Can the proceeds from the relinquished property be used to make improvements to the replacement property?
Yes. This is known as a Build-to-Suit or Construction or Improvement Exchange. It is similar in concept to a 1031 reverse exchange. The taxpayer is not permitted to build on property they already own. Therefore, a Special Purpose Entity (SPE) must take title to the replacement property, make the improvements, and convey title to the taxpayer before the end of the exchange period. See Case Study 3.
Can the replacement property eventually be converted to the taxpayer’s primary residence or a vacation home?
Under IRS Rev. Proc. 2008-16, you must own the Replacement Property as a rental (or for use in business) for two (2) years after its acquisition. If the property is a residence, you may move into it afterwards and use it as your vacation or primary home. Should you later decide to sell, if it is still a vacation home, the sale will be 100% taxable; if it is your primary home, and your period of ownership equals or exceeds five (5) years, a certain percentage of the sale will be taxable depending upon the ratio of how long the property was not your primary home to the total number of years of your ownership. For example, if you exchange into a residential property, the rules require you to rent it for the first two years, and own it for at least five before you can claim any part of the Primary Residence Exemption under Section 121; in this example, the initial taxable portion would be 40%, which is the ratio of your rental period (2 years) to your ownership period (5 years). The taxable portion itself is calculated by deducting your Adjusted Cost Basis from the Adjusted Gross Sales Price (Gross price less selling expenses) and multiplying the result by the ratio, in this case, 0.4. After the initial taxable portion is deducted, you may then apply as much of the Primary Residence Exemption as you qualify for. Married couples qualify for $500,000, while single persons qualify for $250,000. Any excess after these deductions is also taxed. All taxes are at Capital Gains Rates, but don’t forget Depreciation Recapture, and don’t forget your state (or city).
For a further discussion, click here for an article on the New Section 121 Rules, and for a chart of the applicable percentages. These New Rules take effect January 1, 2009.
No, not in most situations. The IRS regulations allow the properties to be deeded directly between the parties, just as in a normal sale transaction. The taxpayer’s interests in the property purchase and sale contracts are assigned to the QI. The QI then instructs the property owner to deed the property directly to the appropriate party (for the relinquished property, its buyer; for the replacement property, taxpayer).
If the taxpayer has already signed a contract to sell the relinquished property, is it too late to start a tax-deferred exchange?
No, as long as the taxpayer has not transferred title, or the benefits and burdens of the relinquished property, she can still set up a tax-deferred Exchange. Once the closing occurs, it is too late to take advantage of a Section 1031 tax-deferred exchange (even if the taxpayer has not cashed the proceeds check).
There are three 1031 exchange rules that limit the number of properties that can be identified. The taxpayer must meet the requirements of at least one of these three 1031 exchange rules:
- First 1031 exchange rule: 3-Property Rule – The taxpayer may identify up to 3 potential replacement properties, without regard to their value; or
- Second 1031 exchange rule: 200% Rule – Any number of properties may be identified, but their total value cannot exceed twice the value of the relinquished property, or
- Third 1031 exchange rule: 95% Rule – The taxpayer may identify as many properties as he wants, but before the end of the exchange period the taxpayer must acquire replacement properties with an aggregate fair market value equal to at least 95% of the aggregate fair market value of all the identified properties.
We sold a rental property last year and used the Section 1031 Tax Deferred Exchange law to defer the gains into another like-kind property. How do I handle this transaction on my tax return?
Report the exchange of like-kind property on Form 8824, Like-Kind Exchanges. The instructions for the form explain how to report the details of the exchange. Report the exchange even though no gain or loss is recognized.
If you have any taxable gain because you received money or unlike property, report it on Form 4797, Sales of Business Property, and Form 1040, SCHEDULE D, Capital Gains and Losses. Refer to Publication 544, Sales and Other Dispositions of Assets, which has a detailed section on like-kind exchanges.
The value of the replacement property must be equal to or greater than the value of the relinquished property.
- The equity in the replacement property must be equal to or greater than the equity in the relinquished property.
- The debt on the replacement property must be equal to or greater than the debt on the relinquished property.
- All of the net proceeds from the sale of the relinquished property must be used to acquire the replacement property.
- Qualifying Property – Certain types of property are specifically excluded from Section 1031 treatment: property held primarily for sale; inventories; stocks, bonds or notes; other securities or evidences of indebtedness; interests in a partnership, and certificates of trusts or beneficial interest. In general, if property is not specifically excluded, it can qualify for tax-deferred treatment.
- Proper Purpose – Both the relinquished property and replacement property must be held for productive use in a trade or business or for investment. Property acquired for immediate resale will not qualify. The taxpayer’s personal residence will not qualify.
- Like Kind – Replacement property acquired in an exchange must be “like-kind” to the property being relinquished. All qualifying real property located in the United States is like-kind. Personal property that is relinquished must be either like-kind or like-class to the personal property which is acquired. Property located outside the United States is not like-kind to property located in the United States.
- Exchange Requirement – The relinquished property must be exchanged for other property, rather than sold for cash and using the proceeds to buy the replacement property. Most deferred exchanges are facilitated by Qualified Intermediaries, who assist the taxpayer in meeting the requirements of Section 1031 so that the taxpayer can defer capital gains tax.
Potential replacement property must be identified in writing, signed by the taxpayer, and delivered to a party to the exchange who is not considered a “disqualified person”. A “disqualified” person is any one who has a relationship with the taxpayer that is so close that the person is presumed to be under the control of the taxpayer. Examples include blood relatives, and any person who is or has been the taxpayer’s attorney, accountant, investment banker or real estate agent within the two years prior to the closing of the relinquished property. The identification cannot be made orally.
