1031 TAX DEFERRED PROPERTY EXCHANGE FAQ


1031 TAX DEFERRED PROPERTY EXCHANGE FAQ

Q. Why would someone want to do a 1031 Exchange? 


To defer capital gains tax on the sale of commercial, business, or investment  property.


Q.Is a 1031 Exchange a gimmick or loophole in the Internal Revenue  Code? 


No. Section 1031 has been a part of the Internal Revenue Code since the inception of the Code, during the 1920’s.


Q. What type of property is not eligible for a 1031 Exchange? 


Your residence is not eligible for 1031 treatment. Any other property that  is not held for commercial, business, or investment purposes is also not eligible.


Q. Is 1031 only for capital gains? 


No. Section 1031 applies to capital gains taxes (15%), depreciation recapture (25%),  and state income taxes (generally 8% to 9% where applicable). Long-term capital  gains taxes apply to property held over 1 year – gains from property held  less than a year are typically taxed as ordinary income.


Q. How do I start a 1031 Exchange? 


You must contact a Qualified Intermediary before  you sell your property, so that you can complete the appropriate documentation and structure the exchange.  

 Qualified Intermediary 

Q. Do I have to use a Qualified Intermediary? 


Using a Qualified Intermediary is the most common way to receive ‘safe  harbor’ protection for your 1031 Exchange


Q. Can’t my own attorney or CPA serve as my Qualified Intermediary? 


No. A Qualified Intermediary must remain completely independent and cannot  have been your agent in the past 2 years.    

 1031 Timeframes 

Q. Do I have to know what property I will be purchasing when I start the  exchange? 


No. You have 45 days from the sale of your relinquished property to identify  your potential replacement properties


Q. How long do I have to purchase my replacement property? 


You have 180 days from the sale of your relinquished property by which you  must close on the purchase of your replacement properties


Q. What happens if my 45th or 180th day falls on a Saturday, Sunday, or  holiday? Are there any extensions to these dates? 


As a general principle, there are no extensions for either the 45- or the 180-day  rules. However, the IRS has the authority to provide an extension to these deadlines. Recent  examples of such extensions include the terrorist attacks of September 11, 2001 and recent hurricanes.  

 Property Identification 

Q. How many potential replacement properties may I identify? 


• 3 property rule: You may identify up to 3 properties without regard  to their value.

  • 200% rule: You may identify more than 3 properties provided that their  combined fair market value does not exceed 200% of value of the relinquished  property.

  • 95% rule: You may identify any number of properties, provided that you  acquire 95% of the fair market value of those properties.      

 Napkin Rule 

Q. Do I have to acquire a property of equal or greater value? 


Yes, in order to completely defer the applicable capital gains tax. To the  extent you purchase a property of lesser value, you will be taxed on the difference. (See Napkin Rule)  


Q. Do I have to use all the cash proceeds from my sale on my purchase? 

Yes, you must use all cash proceeds from the transaction in order to completely defer the applicable capital gains tax. To the  extent you do not use all your proceeds on the purchase, you will be  responsible for any tax on  the difference.


Q. Do I have to obtain a mortgage on my replacement property in the same  amount or same percentage of debt as I had on my relinquished property? 


No. Just follow the above rules.


Q. Does Seller Financing jeopardize my exchange?  


Seller Financing is considered boot, which means it is taxable in the year(s)  that it is paid (considered an ‘installment sale’). There is a possibility  that the Seller Financing (Note) can be placed into the exchange without paying  taxes, but the note would have to be paid off or sold before the purchase of  the replacement property.      

 Construction Exchanges 

Q. May I purchase replacement property that is not yet built? 


Yes, you may purchase replacement property that is not yet built, provided that the improvements on the property are completed prior to  the expiration of the 180 days. This is a construction exchange with greater  complexity and fees. In a Construction Exchange, the property is held by a specially  formed LLC called the EAT 

 Reverse Exchanges 

Q. May I purchase replacement property before I sell the property that I  own? 


Yes. This is a Reverse Exchange and has greater complexity and fees. Reverse Exchanges  must be initiated before you purchase the replacement property. Again, the property  is held by an EAT    

 Exchanger: Partnerships/Corporations/Individuals 

Q. May a corporation or partnership be involved in a 1031 exchange? 


Yes, provided the entity selling the relinquished property is the same as the  entity purchasing the replacement property. Corporations or Trusts that are  100% owned by the same entity are considered “Disregarded Entities”,  and the same entity for 1031 purposes.


Q. Are there any age restrictions on the exchanger (i.e. are people over  a certain age exempt from paying taxes)? 

 

 Relinquished Property - Holding Period 

Q. How long must I hold my current property in order for it to qualify for  a 1031 Exchange? 


Property involved in a 1031 Exchange must   be held for “investment or  productive use in a trade or a business.”


