Dulles Commercial: 1031 Exchange

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IRS Section 1031 is also commonly referred to as "tax-deferred, "tax-free", like-kind" or "Starker Exchanges", this section of the tax code provides a means by which a property held for investment or income purposes can be sold (relinquished) and a replacement property acquired without paying any taxes. As a quick summary, under Section 1031 and subject to the "safe harbor" provisions contained therein, a taxpayer may exchange qualified commercial or investment property for other qualified commercial or investment property. Typically, in a non-simultaneous exchange, the taxpayer sells the property it no longer wants (the "relinquished property") and purchases a "replacement property". If the taxpayer then identifies up to three replacement properties within 45 days of the sale of the relinquished property, and settles on the replacement property within 180 days of the settlement on the relinquished property, the taxpayer can defer all capital gains tax.

Glossary of Terms

Commonly used in tax deferred exchanges

Accommodator
Often referred to as the "Accommodating Party," this person is either the seller or buyer who serves as an intermediary for the exchange, which would not otherwise be necessary to accomplish the exchanger's goals. (Also refered to as a "Qualified Intermediary.")

Basis
Also called "Adjusted Basis. The 'book value" of the property. Basis or adjusted basis is arrived at by taking the property's cost, adding the costs of improvements, and subtracting the depreciation deductions taken over the years that the property has been owned.

Boot
Refers to a consideration or property which is not eligible for a 1031 exchange. Section 1031 lists several kinds of 'boot" property, but most common types of boot are cash, net mortgages, indebtedness relief, partnership interests, and exchanger carry back financing.

Buyer
The person who wants to buy the exchanger's property.

Capital Gains
Results from the disposition of a capital asset such as real estate, stocks, or bonds.

Capital Gains Tax
Gains on properties are taxed at 15% of the gain, In addition, an additional 5% must be paid on the amount of depreciation accumulated on the asset. This is generally referred to as "recapture." Refers to the tax paid on the sale of a capital asset.

Delayed Exchange
Also called a "Starker Exchange." The disposition of the exchange property and the acquisition of the target property are not simultaneous. The exchange property is disposed of in the first step and the target property is acquired in a later step.

Direct Deeding
The practice used in tax deferred exchanges whereby the deed to the target property bypasses the accommodator or facilitator and goes directly to the exchange. All of the closing documents and Settlement Statements read as though the facilitator Qualified Intermediary is taking title to the target property.

Exchanger
The person who wants to complete a tax deferred exchange.

Facilitator
Typically, a corporation that helps structure and document the exchange for a fee. The facilitator's role will vary with the type of exchange. The new name approved by the Internal Revenue Service now is a "Qualified Intermediary." You may hear the term "facilitator" and "Qualified Intermediary" used interchangeably. They mean exactly the same.

Improvement Exchange
Refers to a 1031 exchange where the target property must have its value enhanced to equalize the equity in the exchange property.

Like-Kind Property
Like-Kind property refers to property used for productive use in a trade or business or held as an investment which is eligible property for a 1031 exchange.

Qualified Intermediary (QI)
Normally a corporation that assists the exchanger by properly documenting the exchange and does so for a fee. Also known as a facilitator. New regulations from the IRS have formally approved the use of a facilitator.

Reverse Starker
Refers to a 1031 exchange where the target property is acquired before the exchange property is disposed of by the exchanger. Normally, a facilitator or other third party will hold title to (warehouse) the target property until the disposition of the exchange property can be completed. (Guidelines from IRS were made available in late 2000.)

Seller
A person or entity who wants to sell his property and is willing to pay the capital gains tax. (Note: If you engage 1031 you are the "exchanger").

Sequential Deeding
Refers to the practice used in tax deferred exchanges whereby the deed to the target property goes first to the accommodator or facilitator and then the accommodator or facilitator deeds the target property to the exchange. All of the closing documents, including the documents of conveyance, reflect the title to the target first passing to the accommodator or facilitator.

Simultaneous Exchange or Simultaneous Closing
The disposition of the exchange property and the acquisition of the target property are interdependent: one cannot happen without the other.

1031 Exchange Or Tax Free Exchange Or Tax Deferred Exchange
The term for a transaction where an exchanger disposes of his property and postpones the tax on the gain from that disposition. Improperly called a tax free exchange as the tax is only deferred or transferred to the new property acquired.

Technical Aspects

I. Property Held For Productive Use In a Trade or Business or Held For Investment

In order to qualify for like-kind exchange treatment, the property must be �held for productive use in a trade or business or for investment.� This requirement excludes property held for sale to customers in the ordinary course of business or owned by a �dealer� whose activities �taint� his property from qualification under this section. The acquired property must also be held for one of these qualified purposes.

