment. This is known as a “qualified use” or as “qualified use property.”

    For example, property used to generate rental income or property used in the owner's business meets the “qualified use” test. Vacant land and unproductive property held by a non-dealer for future use or for appreciation meets the held for “investment” requirement and is a “qualified use” under Section 1031.

    Property used for personal reasons (for example, a personal residence) or primarily for sale as stock in trade (like inventory) or for quick re-sale is not entitled to tax-deferred treatment.

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10. How long must 1031 property be held before its sold or converted to other uses?

Unfortunately, there is no fixed holding period set by law for “qualified use property.” IRS scrutinizes taxpayer's “intent” at the time property is acquired. All surrounding facts and circumstances are taken into account: time, taxpayer's ordinary business, number of sales/re-sales, and property utilization. Many Intermediaries recommend a holding period in at least part of two successive tax years. Some view one year's time is sufficient. On good facts showing non-tax driven transfers, courts have approved a six month holding period.

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11. What is an improvement exchange?

    It's a 1031 exchange in which the replacement property is improved to the exchangor's specifications before it is transferred to the exchangor.

    Planned improvements must be carried out within the 180 day exchange period in order to receive tax-deferred treatment. This can be a challenging task.

    In an improvement exchange, the responsibility for ownership and disbursement of exchange funds is lodged with the intermediary, although the exchangor may act in a consultative or advisory capacity, approving development steps and authorizing outlays in accord with a predetermined plan.

    Because the intermediary is the title holder throughout the exchange period, payment of liability and workers' compensation premiums, management fees and other costs makes the improvement exchange a substantial financial undertaking.

    Improvement and Reverse exchange fees are set by quotation in consultation with taxpayer.

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12. What is a reverse or parking exchange?

A reverse exchange is the popular name given to one method of structuring a transaction when taxpayer must or wishes to acquire replacement property before having disposed of the old property. These kinds of transactions are also referred to as parking exchanges because the replacement property is typically acquired by the Intermediary on taxpayer's behalf and “parked” in a specially formed entity (an LLC is the usual choice) until it can be traded with the exchangor upon sale of the old property.

IRS has issued “safe harbor” rules expressly permitting the acquisition of replacement property before selling the old property as long as certain requirements are met. The LLC must be considered the owner for federal income tax purposes, the 45-day identification and 180-day exchange time limits must be observed and specially crafted contractual provisions need to be followed.

In a parking exchange the intermediary's role is significantly broadened, as are transaction costs. The intermediary arranges for formation of the LLC which holds title to at least one of the properties for a time. Even though the exchangor/client is allowed to manage the property, the intermediary takes on the duty of collecting and reporting income and operating costs as would a real owner.

Because of increased transaction costs and extra management burdens, the would-be reverse or parking exchangor should always explore alternate ways of accomplishing their objectives.

For example, the taxpayer might secure the replacement property by entering into a lease with an option to purchase (at a time after the old property is sold). Or the exchangor could bargain for and offer to pay a premium to the seller for an extended closing period.

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13. Under what circumstances may vacation homes receive tax-deferred treatment?

Vacation homes may be considered “qualified use” property and entitled to full 1031 tax-deferment if personal use is minimal (no more than 14 days per year or 10% of the number of days each year the property is rented at FMV) and it is maintained as a bona fide rental property for one year or preferably longer. While no fixed holding period is set, establishing a strong showing of a proper purpose is vital.

Exchangors trading into a second home or vacation property from “qualified use” property, may, after an adequate “holding period,” later convert it to personal residence property under Section 121 to exclude gain on resale; but only after five years, less any depreciation taken.

Another provision of the tax law (Section 280A) should permit limited tax-deferment of that portion of gain realized on a sale allocable to the rental activity when the taxpayer uses vacation property both for personal use for more than 14 days per year and as a rental .

The importance of detailed record keeping, to clearly establish personal and rental use periods, cannot be overstated.

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14. Can I take back a note on the sale of my old property?

Yes, you can sell your old property and take back a Note & Trust Deed to help finance the sale. If the Note & Trust Deed is made out to the Exchangor the Note is taxable.

However if the Note & Trust Deed is made out in the name of the Qualified Intermediary, you have choices on how to use it to buy Replacement property:

You can use it to acquire Replacement property by trading it to the Seller for part of the equity in the new property. Use it as an additional consideration.
You can instruct the Qualified Intermediary to sell the note on the open market and add the amount realized to the exchange proceeds. This will give you all cash to negotiate your replacement purchase.
A party related to the Exchangor such as a closely held corporation or relative may either purchase the Note from the Qualified Intermediary or provide financing so that the Qualified Intermediary receives all cash at closing.

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15. Does the manner of holding title to exchange property matter?

     In general, IRS follows a “same taxpayer” rule. The same taxpayer who starts an exchange must be the one who takes title to the replacement property.

    An individual or spouses in a community property state (i.e. California) may permissibly hold their property in an LLC at either end of an exchange. Such LLC's are “transparent entities” for tax purposes. Revocable or living trusts are likewise tax transparent: the grantors and trustees are typically the taxpayers' themselves.

    But, Irrevocable trusts are separate tax entities, as are partnerships and corporations and such entities must start and complete 1031 transactions in their own name.

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16. Can 1031 be combined with the Personal Residence Exemption of Section 121?

Yes. If taxpayer qualifies for the personal home exemption by having occupied the property for 24 months within the last five years, $250,000/$500,000 of cash may be excluded and any remaining gain is eligible for deferral under 1031 when either:
(a) the property has been converted to rental (qualified use) property for an adequate holding period or
(b) a home office has been claimed on prior tax returns enabling the home office portion of gain to be deferred and reinvested.

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17. What are the steps for beginning an exchange?

     First, explore the exchange option with your personal tax advisor, attorney or accountant. Find out if the disposition of your property triggers a taxable gain. It's a good idea to do the tax calculation before you decide on your course of action. Know what the tax bite would be in the event of a sale.

    Then, market your property in the usual manner. Add a provision in all binding purchase and sale contracts obligating the other party to cooperate with you in the exchange. LEX will provide the protective 1031 provision for you should your real estate agent be unfamiliar with exchanging. Many printed form purchase and sale contracts have a check-the-box item for tax-deferred exchanging.

    When the contract to dispose of your old property is firm and you are ready to open escrow or begin the closing process, contact LEX and complete the start form provided on this site or call our toll free telephone (888) 210-1234 for assistance.

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