A taxpayer has 45-days after the date that the relinquished property is transferred to properly identify potential replacement properties. The exchange must be completed by the date that is 180 days after the transfer of the relinquished property, or the due date of the taxpayer’s federal tax return for the year in which the relinquished property was transferred, whichever is earlier. Thus, for a calendar year taxpayer, the exchange period may be cut short for any exchange that begins after October 17th. However, the taxpayer can get the full 180 days, by obtaining an extension of the due date for filing the tax return.
What happens if the exchange cannot be completed within 180 days? Should I consider a 1031 reverse exchange?
If the 1031 exchange period exceeds 180 days, then the exchange is outside the safe harbor of Rev. Proc. 2000-37. With careful planning, it is possible to structure a 1031 reverse exchange (See Case Studies 2 & 5) that will go beyond 180 days, but the taxpayer will lose the presumptions that accompany compliance with the safe harbor.
What if the taxpayer cannot identify any replacement property within 45 days or close on a replacement property before the end of the exchange period?
Unfortunately, there are no extensions available, except for a Disaster Declared by the President, in which case 120 additional days are available. If the taxpayer does not meet the time limits, the exchange will fail and the taxpayer will have to pay any taxes arising from the sale of the relinquished property.
Qualified Intermediary is an independent party who facilitates tax-deferred exchanges pursuant to Section 1031 of the Internal Revenue Code. The QI cannot be the taxpayer or a disqualified person.
- Acting under a written agreement with the taxpayer, the QI acquires the relinquished property and transfers it to the buyer.
- The QI holds the sales proceeds, to prevent the taxpayer from having actual or constructive receipt of the funds.
- Finally, the QI acquires the replacement property and transfers it to the taxpayer to complete the exchange within the appropriate time limits in order for the taxpayer to defer capital gains tax.
In a typical transaction, the property owner is taxed on any gain realized from the sale. However, through a Section 1031 Exchange, the property owner is able to defer capital gains tax until some future date.
Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of “like-kind”, while deferring the payment of federal income taxes and some state taxes on the transaction.
The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer’s investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a “paper” gain.
The like-kind exchange under Section 1031 is able to defer capital gains tax, it is not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.
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.
Cash Boot is any boot received by the taxpayer, other than mortgage boot. Cash boot may be in the form of money or other property.
Mortgage Boot consists of liabilities assumed or given up by the taxpayer. The taxpayer pays mortgage boot when he assumes or places debt on the replacement property. The taxpayer receives mortgage boot when he is relieved of debt on the relinquished property. If the taxpayer does not acquire debt that is equal to or greater than the debt that was paid off, they are considered to be relieved of debt. The debt relief portion is taxable, unless offset when netted against other boot in the transaction.
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.
Once the money is deposited into an exchange account, funds can only be withdrawn in accordance with the Regulations. The taxpayer cannot receive any money until the exchange is complete. If you want to receive a portion of the proceeds in cash, this must be done before the funds are deposited with the Qualified Intermediary.
The exchange ends the moment the taxpayer has actual or constructive receipt (i.e. direct or indirect use or control) of the proceeds from the sale of the relinquished property. The use of a QI is a safe harbor established by the Treasury Regulations. If the taxpayer meets the requirements of this safe harbor, the IRS will not consider the taxpayer to be in receipt of the funds. The sale proceeds go directly to the QI, who holds them until they are needed to acquire the replacement property. The QI then delivers the funds directly to the closing agent.
What is described is a little known law which permits the seller of commercial or rental real estate, or land to pay no Federal or state capital gains taxes on the sale. (Primary residences and vacation homes can also be made to qualify.) It doesn’t take a math wizard to figure out that on a sale of low (or no) basis property the tax and transaction costs (Federal, state, broker, legal) can exceed 30%.
Let’s use you as an example here. Pretend that you own real estate someplace in the U.S. that you have depreciated, etc., and for which you now have a cash buyer. Suppose further that you would like to acquire a new property someplace else with the money.
If you go through a regular closing, the capital gains taxes on the transaction become due immediately. These taxes are now virtually impossible to avoid because buyers are now required to give the IRS your name, Social Security number, the date of sale and the gross amount paid, all via the mechanism of a 1099 form. The Federal Government is alerted to look for the sale on your next tax return, and, of course, their information is shared with the states. Depending on the cost basis of the property you have just sold, you now have as little as two-thirds left available to reinvest, after taxes.
Furthermore, when you repurchase, the seller of the property you buy also has to pay capital gains taxes, and the IRS is alerted to look for him or her too via the 1099 which you are required to submit under that seller’s name. So in a normal sale and repurchase, the government gets tax revenue twice, once from you and once from the person you buy from.
However, pretend now that you structured your closing as a Section 1031 Exchange instead of a sale:
Does your buyer get what he or she wants, at Step 1? Yes.
Is a 1099 issued to you, evidencing the sale? Yes, but language is added to inform the IRS that a Section 1031 Like-Kind Exchange is taking place and to look elsewhere on your return for an accounting.
What happens to the money? It goes into a special escrow account at a money center bank under our control as your Qualified Intermediary, however, you are named as account owner(s) and interest goes to you.
Is the money taxed? No, not by either the Federal or state (or city) governments if the funds are spent within 180 days on Replacement Property as selected by you anywhere in the U.S. and if other rules are followed.