WHAT IS A 1031 EXCHANGE?
 A
1031 property exchange is based on a provision in the IRC rules (section
1031) which provides that no gain or loss related to capital gains
need be recognized on the "exchange" of any type of property used
for business or investment.
1031 exchanges are not actual exchanges where two entities exchange properties in some sort of barter, rather they are typically sales and purchases occurring the same way as any other sale or purchase, but without attracting a capital gains tax if they follow the procedures laid out in Section 1031 of the IRC rules. The real difference is that the investor is increasing his selling and buying power by avoiding capital gains taxes under Section 1031 regulations. No other aspects of the transaction are affected.
WHO SHOULD CONSIDER A 1031 TAX DEFERRED EXCHANGE?
Anyone who is considering selling a business or investment property should investigate the merits of a 1031 exchange. By electing to use a 1031 exchange, the savvy investor has an opportunity to reinvest the federal capital gains that he would normally pay on the sale and put that money to work. Don't let a portion of your hard work go to the IRS without carefully considering this reinvestment option. You can consider the savings resulting from a 1031 exchange as an interest free loan from the IRS and a loan in which the principal may be increased through subsequent exchanges and which may never require repayment if you plan properly.
MISCONCEPTIONS ABOUT 1031 EXCHANGES
1. There are those who still believe that you must “swap” properties in order to effect a successful 1031 exchange. Although this was a requirement in the original code, this is no longer required today. You are now able to sell you property in a normal manner, provided that you reinvest the returns of that sale in accordance with the 1031 rules.
2. Many believe that only investors in large commercial properties can get the benefits of Section 1031, but this is not the case. The nice thing about 1031 exchanges is that they apply to all investment properties, large and small. 1031 exchanges result in savings for a corporation selling a large shopping mall and will also provide benefits for an individual selling a single-family home used as a rental property in a vacation area.
3. Many believe you must acquire a property of similar kind or type in order to qualify for the benefits of a 1031 exchange. While the term "like-kind" exchanges is often used in reference to 1031 exchanges, this term simply refers to real property held for business use or investment. You can sell vacant land and acquire an apartment building or sell a warehouse and acquire raw land; you can sell one property and use the proceeds to invest in three properties or you can sell four properties and only acquire one. Virtually any type of real property used for business use or investment will qualify.
4. A common misconception is that 1031 exchanges are too complicated to be worth doing. Nothing could be further from the truth! In fact, when working with a qualified 1031 exchange intermediary the process is very simple. The intermediary will keep you aware of the requirements you must comply with and insure that everything is done in strict compliance with 1031 regulations.
ADVANTAGES OF 1031 EXCHANGES
1. You can increase your buying power since federal capital gains taxes are deferred, allowing you to leverage these savings by putting them into the new property you are purchasing. This additional equity reinvested in the new property will make your financing easier.
2. You can do exchange after exchange, each time pyramiding your savings, and the deferred tax liability is forgiven upon the death of the investor, with the result that your heirs may have a lesser liability on the inherited property.
3. As the Exchanger you will have greater selling power since you do not have to inflate the sales price in order to recoup some of the capital gains that would normally accrue when selling an investment property. This will enable you to set a more flexible, and possibly profitable, price.
4. You can acquire replacement property with greater income potential, for instance by selling raw land and acquire income-producing property. You could also acquire an apartment building with additional units or another income-producing property in a more profitable location.
5. You have the opportunity to consolidate several difficult-to-manage properties into one easy-to-manage, large property, or to relocate or expand a current business or investment.
6. Especially when combined with a triple-net lease, a 1031 exchange can also help an investor acquire a less management-intense property.
BESIDES TAX REDUCTION, 1031 SWAPS CAN ACCOMPLISH MANY INVESTMENT GOALS:
- Increased buying power due to the availability of funds that normally would have gone to pay capital gains taxes
- Preservation of your estate
- Your selling power is increased since you can offer a more flexible selling price
- Increased your income by exchanging for properties with greater income (More profitable locations, lower operating costs, more rental units or a higher rental income per unit, etc.)
- Relocation of your business or investment property to a more profitable or desirable location.
- Expand you business into a larger space without tax penalties
All of these advantages culminate in the ability to speed wealth accumulation in real property ownership.
ARE THERE ANY DISADVANTAGES?
There is one slight disadvantage in that the value of your replacement property will be lowered by the deferred capital gains tax normally due on the sale of your exchanged property. Most savvy investors can see past this apparant disadvantage and see that in the long run you will still be ahead with a 1031 exchange.
QUALIFIED INTERMEDIARIES (QIs)
The use of a Qualified Intermediary is required by the regulations of Section 1031. The role of the Intermediary is to act as a middleman in both the sale and purchase transactions and to insure that all regulations and timelines are observed.
BASIC REQUIREMENTS OF 1031 EXCHANGES
1. BOTH PROPERTIES MUST BE "LIKE-KIND".
Like-kind simply means real property and refers to the nature or character of the property, not its grade or quality.
Like-kind is a very broad and liberal category where just about any type of investment or business-use property would qualify.
Examples of like-kind properties:
- rental properties (single family homes, apartment buildings, triplexes, etc.),
- raw or vacant land
- office buildings, shopping malls, almost any type businesses, airports, marinas, golf courses, etc with a lease of at least 30 years including options
- parking lots
- farms
- factories, retail stores,
- aircraft used for business purposes
- interest in a co-tenancy.
It is improtant to note that properties which are not considered as like kind include: stocks, bonds, notes, interest in a partnership, personal property, certificates of trust.
Properties can be located anywhere within the US with no restrictions relating to the exchange taking place in one or more states.
