WHAT IS AN EXCHANGE?
Often called the last great wealth building tool available to real estate investors, a tax deferred exchange is an Internal Revenue Service approved approach where a property owner can sell a highly appreciated asset and replace it with another like-kind property on a tax deferred basis, provided the transaction was completed within some basic guidelines set for the by the IRS. Although the logistics of selling one property and buying another are virtually identical to any standard sale and purchase scenario, an exchange is different because the entire transaction is memorialized as an exchange and not a taxable sale. It is this distinction between exchanging and not simply selling and buying, which ultimately allows the taxpayer to qualify for deferred gain treatment. So essentially, sales are taxable and exchanges are not.WHY SHOULD AN INVESTMENT PROPERTY OWNER CONSIDER AN EXCHANGE?
There are several excellent reasons why an investment or income property owner should consider an exchange when they are selling a qualifying property. The first and most obvious is that the normal capital gains tax which is traditionally due upon a sale can be deferred until a later date and a later sale. This is because the IRS allows a tax deferred transaction because they view it as an investment or income property owner transferring their cost basis for tax purposes from one qualifying property to another. Make no mistake, your capital gain tax exposure does not go away outright, it is simply transferred to the replacement property which is acquired in the exchange transaction. How does the capital gain tax transfer to the new property? It is transferred to the replacement property as a new adjusted cost basis is created upon the purchase. The new adjusted basis will essentially be the replacement property purchase price less the amount of the capital gain deferred. Some of the other reasons for considering an exchange include:IRS REQUIREMENTS FOR YOUR EXCHANGE AND IRC SECTION 1031
The IRS has set forth a few modest requirements for an exchange to qualify for deferred gain treatment. Among the main requirements are:1) The Three Property Rule dictates that the Exchanger may identify three properties of any value, one or more of which must be acquired within the 180 Day Exchange Period.
2) The Two Hundred Percent Rule dictates that if four or more properties are identified, the aggregate market value of all properties may not exceed 200% of the value of the Relinquished Property.
3) The Ninety-five Percent Exception dictates that in the event the other rules do not apply, if the replacement properties acquired represent at least 95% of the aggregate value of properties identified, the exchange will still qualify.
As a caveat it should be mentioned that these identification rules are absolutely critical to any exchange. No deviation is possible and the Internal Revenue Service will grant no extensions.
* Ironically, although only approximately 3-5 percent of exchanges are audited, the few exchanges which don't pass upon audit, typically they fail because of discrepancies in identification.
1031 EXCHANGE MATH - COMPLETING A TOTALLY TAX-FREE TRANSACTION
The IRS expects you to replace both your equity and your debt in order to create a fully tax deferred transaction. If you'd like to ensure that your exchange will be totally tax deferred, do these three things:THE FOUR MOST POPULAR TYPES OF EXCHANGES
IRS compliant exchanges can be completed in several forms, depending upon the Exchanger's circumstances and the transactional logistics and structure of the exchange itself. Among them are:THE SIMULTANEOUS EXCHANGE
Up until the delayed or deferred exchange was codified into the Internal Revenue Code in 1984, virtually all exchanges were of the simultaneous type. To qualify as a simultaneous exchange, both the relinquished property and the replacement property must close and record on the same day. This can be difficult depending upon the properties and the closings involved with the exchange.Some investors still try to complete simultaneous exchanges, primarily to avoid or reduce the payment of multiple closing fees or exchange fees for a Qualified Intermediary, essentially using the relinquished ad replacement closing statements in lieu of an exchange agreement.
There is significant danger and legal exposure in this attempt since many unforeseen events can cause the closing to be delayed on one of the properties, leaving the investor with a failed exchange and the obligation of taxes that would otherwise be deferred. For example, if the properties are located in different counties, it is highly unlikely that the closing can take place on the same day. If two different closing firms or attorneys are involved, it is virtually impossible for both to have the funds to close in their possession on the same day. For instance, with "Good Funds" laws existing in many states, an escrow holder or closer cannot disburse funds not actually in their possession. Further, in directing an escrow holder or closer to disburse funds for the purchase of the replacement property, it could be contended by the IRS that the investor had what is considered "constructive receipt" of the proceeds of the sale, and therefore taxes on the gain would be due.
