Invest in Real Estate Using Your Code §1031 Exchange Property

What are IRS Code §1031 Like-Kind Exchange Services?

Under Code §1031 of the Internal Revenue Code, a real property owner can sell his/her property and then reinvest the proceeds in ownership of like-kind property and defer the capital gains taxes. To qualify as a Code §1031 like-kind exchange, property exchanges must be done in accordance with the rules set forth in the tax code and in the Treasury regulations. IRS Code §1031 exchange services can offer significant tax advantages to real estate buyers. Often overlooked, a Code §1031 like-kind exchange is considered one of the best-kept secrets in the Internal Revenue Code.



Who Should Consider a Code §1031 Exchange?

If you have real property that will net you a gain upon sale (generally property that has been substantially depreciated for tax purposes and/or has appreciated in fair market value), then you are exactly the person who should consider a Code §1031 exchange.

There are five (5) tax classes of property: 

         1) Property used in taxpayer's trade or business. 
         2) Property held primarily for sale to customers. 
         3) Property which is used as your principal
             residence. 
         4) Property held for investment.
         5) Property used as a vacation home. 

Code §1031 applies to the first and fourth categories, and potentially the fifth category. Business use is defined as, "To hold property for productive use in trade or business." Property retired from previous productive use in business can be a qualifying property.  Investment is the passive holding of property, for more than a temporary period, with the expectation that it will appreciate. Property held for sale in the immediate future is not held for investment.


MISCONCEPTIONS ABOUT EXCHANGING

1. Many still believe that you must "swap" properties. Although this was required in the original code, this is rarely done in present times. Code §1031 Exchanges now enable one to sell their property to someone totally unrelated to the person from whom they are purchasing their replacement

2. Many believe only investors of large commercial properties can utilize the benefits of Code §1031. The great thing about Code §1031 Exchanges is that it applies to all investment properties, large and small. It will work the same way for a corporation selling a large shopping center as it would 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 use or service." While Code §1031 exchanges are also known as "like-kind" exchanges, like-kind simply applies to real property held for business use or investment. Therefore, an investor may sell raw land and acquire a five-unit apartment building or sell a warehouse and acquire raw land. He can sell one property and acquire three or sell four and acquire one. Virtually any type of real property used for business use or investment will qualify.

4. Many believe Code §1031 exchanges are very complicated and not worth doing. The fact is that when working with a qualified intermediary who specializes in Code §1031 tax deferred exchanges, the exchange process is very simple. The intermediary will keep you aware of your time deadlines and ensure you do everything in strict compliance with IRS regulations.


Why Should You Consider a IRS
Code §1031 Exchange?

·Defer paying capital gains taxes.
 
·Leverage.

·A properly structured exchange can provide real estate
 investors with the opportunity to defer all of their capital
 gains taxes. By exchanging, the investor essentially
 receives an interest-free, no-term loan from the
 government. 
 
·Upgrade or consolidate property.
 
·Diversify. Own multiple properties rather than just one.

·Relocation to a new area.

·Differences in regional growth or income potential.

·Change property types among residential, commercial, 
 retail, etc.


ADVANTAGES OF EXCHANGING

1. The Exchanger will have more buying power because the federal income taxes are deferred. This will enable him to leverage himself up greater than he could had he paid the tax liability. The additional equity to reinvest will make him a more solid buyer and help him get easier financing.

2. Investors can do exchange after exchange to create a pyramiding effect. This tax liability is forgiven upon the death of the investor as the heirs get a stepped up basis on the inherited property.

3. The Exchanger will have greater selling power because he does not have to inflate the sales price to try to cover some of the capital gains that would normally be due upon the sale of an investment property. It will enable him to be more flexible with the selling price.

4. The Exchanger can acquire a replacement property with greater income potential. He can sell raw land and acquire income producing property. Perhaps, he wants to acquire a building with additional units or in an easier to rent location.

5. The Exchanger has the opportunity to consolidate several hard to manage properties into one easier to manage property or consolidate several smaller properties into one large property or the reverse. It provides an excellent opportunity to relocate or expand a current business or investment.

6. An exchange can also help an investor acquire a less management intense property.



BESIDES TAX REDUCTION, Code §1031 EXCHANGES CAN ACCOMPLISH MANY INVESTMENT GOALS:

Estate preservation.
 
Increased buying power because of greater cash flow.

Increased selling power because the federal capital gain tax liability is deferred.

Exchange for property with an increased income (more rental units, higher rental income per unit, lower operating expenses, easier to rent location, etc.)
 
The need or desire to relocate a business or investment property.

Exchange for property that requires less management.

Exchange for property that is easier to finance.

