1031 Tax Exchange – Frequently Asked Questions
After years of conducting tens of thousands of successful
1031 exchanges, we found that there are a number of frequently asked questions
related to this type of transaction…
Equity and Gain
Is my tax based on my equity or my taxable gain?
Tax is calculated upon the taxable gain. Gain and equity
are two separate and distinct items. To determine your gain, identify
your original purchase price, deduct any depreciation which has been previously
reported, then add the value of any improvements which have been made
to the property. The resulting figure will reflect your cost or tax basis.
Your gain is then calculated by subtracting the cost basis from the net
Deferring All Gain
Is there a simple rule for structuring an exchange where
all the taxable gain will be deferred?
Yes, the gain will be totally deferred if you:
1) Purchase a replacement property which is equal to or
greater in value than the net selling price of your relinquished (exchange)
2) Move all equity from one property to the other.
Definition of Like-Kind
What are the rules regarding the exchange of like-kind
properties? May I exchange a vacant parcel of land for an improved property
or a rental house for a multiple-unit building?
Yes, "like-kind" refers more to the type of
investment than to the type of property. Think in terms of investment
real estate for investment real estate, business assets for business assets,
Simultaneous Exchange Pitfalls
Is it possible to complete a simultaneous exchange without
an intermediary or an exchange agreement?
While it may be possible, it may not be wise. With the
Safe Harbor addition of qualified intermediaries in the Treasury Regulations
and the recent adoption of good funds laws in several states, it is very
difficult to close a simultaneous exchange without the benefit of either
an intermediary or exchange agreement. Since two closing entities cannot
hold the same exchange funds on the same day, serious constructive receipt
and other legal issues arise for the Exchangor attempting such a simultaneous
transaction. The addition of the intermediary Safe Harbor was an effort
to abate the practice of attempting these marginal transactions. It is
the view of most tax professionals that an exchange completed without
an intermediary or an exchange agreement will not qualify for deferred
gain treatment. And if already completed, the transaction would not pass
an IRS examination due to constructive receipt and structural exchange
discrepancies. The investment in a qualified intermediary is insignificant
in comparison to the tax risk associated with attempting an exchange,
which could be easily disqualified.
How long must I wait before I can convert an investment
property into my personal residence?
A few years ago the Internal Revenue Service proposed
a one-year holding period before investment property could be converted,
sold or transferred. Congress never adopted this proposal, so therefore
no definitive holding period exists currently. However, this should not
be interpreted as an unwritten approval to convert investment property
at any time. Because the one-year period clearly reflects the intent of
the IRS, most tax practitioners advise their clients to hold property
at least one year before converting it into a personal residence.
Remember, intent is very important. It should be your
intention at the time of acquisition to hold the property for its productive
use in a trade or business or for its investment potential.
What if my property was involuntarily converted by a disaster
or I was required to sell due to a governmental or eminent domain action?
Involuntary conversion is addressed within Section 1033
of the Internal Revenue Code. If your property is converted involuntarily,
the time frame for reinvestment is extended to 24 months from the end
of the tax year in which the property was converted. You may also apply
for a 12-month reinvestment extension.
Facilitators and Intermediaries
Is there a difference between facilitators?
Most definitely. As in any professional discipline, the
capability of facilitators will vary based upon their exchange knowledge,
experience and real estate and/or tax familiarity.
Facilitators and Fees
Should fees be a factor in selecting a facilitator?
Yes. However, they should be considered only after first
determining each facilitator's ability to complete a qualifying transaction.
This can be accomplished by researching their reputation, knowledge and
level of experience.
Personal Residence Exchanges
Do the exchange rules differ between investment properties
and personal residences? If I sell my personal residence, what is the
time frame in which I must reinvest in another home and what must I spend
on the new residence to defer gain taxes?
The rules for personal residence rollovers were formerly
found in Section 1034 of the Internal Revenue Code. You may remember that
those rules dictated that you had to reinvest the proceeds from the sale
of your personal residence within 24 months before or after the sale,
and you had to acquire a property which reflected a value equal to or
greater than the value of the residence sold. These rules were discontinued
with the passage of the 1997 Tax Reform Act. Currently, if a personal
residence is sold, provided that residence was occupied by the taxpayer
for at least two of the last five years, up to $250,000 (single) and $500,000
(married) of capital gain is exempt from taxation.
Exchanging and Improvements
May I exchange my equity in an investment property and
use the proceeds to complete an improvement on a vacant lot I currently
Although the attempt to move equity from one investment
property to another is a key element of tax deferred exchanging, you may
not exchange into property you already own.
May I exchange into a property that is being sold by a
Yes. However, any exchange between related parties requires
a two-year holding period for both parties.
Partnership or Partial Interests
If I am an owner of investment property in conjunction
with others, may I exchange only my partial interest in the property?
Yes. Partial interests qualify for exchanging within the
scope of Section 1031. However, if your interest is not in the property
but actually an interest in the partnership which owns the property, your
exchange would not qualify. This is because partnership interests are
excepted from Section 1031. But don't be confused! If the entire partnership
desired to stay together and exchange their property for a replacement,
that would qualify.
Another caveat. Those individuals or groups owning partnership
interests, who desire to complete an exchange and have for tax purposes
made an election under IRC Section 761(a), can qualify for deferred gain
treatment under Section 1031. This can be a tricky issue! See elsewhere
in this publication for more information. Then, only undertake this election
with proper tax counsel and only with the election by all partners!
Are reverse exchanges considered legal?
Although reverse exchanges were deliberately omitted from
Section 1031, they can still be accomplished with the aid of an experienced
intermediary. Since reverses are considered an aggressive form of exchanging,
your intermediary and tax advisor should assist you with exchange and
tax planning based upon successful reverse exchange case law.
The Taxation Section of the American Bar Association has
submitted suggested guidelines for the IRS in evaluating reverse exchanges
and issuing new regulations. Although it is unknown when the IRS will
make a definitive reverse exchange ruling, one is expected in the future.
Why are the identification rules so time restrictive?
Is there any flexibility within them?
The current identification rules represent a compromise
which was proposed by the IRS and adopted in 1984. Prior to that time
there were no time-related guidelines. The current 45-day provision was
created to eliminate questions about the time period for identification
and there is absolutely no flexibility written into the rule and no extensions
In a delayed exchange, is there any limit to property
value when identifying by using the 200% rule?
Yes. Although you may identify any three properties of
any value under the three property rule, when using the 200% rule there
is a restriction. It is when identifying four or more properties, the
total aggregate value of the properties identified must not exceed more
than 200% of the value of the relinquished property.
An additional exception exists for those whose identification
does not qualify under the three property or two hundred percent rules.
The 95% exception allows the identification of any number of properties,
provided the total aggregate value of the properties acquired totals at
least 95% of the properties identified.
Should identifications be made to the intermediary or
to an attorney or escrow or title company?
Identifications may be made to any party listed above.
However, many times the escrow holder is not equipped to receive your
identification if they have not yet opened an escrow. Therefore it is
easier and safer to identify through the intermediary, provided the identification
is postmarked or received within the 45-day identification period.
About the Author:
This article brought to you by Nationwide Exchange
Services. Nationwide Exchange Services (NES) is a leading provider
of 1031 tax deferred property exchange products and services. Learn more
about 1031 Tax
Read more articles by: Nationwide1031
Article Source: www.iSnare.com
Published - August 2006