However, the 1031 regulations do contain what is referred to as a "Safe Harbor" provision, which does provide that in the event a facilitator or intermediary is used in a simultaneous exchange, and the transaction proves not to be simultaneous, the exchange will not fail simply for that reason.
THE DEFERRED EXCHANGE
Generally, when one discusses exchanges, the type of exchange referred to is the delayed or deferred exchange. This is the most common type of tax deferred exchange.In a delayed exchange, the Relinquished Property is sold at Time 1, and after a delay of up to 180 days, the Replacement Property is acquired at Time 2.
THE REVERSE EXCHANGE - BUYING BEFORE YOU SELL
There are occasions when an Exchanger needs to acquire their replacement property prior to selling their relinquished property. But, because the IRS will not allow an to exchange into property they already own, a special process was created by the IRS in Revenue Procedure 2000-37 to provide logistical guidance for buying before you sell and still having a compliant exchange.The most popular reverse exchange approach, known as an exchange last reverse, is where an Exchanger arranges the acquisition of the replacement property by adding enough cash (or arranging suitable financing) to buy the new property through a surrogate set up by the Qualified Intermediary, known as an Exchange Accommodation Titleholder, or EAT. The EAT holds title to the replacement property until such a time within the 180 day exchange period that the relinquished property is sold. When the relinquished property is sold and the exchange proceeds from that sale are wired to the Qualified Intermediary, two things happen. First, the amount of cash advanced by the Exchanger (in the form of a loan to the EAT) to acquire the replacement property is repaid to the Exchanger. Additionally, the replacement property is deeded to the Exchanger by the EAT, or the EAT itself is transferred to the Exchanger by the Qualified Intermediary.
Another technique, known as an exchange first reverse, provides for an opposite approach where the relinquished property is deeded to the EAT at the beginning of the process. This allows the Exchanger to then go ahead and close on the replacement property. Then, within the 180 day exchange period and when the relinquished property is sold to a new buyer, the relinquished property is deeded to the new buyer by the EAT. It should be noted that in an exchange first reverse, that it is best if the equities between the relinquished and replacement properties are balanced prior to deeding the relinquished property to the EAT.
Obviously, due to the transactional and qualifying logistics of reverse exchanges, they tend to be more complicated exchanges, with the resulting reverse exchange fees amounting to much more than the typical deferred exchange. Also, since they tend to be more complex than other exchanges, and because they involve the holding, parking or warehousing of title by a facilitator in the form of an Exchange Accommodation Titleholder, they require extensive planning. Do not undertake a reverse exchange without the assistance of an experienced and knowledgeable facilitator or Qualified Intermediary.
IMPROVEMENT AND CONSTRUCTION EXCHANGES
In some cases, the replacement property selected by the Exchanger requires new construction or significant improvements to be completed in order to make it viable for the specific purpose intended for the property. Such construction or improvements can be accomplished as part of the exchange process, with payments to contractors and other suppliers being made by the Qualified intermediary out of funds held in a 1031 exchange trust account. Therefore, if the replacement property is of lesser value than the relinquished property at the time of the original transaction, the improvement or construction costs can bring the value of the replacement property up to an exchange value which would allow the transaction to remain completely tax deferred.1031 EXCHANGE PLANNING
Since tax deferred exchanges involve a minimum of two properties, and often many more, they include some extraordinary logistics because of the necessary multiple closings and the difficulties associated with many transactional moving parts. For this reason, and because a significant amount of deferred gain treatment is at stake, every exchange deserves to be planned by the Exchanger beforehand.It usually only takes a few minutes with a 1031 exchange professional for an Exchanger to theoretically walk through the entirety of the exchange logistics before starting. This type of pre-planning can often assist an Exchanger to avoid many pitfalls and create workarounds or mitigation strategies before any problems can arise.