When looking at “investment intent” the courts will often look  to the period of time over which the property is held. That said, there is no  specific holding period requirement for either the relinquished or  replacement property


Taxpayers who hold their relinquished property for two years satisfy the requisite  intent for a 1031 Exchange (or two tax reporting periods, since in an audit  the IRS may look backwards and forwards two tax returns). A holding period of  over a year has generally been accepted, but may be subject to review by the  IRS. A much shorter holding period has been accepted, where a change in circumstances  indicates that the taxpayer had intended to hold the property for a longer period.  The IRS will look at ‘investment intent’ and will call a taxpayer  quickly flipping property a ‘dealer’ vs. an ‘investor’.      

 Relinquished Property - Personal Residence 

Q. May I use my personal residence in a 1031 Exchange? 


No. If, however, a portion of your property is held either for productive use  in a trade or business or for investment, that portion may be eligible   for 1031 Exchange treatment.


Q. What if I live on part of the property? 


The taxpayer can split the transaction   between 1031 Exchange and   the personal residence exemption (Section 121: $250,000 for an individual or $500,000 for a married couple).


Q. What about a Second Home? 


If the taxpayer has claimed the residence as a second home on their tax returns,  they likely cannot consummate a 1031 Exchange.   If the taxpayer has lived in  the residence over two weeks, the residence is a second home and will not qualify  for 1031 treatment. The two weeks can be longer if 10% times the number of days  that the residence is rented a year is more than two weeks.


Example 1: a residence rented 83 days cannot be lived in by the taxpayer more  than two weeks.


Example 2: a residence rented 200 days cannot be lived in by the taxpayer more  than 20 days.


Q. May I do a 1031 Exchange, and later move into the replacement property  as my personal residence? 


You cannot purchase the replacement property with the intent to move into it  as a personal residence. If, however, you hold the replacement property for  a sufficient time to establish the requisite intent for   a 1031 Exchange, then  you may move into the property and thus change the nature of the use of the property.


After moving into the property, a taxpayer may look to take the Section 121  exemption for personal residences. Under the recently enacted law, to gain the  121 exemption, the property must not have been the subject of a 1031 Exchange  in the previous 5 years (that is, 5 years from the closing of the phase 2 acquisition).      

 Relinquished Property - Foreign Properties 

Q. What about foreign properties? 


Property within the United States must be exchanged for property within the  United States. Property outside the United States can be exchanged for property  outside the United States, but not with property within the United States. The  United States, for purposes of §1031, includes the U.S. Virgin Islands, if  you are doing business there.      

 Relinquished/Replacement Property - Incidental Costs 

Q. What costs or fees are reimbursable to the taxpayer? 


Any costs or fees that are incidental to the sale or purchase. Fees associated with loans,  rental deposits, etc., must be covered by cash in the purchase of   the replacement property or   will be considered boot.


Q. What happens when I need to make a down payment on my replacement property?    


Your Qualified Intermediary may directly wire the down payment from the funds  held on your behalf. Alternatively, you may make the down payment and be reimbursed  at the closing of the purchase of   your replacement property.      

 Tax Deferral vs. Tax Savings 

Q. Is a 1031 Exchange tax-free? 


A 1031 exchange defers   taxes; it generally does not eliminate them.   The replacement property will   carry the tax basis of   the relinquished property – which  means that upon the sale of   the replacement property all   tax will be due or the taxpayer can enter into   another 1031 exchange.


Q. How can deferral turn into savings?  


If the replacement property is   purchased with investment intent, and later  converted to a personal residence, the taxpayer may receive Section 121 exemption  from a certain amount of taxes ($250,000 for an individual or $500,000 for a  married couple). Again, to gain the 121 exemption, the property must not have  been the subject of a 1031 Exchange in   the previous 5 years. Also, at the time  of the death of the taxpayer, the interested parties may be able to take the  estate tax-free. This would depend on the applicable inheritance laws at that  time (currently at $2,000,000 for an individual).      

 Tenancy-In-Common 

Q. What is a Tenancy-In-Common? 


A tenancy-in-common is a form of ownership of real property whereby two or  more individuals own an undivided interest in the property, and upon an owner’s  death, the interest passes to the owner’s heirs. Interests in tenancies-in-common  are usually divisible, and can be placed into   a  101031 1031Exchange  independently.




A TIC is a type of tenancy-in-common that is offered as   a replacement property investment   to 1031 exchangers. TIC’s have Sponsors that purchase the property  and apply for financing on the property. active management in   their replacement property.

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