Consolidate smaller properties into a larger property.

Diversify a large property into several smaller properties.
The need or desire to expand a business into a larger space

All of the above culminates into one significant power- The ability to create pyramiding wealth accumulation in real estate ownership.


SLIGHT DISADVANTAGE:

The basis of your replacement property will be lowered by the amount of gain deferred on the sale of your relinquished property. However, when weighing this against the deferred gain, the astute investor can clearly see he is still significantly ahead.


THE PROPERTIES IN THE EXCHANGE

RELINQUISHED PROPERTY:

The relinquished property is the business use or investment property the Exchanger owns and wants to sell via the Code §1031 Exchange.

REPLACEMENT PROPERTY:

The replacement property is the business use or investment property the Exchanger wants to acquire to complete the Code §1031 Exchange. There can be more than one of each of the relinquished and replacement properties. For example, an Exchanger can sell three small properties and purchase one large property or sell one large property and acquire four smaller ones. An Exchanger does not have to purchase the same type of property. For example, he can sell a storage facility and acquire an apartment building or sell a raw piece of land and acquire a shopping center.


THE PARTIES INVOLVED IN THE EXCHANGE

EXCHANGER: The Exchanger is the taxpayer who is electing to defer the capital gains by effecting a Code §1031 Exchange.

SELLER: The seller is the person who owns the property the Exchanger wishes to acquire as a replacement property.

BUYER: The buyer is the person who wants to purchase the property the Exchanger is selling

INTERMEDIARY: The use of a qualified Intermediary is required by the regulations of Code §1031. The role of the Intermediary is to act as a middleman in both the sale and purchase transactions


What are the IRS Code §1031 Exchange Rules? 

1.The real property you sell and the real property you buy must both be held for productive use in a trade or business or for investment purposes and must be like-kind.       

2.The proceeds from the sale must go through the hands of a qualified intermediary and not through your hands or the hands of one of your agents or else all the proceeds will become taxable.

3.All the cash proceeds from the original sale must be reinvested in the replacement property - any cash proceeds that you retain will be taxable.

4.The replacement property must be subject to an equal level or greater level of debt than the relinquished property or the buyer will either have to pay taxes on the amount of the decrease or have to put in additional cash funds to offset the lower level of debt in the replacement property.



IRS Code §1031 Timelines

Identification Period: 

Within 45 days of selling the relinquished property you must identify suitable replacement properties. This 45 day rule is very strict and is not extended should the 45th day fall on a Saturday, Sunday, or legal holiday.

Exchange Period:

The replacement property must be received by the taxpayer within the "exchange period," which ends within the earlier of . . . 180 days after the date on which the taxpayer transfers the property relinquished, or . . . the due date for the taxpayer tax return for the taxable year in which the transfer of the relinquished property occurs. This 180-day rule is very strict and is not extended if the 180th day should happen to fall on a Saturday, Sunday or legal holiday.


Replacement Property Identification

3-property rule:

You may identify any three properties as possible replacements for your relinquished property. The vast majority of exchanges use the 3-property rule.


200% rule:

You may identify any number of properties as possible replacements for your relinquished property as long as the aggregate value of those properties does not exceed 200% of the value of your relinquished property.


95% exemption:

You may identify any number of properties as possible replacements for your relinquished property as long as you end up purchasing at least 95% of the aggregate value of all properties identified.



Like-Kind Property
 
In a Code §1031 exchange you can exchange any real property for any other real property within the United States or its possessions if said properties are held for productive use in trade or business or for investment purposes. Examples of like-kind property include apartments, commercial, condos, duplexes, raw land and rental homes*.

As used in IRC §1031(a), the words "like-kind" mean similar in nature or character, notwithstanding differences in grade or quality. One kind of class of property may not, under that section, be exchanged for property of a different kind or class. Examples of qualified like-kind exchanges:

   ·apartment building for farm/ranch 
   ·office building for hotel 
   ·raw land for retail space      
   ·unimproved property for commercial property
   ·airplane for airplane

Examples of non like-kind properties include primary residences, stocks and bonds, notes, partnership interests, developed lots held primarily for sale and property to be resold immediately after initial purchase or completion of improvements.

* Qualification for Code §1031 exchanges depends upon the extent of personal use.


IRC §1031 Exchange Formats
 
   ·Simultaneous 
         - Two-party swap
         - Alderson exchange 

   ·Delayed exchange (most common) 
         - Safe Harbor 

   ·Multiple sales/acquisitions 

   ·Reverse exchange 

   ·Improvement exchange
 
   ·Tenant-In-Common (TIC) exchange 

   ·The other types of Code §1031 exchanges


The Role of the Qualified Intermediary (QI)

The QI is a person or entity that can legally hold funds to facilitate a Code §1031 exchange. To be qualified, the intermediary must not be relative or agent of the exchanging party. As an exception, a real estate agent may serve as an intermediary if the current transaction is the only instance in which the agent has represented the exchanging party over the past two years.