1031 TRANSACTIONAL LOGISTICS
It is important that any exchange be carefully planned with the help of an experienced, competent and creative legal and exchange professional. Preferably one who is completely familiar with the tax code in general, not just Internal Revenue Code Section 1031. Also, one who has extensive experience in doing many different kinds of exchanges. Thorough planning can help avoid many subtle exchanging pitfalls and also ensure that the Exchanger will accomplish the goals which the transaction is intended to facilitate.Once the planning is complete, the exchange structure and timing are decided, and the relinquished property is sold, the Qualified Intermediary needs to create the appropriate exchange agreement and set up a trust account for the Exchanger's sale proceeds before the transaction is closed. After closing the exchange funds are wired to the Exchanger's trust account until the Replacement Property is located and instructions are received to fund the Replacement Property purchase. The funds are then wired or sent to the closing entity in the most appropriate and expeditious manner, and the Replacement Property is purchased and deeded directly to the Exchanger. All the necessary documentation to clearly memorialize the transaction as an exchange is provided by the facilitator or Qualified Intermediary such as exchange agreement, assignment agreement and appropriate closing instructions.
SELECTING A QUALIFIED INTERMEDIARY
The process of selecting a Qualified Intermediary has never been more important. This is because, in addition to there being relatively few federal regulations governing the function of intermediaries, how a Qualified Intermediary handles the facilitation of your exchange and even more importantly, how they handle your exchange funds, has never been more critical.Elsewhere we discuss how pivotal it is that every Exchanger choose a Qualified Intermediary that will facilitate their exchange within an encrypted processing environment, and appropriately provide for the absolute security of the Exchanger's personal data as well as their exchange funds.
Select the facilitator as you would an attorney for personal representation or a physician to treat your children. Look for experience in doing exchanges and reputation in the real estate, legal or tax communities.
Ask about the security of your funds, and what options you as an Exchanger may have to assure that your funds will be safeguarded. Although the costs and fees for an exchange are relatively insignificant, ask about them, and get a clear explanation of what you will be charged. With a few notable exceptions, fees are very similar, one facilitator to the next. What is of far greater importance is the competence and ability of the facilitator and its personnel to complete your exchange promptly, professionally and compliantly.
REPLACEMENT PROPERTY IDENTIFICATION
Three rules exist for the correct identification of replacement properties.1) The Three Property Rule dictates that the Exchanger may identify three properties of any value, one or more of which must be acquired within the 180 Day Exchange Period.
2) The Two Hundred Percent Rule dictates that if four or more properties are identified, the aggregate market value of all properties may not exceed 200% of the value of the Relinquished Property.
3) The Ninety-five Percent Exception dictates that in the event the other rules do not apply, if the replacement properties acquired represent at least 95% of the aggregate value of properties identified, the exchange will still qualify.
As a caveat it should be mentioned that these identification rules are absolutely critical to any exchange. No deviation is possible and the Internal Revenue Service will grant no extensions.
* Ironically, although only approximately 3-5 percent of exchanges are audited, the few exchanges which don't pass upon audit, typically they fail because of discrepancies in identification.
THE SECURITY OF YOUR PERSONAL DATA AND 1031 FUNDS
Many Exchangers don't understand that the 1031 exchange industry is largely unregulated. Across the country there are very few provisions set forth legislatively to ensure that your exchange as well as your hard-earned exchange funds are handled appropriately. To be sure, there are a handful of states that require the licensing of Qualified Intermediaries and some basic requirements for minimum fidelity bonding and errors and omissions insurance for facilitators.This is just one of the reasons why as an Exchanger, you must take an active role in ensuring that the processing of your exchange is secure and that your exchange funds, while on deposit with the Qualified Intermediary are always safe. You owe it to yourself to understand both the environment in which your exchange documentation and data is handled, but also how your 1031 funds will be truly safe.
The Security of Your Personal DataThe online world in which we live today can be dangerous. Especially for those involved in the sale and transfer of real estate. Your personal data is always at risk of being hacked or compromised, and it is even more risky to allow the transport of your personal data across free email platforms like Gmail and Yahoo.
Frankly, this is one of the primary rationales we utilize whenever we refer an Exchanger to any Qualified Intermediary. We encourage every Exchanger to insist that their exchange is processed within a fully encrypted environment, to ensure that no data is ever at risk. That is also why we will refer you to a processor that will set up your account and securely send you login credentials, so you can log in to a secure ecosystem where you can safely interact with your exchange documents, view your trust account activity, or communicate with your 1031 Coordinator.