II. �Like-Kind� Property

Property of a like-kind does not mean property of the precise same type (e.g., an apartment building exchanged for an apartment building). The only requirement is that the property exchanged must be real property for real property, or personal property (with exclusions of certain types of personal property) for personal property. This rule permits the exchange of improved realty for unimproved realty. A long-term lease of real estate (exceeding 30 years) qualifies as real property for exchange purposes.

What Properties Qualify?

This area can be very confusing. Very simply, any real estate used for business, trade or investment purposes will qualify. Examples include apartments, office buildings, multiplexes, single family or condo rentals, raw land, farms ranches, and commercial and industrial complexes. All of these qualify! A lot adjoining a primary residence can also qualify if it is considered investment property.

Mix and Match

You are not restricted to exchanging for property similar or identical to your present property. The IRS allows you to trade raw land for an apartment building, a commercial mall, or a condo rental property as long as the transaction is structured as an exchange. Provided you sell or exchange real property used for business, trade or investment purposes, you can buy (exchange it for) any other type of business, trade or investment properties. For example, you can sell your self operated gas station and buy an apartment building and pay no taxes!

What Properties Don't Qualify?

Internal Revenue Code Section 1034 concerns your personal residence. The home you live in will not qualify for an exchange because you cannot mix IRC Sections 1031 with 1034. In other words, you cannot sell your home and use the proceeds to buy business or investment property without paying capital gains taxes if the gain exceeds $250,000 ($500,000 for married couples). Nor can you sell business or investment properties and buy a primary residence that you intend to live in shortly after acquiring it without paying capital gains taxes. There is however, nothing to preclude you from buying a home that you intend to use as a principal residence in the future and using it as a Qualified Rental Property now for the purpose of the exchange. Remember, all of the properties you exchange for and exchange into a Tax Deferred exchange must be trade, business or investment related.

Stock, in trade or other property held primarily for sale; Stocks, bonds or notes;
Other securities or evidences of indebtedness or interest;
Interests in a partnership (subject to election under subchapter �K�)
Certificates of trust or beneficial interest;
Chooses in action (Lawsuits).

III. �Boot� And Depreciation

Any money received in a like-kind exchange is considered �boot� and is recognized and taxed to the extent received. �Boot� is the cash or other consideration including relief from indebtedness that benefits a party to an exchange when the items exchanged do not have equal equities. If gain is recognized, depreciation will be recaptured (�if applicable�) first to the extent that any gain is recognized until the depreciation is fully recaptured. Click here to learn more about 1031 Exchanges and see the Capital Gains Tax Estimate Calculator.

IV. Non-Simultaneous Exchanges Or Delayed Exchanges (Previously Called Starker Exchanges)

In many instances a typical three party exchange is not workable because exchange property has not yet been identified. Prior to the decision of the Ninth Circuit Court of Appeals in Starker v. United States, 602 F 2d 1341 (9th Cir. 1979), a method to achieve the same result was to permit the cash buyer the right to use the property with an exchange option, until appropriate exchange property could be identified. The Starker case permitted a more attractive alternative structure. In Starker the taxpayer transferred approximately $1,000,000.00 worth of real property to Crown Zellerbach under an agreement which provided that Crown Zellerbach would credit the taxpayer with approximately $1,000,000.00 on its books and locate suitable exchange property to be transferred to the taxpayer over a period of five years. If suitable exchange property could not be located then the taxpayer would be entitled, at the end of five years, to the remaining cash balance of the bookkeeping account as well as a �growth factor� of six percent per annum. The Ninth Circuit held that the �growth factor� was currently taxable as ordinary income, but the overall exchange deferred the capital gain. It should be noted that the structure of this transaction studiously avoided any argument of constructive receipt of cash or its equivalent by the taxpayer. The taxpayer was not entitled to receive any funds and could only accept property for a five year period and the funds were not held in trust or otherwise for the taxpayer. A large part of the decision in the Starker case rests in the substantial financial resources of Crown Zellerbach upon which the taxpayer relied in making the tax deferred exchange.

V. Non-Simultaneous Exchanges And The Tax Reform Act Of 1984

The Tax Reform Act of 1984 imposed limits on the length of time Starker type transactions may be open and further requires that the property to be received in the exchange be identified within 45 days of the original transfer. The like-kind property must then actually be received within 180 days of the original transfer or, if earlier, by the due date of the tax return for that year (including extensions).

VI. Reverse Exchanges

In a �reverse exchange,� before the relinquished property is sold, the replacement property is acquired and placed with a Qualified Intermediary who holds it as title holder until the relinquished property is sold to a third party buyer. With this reverse exchange, the taxpayer preserves the 1031 exchange tax benefits by then receiving the replacement property at the same time the relinquished property is sold. During the time period between the purchase and exchange, the replacement property is net-leased to the taxpayer. Click here to learn more at Wachovia Corporate & Institutional - Reverse Exchanges.