The regulations of Code §1031 require the use of a qualified intermediary to act as a middleman for the Exchanger. The intermediary is an independent fourth party which acquires and conveys both properties and receives, holds, and controls the sale proceeds. The use of a qualified intermediary provides many advantages such as the right to direct deed, protection against imputation of agency, and the safe harbor regulations relating to the security of Exchanger's escrow funds.

The use of a QI is essential to completing a successful Code §1031 exchange. The QI performs several important functions in the Code §1031 exchange process including creating the exchange of properties, holding the exchange proceeds and preparing the legal documents. 


HOW DO I CHOOSE A QUALIFIED INTERMEDIARY?

Unfortunately, qualified does not have anything to do with the qualifications of the intermediary. Qualified simply means the intermediary is not the taxpayer or an agent of the taxpayer. As state previously, anyone the taxpayer has worked with, in any capacity, within the past two years is disqualified from acting as the intermediary. This automatically excludes the taxpayer's attorney, accountant, Realtor, broker, financial planner, partner, employee or close relative.  Currently, the only state requiring licensing to be an intermediary is Nevada. However, those intermediaries affiliated with a title company are exempt.

It is recommended you choose a corporation rather than an individual, specializing in Code §1031 Exchanges. The intermediary should be fully knowledgeable on all current regulations and be able to guide the Exchanger through all aspects of the exchange process, prepare the necessary documentation, and provide instructions to you and all related parties to ensure a smooth transaction period.  Additionally, choose an intermediary who is a member of the Federation of Exchange Accommodators (FEA), the only national association for professional exchange practitioners.  The FEA, based in Sacramento, California, is organized to promote the discussion of ideas and innovations in the industry and general public, and to work toward the development of a uniformity of practice and terminology within the exchange profession. The FEA also provides timely input and updates on pending State and Federal legislation, Internal Revenue Service and U.S. Treasury rulings, and court decisions. As your sale proceeds will be placed into an escrow account in the name and federal tax identification number of the Intermediary, be sure the Intermediary is bonded and insured.

You may wish to request a list of references from the Intermediary.


WHEN IS THE BEST TIME TO RETAIN AN INTERMEDIARY?

Of course, the ideal situation is advanced planning. Retaining the services of an Intermediary as soon as you decide to sell your property, will ensure a smooth transaction. However, you may retain an Intermediary all the way up to just prior to settlement. However, once the settlement has been completed, you cannot attempt an Exchange.

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SO, LET'S GO OVER THIS ONE MORE TIME:

BASIC REQUIREMENTS OF EXCHANGES

1. BOTH PROPERTIES MUST BE "LIKE-KIND".

Like-kind simply means real property. Like-kind refers to the nature or character, 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. Properties can be located anywhere within the United States with Exchanges taking place in one or more states. Examples of like-kind real estate exchanges: 
rental properties (single family homes, duplexes, triplexes,  apartment buildings and complexes, etc.), raw land, office buildings, shopping centers businesses, marinas, golf courses, a lease of at least 30 years including options, parking lots, farms, factories, trailer parks, storage facilities, retail stores, interest in a co-tenancy.

Examples of non like-kind exchanges for real estate:
stocks, bonds, notes, interest in a partnership, personal property, certificates of trust, chooses in action.

Investors can "mix and match" their properties. For example, an investor can sell a duplex and acquire raw land or sell a parking garage and acquire a multi-unit apartment building and a warehouse.


2. BOTH PROPERTIES MUST BE HELD FOR INVESTMENT OR BUSINESS USE.

Your use of both the relinquished property and replacement property must be investment or business use; each for a minimum of one to two years. Properties must not be used for personal use for more than 14 days per year or 10% of the actual number of days the property has been rented in a given year. Replacement property cannot be purchased with the intent to sell immediately.


3. EXCHANGER MUST USE A QUALIFIED INTERMEDIARY OR FACILITATOR.

One of the safe harbors of the regulations is the use of a qualified Intermediary to facilitate the Exchange. The sale of the relinquished property and the acquisition of the replacement property must "flow" through the Intermediary. This is done through direct deeding to avoid duplicate transfer taxes.

4. EXCHANGER MUST USE A QUALIFIED ESCROW AGENT AND HAVE NO ACTUAL OR CONSTRUCTIVE RIGHTS TO THE SALE PROCEEDS OF THE RELINQUISHED PROPERTY.