This encryption is the backbone that works to protect you and your business 24/7:
For many years, Qualified Intermediaries commingled the exchange proceeds of their Exchangers and provided for the sub-accounting of individual Exchanger balances on their own books. Over time, as banking software became more sophisticated, it was possible to set up individual accounts for the benefit of Exchangers (FBO), however the accounts were always in the name of the Qualified Intermediary and never required the approval of the Exchanger to transfer and exchange funds.
Qualified Escrow AccountsA segregated trust account is the bedrock of a secure and IRS-compliant 1031 exchange. Here's why it's non-negotiable:
In today's digital age, having access to financial information at any time is imperative.
This standard now represents the safest method for having your funds on deposit with any Qualified Intermediary. If a QI suggests to you that this is unnecessary or refuses to offer you a QEA, you shouldn't immediately assume your exchange proceeds will be safe in their custody.
A Word About BanksLastly, while we know it is possible to arrange extended FDIC insurance for individual accounts, we suggest having your exchange proceeds at banks or institutions which are frankly 'too big to fail'. While this may be a new concept for many Americans, candidly this means that exchange funds are kept on deposit with a very select few banks which are so large that their deposit base is effectively guaranteed by the full faith and credit of the United States of America. In practical terms this means that the bank deposit base is so large, that it cannot be taken over by regulators and sold to another institution. Rather it must be fully backstopped by US Treasury.
Fidelity Bonding
First, while fidelity bonding is a standard requirement for all Qualified Intermediaries, it is not the same as insurance, nor is it secured for the benefit of the Exchanger. Most QIs maintain a minimum $1 million bond for qualification purposes, although Exchangers should know that bonding is designed to protect the facilitator, not the Exchanger.
There are some facilitators who tout a large fidelity bond as the tacit security for the exchange funds in their custody. Such a suggestion is false, as often the exchange funds held by that facilitator dramatically exceed the face amount of the fidelity bond by an order of magnitude. If your Qualified Intermediary suggests that such a bond represents the security of your exchange funds, you owe it to yourself to Google LandAmerica Title Company and LandAmerica 1031 Exchange' before committing to such an arrangement.
Our Approach
We've tried our best to build the most secure and most transparent value proposition for Exchangers.
We've done this by encouraging:
AN EXPERIENCED EXCHANGER'S CHECKLIST FOR SUCCESS (YOUR KEYS TO EXCHANGING)
Owners of investment and income properties have access to the greatest real estate wealth building tool ever developed, the 1031 tax deferred exchange.Exchanges don't have to be difficult, however you need to understand a few keys to 1031 exchanging to have an efficient and fully compliant transaction.
THE CHECKLIST:
THERE ARE DIFFERENT TYPES OF EXCHANGES DEPENDING UPON YOUR CIRCUMSTANCES.
You may exchange investment or income property for many reasons and still defer capital gain and depreciation recapture taxes. The Internal Revenue Service views your exchange of one property and the replacement with another as simply moving your adjusted cost basis from one property to another. This is why they allow the transfer to be tax deferred.THE PROPERTIES YOU EXPECT TO EXCHANGE MUST BE CONSIDERED 'LIKE KIND'
The Internal Revenue Service requires that the property you sell, as well as the property you buy must be like-kind. And, like kind means one of two things. Either property held for investment, or property held for income. This would exclude your personal residence.H3>YOU MUST UTILIZE THE SERVICES OF A QUALIFIED INTERMEDIARY The IRS requires that your exchange be completed with the assistance of a Qualified Intermediary or facilitator. You should use a well-established firm like FYNTEX, so you know that your exchange documentation will be always be correct and that your exchange funds will be safely held in a Qualified Escrow Account between the time you sell and the time you buy.