2. BOTH PROPERTIES MUST BE HELD FOR INVESTMENT OR BUSINESS USE.
Both the relinquished property and replacement property must be for investment or business use and each must be held for a minimum of one to two years.
You cannot purchase a replacement property with the intent to sell immediately.
Qualified 1031 exchange properties cannot be used for personal use more than 14 days per year (or 10% of the actual number of days the property has been rented in a given year).
3. EXCHANGER MUST USE A QUALIFIED INTERMEDIARY OR FACILITATOR.
One of the so-called "safe harbors" in the 1031 exchange regulations is the requirement to use a Qualified Intermediary or Facilitator in the actual exchange process.
Both the sale of the property you sell and the purchase of the replacement property must flow through the Intermediary, usually by direct deeding to avoid duplicate transfer taxes.
The Qualified Intermediary may not be the taxpayer or an agent of the taxpayer (realtor, attorney, tax advisor, banker, accountant, employee, etc.) or lineal descendant of the exchanger.
4. SELLER MUST USE A QUALIFIED ESCROW AGENT.
The qualified Escrow Agent may not be the taxpayer (seller) or an agent of the taxpayer (such as your realtor, attorney, banker, accountant, or other employee, etc.) or an actual lineal descendant of the Seller.
The Seller should not have any type of access to the proceeds of the property he is selling.
The Seller is entitled to all earnings on the escrow funds, but thes taxable funds must also be restricted in the same manner as the principal.
The Seller has the right to choose his Escrow Agent.
The Seller is entitled to obtain security for his funds while the 1031 transaction is in progress.
5. TO GAIN THE BENEFITS OF A 1031 TAX EXCHANGE THE PROPER DOCUMENTATION MUST BE USED.
1031 EXCHANGE AGREEMENT BETWEEN THE SELLER AND THE QUALIFIED INTERMEDIARY
This is the most important document in a 1031 exchange; in this document the Seller gives the Intermediary the right to acquire the relinquished property from the Seller and convey it to the buyer. It also gives the Intermediary the right to acquire the replacement property from the seller and then convey it to the Exchanger.
1031 EXCHANGE ESCROW AGREEMENT BETWEEN THE INTERMEDIARY AND ESCROW AGENT
If Westwood Net Lease Advisors is acting as both your Intermediary and Escrow Agent, the Escrow Agreement may be incorporated into the Exchange Agreement between the Exchanger and the Intermediary.
1031 EXCHANGE ASSIGNMENT FOR THE ROLLOVER OF THE RELINQUISHED PROPERTY
This document assigns the Exchanger's rights in the Agreement of Sale to the Intermediary and serves as written notification to the buyer of the relinquished property of the Seller's intent to effect a 1031 Exchange and also includes a hold harmless clause which assures the buyer that there are no hidden liabilities or costs.
Alternately a 1031 Clause may be inserted into the Agreement of Sale, in which case this document is not required.
1031 EXCHANGE AMENDMENT AND ASSIGNMENT OF THE IDENTIFIED REPLACEMENT PROPERTY
This document assigns the Seller's rights in the Agreement of Sale to the Intermediary and also serves as a written notification to the Seller of the replacement property that the Exchanger intends to effect a 1031 Exchange. Normally this document also includes a hold harmless clause to assure the seller of the replacement property that there are no additional liabilities or costs which may accrue to him.
Alternately a 1031 Clause may be included into the Agreement of Sale, and in such a case this document is no longer necessary.
6. EXCHANGER MUST ADHERE TO THE 1031 TIMELINE.
- The first node on the 1031 timeline is the 45-Day Identification Period which begins with the closing of the relinquished property and requires that the identification of like-kind replacement property be declared.
During this 45-Day Identification Period, you may chose a new propery by revoking the intial identification and making a new one.
If the replacement property has not been properly identified to the Intermediary by midnight of the 45th day, the Exchange has not been met and the taxpayer will not be eligible for the deferment of the capital gains tax due on the sale.
- The 180-Day Exchange Period commences at the same time as the 45-day Identification Period and requires that at least one of the identified replacement properties has been acquired before this period elapses.
- In cases where the settlement of the relinquished property occurs between October 16 and December 31, the 180-day Exchange Period will be shortened to the income tax deadline of April 15 of the next calendar year unless you file a timely IRS extension. For a corporation, this filing date is March 15 of the next calendar year unless an IRS extension is filed.
LIMITS ON THE NUMBER OF REPLACEMENT PROPERTIES THAT CAN BE IDENTIFIED:
- THREE PROPERTY RULE:
The Exchanger (Seller) may identify up to three replacement properties regardless of their fair market value. The Exchanger is not required to purchase all three properties but must purchase at least one of the identified properties. For example, if selling a relinquished property for $100,000, three replacement properties can be identified with a combined fair market of $750,000.
- 200% VALUE RULE:
Exchanger may identify more than three properties but their combined fair market value cannot exceed 200% of the fair market value of the relinquished property. For example, if your relinquished property was sold for $200,000 and four or more replacements are identified, their combined fair market value cannot exceed $400,000 or double the sale price of the relinquished property.
Important Exceptions to the Three Property Rule and the 200% Value Rule:
1. Any replacement property which is acquired within the 45-day Identification Period will be treated as properly identified, regardless of whether or not it is within the Three Property Rule or 200% Value Rule.
2. If the Three Property Rule and 200% Value Rule are violated, the property will still be treated as properly identified, provided that 95% of the combined fair market value of the identified replacement property has been acquired.
For example, if you sell a propperty for $200,000 property and identify five properties with a combined fair market value of $800,000, this may be treated as properly identified provided all five properties are acquired.
To contact a Net-lease specialist either fill out our brief Inquiry Form or call us Toll-free 866-638-1031.
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