There are two types of reverse exchanges: Safe harbor

In the fall of 2000, the IRS issued a Revenue Procedure (2000-37) which provides a safe harbor for reverse exchanges. This outlines the necessary requirements and procedures to provide taxpayers with a �safe harbor� for the structure of a reverse exchange in limited circumstances. The taxpayer must still be wary of the time limits, and must settle on the relinquished property within 180 days of the time the taxpayer settled on the replacement property. Non-safe harbor

Transactions which are �non-safe harbor� are significantly more complex, and therefore require additional planning and structuring on behalf of the taxpayer.

VII. The Role Of A Facilitator And Qualified Intermediary And The Tax Reform Act Of 1987

The Tax Reform Act of 1987 and the demise of capital gains treatment caused renewed interest in exchanging. However, most two party exchanges are not completed because it is difficult to find target properties with suitable valuations and still comply with the strict time limitations of identification and closing. A need arose for a facilitator that could assure compliance with the statute. A qualified intermediary is a person who: a) is not the taxpayer or a disqualified person, and b) acts to facilitate the deferred exchange by entering into a written agreement with the taxpayer for the exchange of properties pursuant to which such person 1) acquires the relinquished property from the taxpayer, 2) transfers the relinquished property (either on its own behalf or as an agent of any party to the transaction), 3) acquires the replacement property (either on its own behalf or as the agent of any party of the transaction) and 4) transfers the replacement property (either on its own behalf or as an agent of any party to the transaction) to the taxpayer. The qualified intermediary does not have to take legal title to either the relinquished property or the replacement property. By using a qualified intermediary, an exchanger can complete the sale of its own property and take advantage of the time provided in the code to complete a tax deferred exchange. Click here to learn more about a Realty Exchange.

VIII. Managing The Exchange Process

The exchange process must be carefully orchestrated and managed in order to ensure the success of a 1031 exchange. Elkins Lane Realty Advisors is involved with each important facet during this continuum, interfacing with lawyers, accountants, and estate planners. We provide the expert oversight and guidance to avoid a "failed 1031" that results in a large check being written to pay the tax. We are not lawyers, facilitators or qualified intermediaries, but rather consultants to the entire process. We provide brokerage services to dispose of the relinquished property and/or supply replacement properties.

Reverse Exchanges

The "Reverse" Exchange allows an investor to acquire real estate now, when an excellent investment may be available, and to sell his or her property later, when a better price might be obtained. The future sale would be tax deferred. This procedure greatly expands the ability of the investor to take advantage of changes in the marketplace and to improve his or her investment position. The use of a Reverse Exchange has been limited in the past due to a misunderstanding of what it really is. The Reverse Exchange finally received federal guidelines September 15, 2000.

The Basics

There are two methods for completing a Reverse Exchange:

Once the Facilitator acquires the desired property, he immediately trades it to the Exchangor. The Exchangor trades his or her property to the Facilitator in exchange. The Exchangor now owns the property he or she desires and has simultaneously traded his or her property away. The Facilitator keeps the Exchangors former property until a buyer is found. The Facilitator then sells the Exchangors former property to complete the transaction.
After the Facilitator acquires the desired property, he retains ownership until the Exchangor has found a buyer for his relinquished property. Just before the sale, the Facilitator trades the desired property for the property owned by the Exchangor and completes the sale.

When a Reverse Exchange is being contemplated, the investor must determine how the acquisition will be financed. The down payment must be available to the Facilitator for purchase of the property. The down payment is normally borrowed by the Facilitator and repaid when the Exchangors property is later sold by the Facilitator. The Exchangor must decide which of the properties he wishes to have ownership of through the exchange period. The Exchangor may choose to have title to either the relinquished or replacement properties. Financial requirements commonly dictate the appropriate course of action.

The new Reverse Exchange guidelines have justified a procedure used for years. The following are a few of the basic requirements:

At the time the property is transferred to the exchange accommodation titleholder (EAT), it is the taxpayers intent that the property held by the EAT represents either the replacement and/or relinquished property.
No later than five business days after the transfer of the property to the EAT, there must be a written qualified exchange accommodation agreement.
No later than 45 days after the transfer of the replacement exchange property to the EAT, identification of the relinquished property or properties is required. The identification must be consistent with the existing delayed rules.
The combined time period that the relinquished and replacement properties are held in the qualified exchange accommodation agreement is not to exceed 180 days.

The above guidelines are the basics. Please contact Dulles Commercial for the additional details.

Consult Tax and Legal Counsel

Dulles Commercial will gladly evaluate your objectives to give you the appropriate options. Any exchange should be well planned, Reverse Exchanges demand it. Competent tax and legal counsel is critical to the success of this exchange technique.