The qualified Escrow Agent may not be the taxpayer or an agent of the taxpayer (Realtor, attorney, tax ad visor, banker, accountant, employee, etc.) or lineal descendant of the Exchanger. As stated in the paragraph above, the Exchanger must not have access to the sale proceeds of the relinquished property. The Exchanger is entitled to all earnings on the escrow funds, however often it is only negotiable percentage of the earnings, so be cautious. These taxable funds must also be restricted in the same manner as the principle. The Exchanger chooses the Escrow Agent. The Exchanger is entitled to obtain security for his funds.


5. THE PROPER DOCUMENTATION MUST BE USED IN ORDER TO COMPLY WITH CODE §1031 REGULATIONS:

CODE §1031 EXCHANGE AGREEMENT BETWEEN THE EXCHANGER AND THE INTERMEDIARY

This is the most important document in the Exchange. It is the document in which the Exchanger gives the Intermediary the right to acquire the relinquished property from the Exchanger 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.


CODE §1031 EXCHANGE ESCROW AGREEMENT BETWEEN THE INTERMEDIARY AND ESCROW AGENT

If the selected Q.I. is acting as both your Intermediary and Escrow Agent, the Escrow Agreement will be incorporated into the Code §1031 Exchange Agreement between the Exchanger and the Intermediary.


CODE §1031 EXCHANGE AMENDMENT AND ASSIGNMENT FOR THE ROLLOVER OF THE RELINQUISHED PROPERTY

Assigns the Exchanger's rights in the Agreement of Sale with the buyer to the Intermediary. Serves as written notification to the buyer of the relinquished property of Exchanger's intent to effect a Code §1031 Exchange and also provides a hold harmless clause to assure the buyer that there are no additional liabilities or costs to him. If a §1031 Exchange Clause is inserted into the Agreement of Sale, this document is unnecessary.

CODE §1031 EXCHANGE AMENDMENT AND ASSIGNMENT FOR THE ACQUISITION OF THE IDENTIFIED REPLACEMENT PROPERTY
Assigns the Exchanger's rights in the Agreement of Sale with the seller to the Intermediary. Serves as written notification to the seller of the replacement property of the Exchanger's intent to effect a Code §1031 Exchange and also provides a hold harmless clause to assure the seller that there are no additional liabilities or cost to him. If a Code §1031 Exchange Clause is inserted into the Agreement of Sale, this document is unnecessary.


6. EXCHANGER MUST ADHERE TO TIME LIMITATIONS.

The 45-Day Identification Period begins at the closing of the relinquished property and requires the identification of like-kind replacement property.

During this 45-Day Identification Period, you may revoke an identification and make a new one.

If a like-kind replacement property has not been properly identified to the Intermediary by midnight of the 45th day, the Exchange will not work and the taxpayer will be unable to defer the capital gains.

The 180-Day Exchange Period runs concurrently with the 45-day Identification Period and requires the acquisition of at least one of the identified replacement properties. * If the settlement of the relinquished property occurs between October 16 and December 31 of the current year, the 180-day Exchange Period will be shortened to the income tax deadline of April 15 of the next calendar year unless a timely and proper IRS extension is filed for their return. For a corporation, this filing date is March 15 of the next calendar year unless an IRS extension is filed.


7. LIMITATIONS ON THE NUMBER OF REPLACEMENT PROPERTIES THAT CAN BE IDENTIFIED:

1. THREE PROPERTY RULE: Exchanger may identify up to three properties regardless of their fair market value. The Exchanger is not obligated to purchase all three properties but must purchase at least one of the three 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.

2. 200% VALUE RULE: Exchanger may identify more than three properties but their combined or fair market value cannot exceed double (200%) the fair market value of the relinquished property. For example, if a relinquished property was sold for $100,00 and four or more replacements are identified, their combined fair market value cannot exceed $200,000 with 200% or double the sale price of the relinquished property.

Exceptions to the Three Property Rule and the 200% Value Rule:

1. Any replacement property 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, assume a $100,000 property was sold and five properties with a combined fair market value of $800,000 are identified. This will be treated as properly identified provided all five properties are acquired. It is almost impossible to acquire 95% of the property without acquiring all 100% of the property.

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When contemplating an exchange, you should always consult a tax and/or legal advisor to determine what is best for you. Ask yourself what are your short and long-term goals and determine if an exchange will help you get there. For additional information on the new tax changes and how they apply to you, you should consult your tax advisor.

If you feel that you qualify and are interested
in the Code §1031 Like-Kind Exchange, please contact us and we discuss it with you thoroughly and then will refer you our affiliate team experts.