YOU HAVE A TOTAL OF 180 DAYS TO COMPLETE YOUR EXCHANGE
You must complete your sale and purchase within a total of 180 days or whenever your tax return is due. The tax return qualifier means that if you start your exchange late in the year, you might have to file for an extension in order to receive your full 180 days.YOU MUST IDENTIFY CANDIDATE REPLACEMENT PROPERTIES WITHIN THE FIRST 45 DAYS
While you have a total of 180 days to complete your 1031 exchange, the IRS requires that you identify your candidate or target Replacement Properties within the first 45 days of your exchange period. This identification is usually made to your Qualified Intermediary by completing a form which is kept in your exchange file. Since the 45 day identification period moves so quickly, start looking for new property as early as possible in the process.THERE ARE SPECIFIC RULES FOR IDENTIFYING THE PROPERTY YOU EXPECT TO ACQUIRE
The IRS requires the use of two rules or one exception for identifying potential Replacement Properties.The first is the Three Property rule, meaning you may identify up to three properties of any value.
The second rule is the Two Hundred Percent rule, meaning you may identify more than three properties provided all of the properties you identify do not exceed two hundred percent of the value of the property you sold.
The one exception is known as the Ninety-five Percent exception. You may identify more than three properties and more than two hundred percent of total identified property value, provided you acquire at least ninety-five percent of everything you identified.
THERE ARE THREE THINGS YOU MUST DO TO HAVE A 100% TAX DEFERRED EXCHANGE
If you want a completely tax deferred transaction you must do these three things. First, buy Replacement Property which is equal or greater than the net selling price of what you sold. Two, move all your equity from the old property into the new property. And three, replace your debt.BUY REPLACEMENT PROPERTY AS THE SAME ENTITY IN WHICH YOU SOLD
It is always best to buy as the same entity in which you sold. To change your vesting (to an LLC for example) in the middle of an exchange will create unnecessary risk because the IRS could make a case that your new ownership entity had not seasoned their ownership sufficiently to qualify for deferred gain treatment under Section 1031.1031 EXCHANGE GLOSSARY OF TERMS
Cost Basis: This is where all tax related calculations in an exchange begin. Cost Basis essentially refers to your original cost in acquiring a given property. Therefore, if the original purchase price of the property you anticipate exchanging was $275,000; your Cost Basis is $275,000.Adjusted Basis: At the time of your sale, it is necessary to determine your current or adjusted basis. This is accomplished by subtracting any depreciation reported previously, from the total of the original cost basis, plus the value of any improvements.
Capital Gain: "Realized Gain" and "Recognized Gain" are the two types of gain found in exchange transactions. Realized Gain reflects the difference between the total consideration or total value received for a given property and the adjusted basis.
Recognized Gain: reflects that portion of the Realized Gain, which is ultimately taxable. The difference between realized and recognized gain exists because not all realized gain is ultimately determined to be taxable and issues such as boot can affect how and when gain is recognized.
Net Sales Price: This figure simply represents the sales price, less costs of sale.
Net Purchase Price: This figure simply represents the purchase price, less costs of purchase.
Boot: When considering an exchange of real property, the receipt of any consideration other than real property is determined to be "boot". So, essentially, a working definition of boot is: any property received which is not considered like-kind. And remember, non like-kind property in an exchange is taxable. Therefore, boot is taxable.
There are two types of boot, which can occur, in any given exchange. They are mortgage boot and cash boot. Mortgage boot typically reflects the difference in mortgage debt, which can arise, between the exchange of relinquished property and the replacement property.
As a general rule, the debt on the replacement property has to be equal to, or greater than, the debt on the relinquished or exchange property. If it is less, you'll have what is called "overhanging debt" and the difference will be taxable.
Let's assume for example that you are selling your Relinquished Property for $375,000 and that it has a mortgage of $250,000. At closing, the mortgage will be paid off and the balance of $125,000 will be held by your facilitator.
Suppose that you then find a new property costing $350,000, with a mortgage of $225,000 that you will assume. The assumption of this debt, along with your exchange trust fund of $125,000 will complete your purchase. Under this example you would have to pay tax on $25,000 of capital gains because your debt decreased by that amount.
Likewise, cash boot reflects the amount of cash or other value received.
New Adjusted Basis: This figure reflects the necessary adjustments to your basis after the replacement property is acquired. Since the amount of deferred gain must be considered, the calculation below will serve as a method for determining the new adjusted basis on the replacement property.